The Absurdity of Capping Deductions

During the Presidential campaigns and now with the approaching expiration of the Bush-era Tax Cuts simultaneous with the sequestration cuts, a revenue-raising strategy is being bounced around: capping deductions. Now, there are some very bad ways to do this such as only having a cap for households above a certain income level. (sample) But I just want to comment on the concept.

In theory, deductions are there for a reason. They subsidize some sort of an activity that the government wants more of. This is often justified in terms of correcting some positive externality. For instance, defenders of the mortgage interest deduction speak of the fact that home-owners are more committed to their communities than renters, so they make their house more beautiful, they help out at the block party, and do other good things which benefit others. The deduction is a way to incentivized home ownership so that we may get more of those benefits. In other words, the deduction is just another way the government spends money to buy stuff.

One downside of deductions is that some people would be doing the incentivized activity even without the deduction. I might buy a slightly larger house because of the mortgage interest deduction, but the majority of what I spent on the house, I would spend anyways. I might donate more to charity because I can deduce it from my taxes, but I would donate some money anyways. I might get solar panels on my house because of the tax incentives, but my 10 neighbors would have done it anyways. All of this is a significant cost. A big chunk of the cost of the tax incentive pays for activity which would have happened anyways.

But look at what happens when we add a cap. Maybe the tax incentive was going to push me towards a solar panel, but if my charitable deduction and mortgage interest already make me hit the cap, I have no tax incentives for solar panels. But much of my charitable contributions and mortgage interest payments I would have done anyways. With a cap on the deductions, a greater proportion of the cost of the deduction will go towards paying for things people would have done anyways and a lesser proportion of the cost of the deduction will go towards providing incentives. In other words, the average dollar spent on the deduction will buy the government a smaller incentive.

It’s a bad idea. Let’s not do it.

Posted in Economics, Politics | Tagged , | 1 Comment

Abolishing The Mortgage Interest Deduction On New Purchases Only Also Runs Against A Reliance Interest

Over at the Volokh Conspiracy, Ilya Somin talks about the possible abolition of the mortgage interest tax deduction.

As many have pointed out, such an abolition would run against the reliance interest of current homeowners. When budgeting for a house, they assumed that they would get to deduct the interest on their mortgage payments and abolishing that deduction might put a big hole in their budget. Ilya implicitly brings up as a solution the idea of abolishing the mortgage interest deductions only for new house sales.

Regardless the reliance argument does not apply to new purchases that occur after the deduction has been abolished. For them, abolition can be immediate.

This is a mistake for several reasons. First, current homeowners do have a reliance interest in home-buyers benefiting from the deduction. If home-buyers can expect to get the deduction, they will be willing and able to pay more for houses. This is something that homeowners relied upon when they bought their houses. If the deduction is abolished, this could mean a significant hit to home values and whatever plans homeowners may have made relying upon that home value could be disrupted.

Second, and I think much more importantly, this would create a harmful discontinuity in the real estate market: If you currently have a mortgage, you would have an incentive to stay in your current house for longer than optimal in order to avoid giving up the deduction. Otherwise, you would have to settle for a cheaper place/dig into your capital/pay a higher mortgage.

Let’s do a simple illustrative example: You have a house with a $100,000 mortgage and you still owe $50,000 to the bank. The mortgage interest deduction is abolished causing house values to fall by 10%, but you still keep the deduction on your current mortgage. Your house is now worth $90,000. Now you consider moving into an identical house. Well, first, you sell your current house, get $90,000, pay $50,000 to the bank and get to keep $40,000. You buy an identical house for $90,000 a $40,000 down-payment and a $50,000 loan. You’re back where you started right? No. Because you now pay taxes on your mortgage interests which means you have to choose: higher monthly payments, buy a cheaper house or get a longer loan. Or of course, stay in your old house.

I favor abolishing the mortgage interest deduction, but we shouldn’t differentiate old and new mortgages.

On the other hand, the phase-out that Ilya mentioned is in my opinion absolutely necessary. Doing it in one go would mean a significant hit to the wealth of homeowners which could be problematic in the current slump.

[UPDATE] Ilya responds. He is of course correct that a gradual phase-out would soften the market distortion relative to simply grandfathering in existing mortgages.

When it comes to whether we should phase out the deduction or just make a clean cut, I understand Ilya’s eagerness, but I think it would be a mistake. A lot of people have a lot of their wealth tied in the value of their house. A sudden drop could cause a fall in nominal spending through the wealth effect which could have serious consequences for the economy as a whole. I think a multi-year phase-out would be much more preferable.

Posted in Economics, Law, Politics | Tagged , , | 3 Comments

The Unifying Force That Is Capitalism

I have heard countless times the trope that capitalism is an individualistic philosophy. That a capitalistic world is one where every man, woman and child stands alone. The critiques of capitalism are often fond of phrases such as: “No man is an island”, “Standing on the shoulders of giants”, or “You didn’t build that”. They are fighting a straw man.

Capitalism is anything but a philosophy for Robinson Crusoe. At its core, capitalism is a system which enables cooperation between millions of individuals so that they may jointly pursue their diverse goals. This is a process described as the Invisible Hand by Adam Smith. It is the same process described by Friedrich Hayek in The Use of Knowledge In Society. This is something which many economists and philosophers have hammered on for a long time. Leonard Read left us I, Pencil, an essay which illustrates very beautifully this process of cooperation among so many strangers which is embodied in something as small and apparently simple as a pencil. The story of the creation of this pencil was presented by Milton Friedman in Free To Choose.

The Competitive Enterprise Institute has made a short video bringing this essay to life. So next time you hear about the individualistic, alienating, selfish nature of capitalism, tell the story of the lowly pencil to your interlocutor. Remind them of the thousands of people throughout the world who have worked together and benefited through the capitalistic system in order to bring a pencil to your desk. It is a beautiful story that deserves to be told again and again and again. Capitalism is simply the name we give to the things we choose do together.

(HT: Don Boudreaux)

Posted in Economics, Uncategorized | Tagged , | 1 Comment

I really don’t understand Matt Yglesias

Again, Matt Yglesias writes that the Republicans will cave and vote for Obama’s tax proposal. Of course, that’s possible, but his explanation makes no sense to me.

And they won’t refuse to pass middle class tax cuts. It’s true that Obama can’t force them to pass middle class tax cuts. They’ll pass them because they’ll want to pass them. Why will they want to pass them? Well, because Obama’s proposal for middle class tax cuts happens to substantially reduce rich people’s tax bills. The whole debate right now is over the marginal rate applied to income above the $250,000 threshold. The so-called “middle class” tax cuts regard the rates paid at lower brackets. But rich people pay those middle class rates too. Whether you have $45,000 or $450,000 or even $4.5 million in taxable income the “middle class” tax cuts cut your taxes. And Republicans will want those tax cuts.

Matt Yglesias is framing this as though the only agent here was the Republican Congress who has to chose between nothing and Obama’s plan. But that’s an absurd way to look at it. Obama is the other agent. He also has political skin in the game and if the talks break down, he will also suffer. When Matt Yglesias is saying that the Republicans want middle class tax cuts, he is saying that the Republicans prefer Obama’s plan to the status quo. But they also have a plan. And Obama cannot afford another recession. (which many people believe will occur if the legal status quo remains in place) Such an event might very well cost him the Senate in 2 years and would make him slip further in the House. So Obama prefers the Republican plan to nothing. So in that sense, Obama wants the Republican plan to happen.

Ultimately, the Republicans may end up caving completely, or Obama may. Or more likely, they will meet in the middle somewhere. But for the life of me I do not understand why Matt Yglesias keeps pushing such a non-argument.

Posted in Uncategorized

Quote of The Day

“No. I’m not interested in the real world. I am interested in the record.”

-Associate Justice Breyer at oral arguments in Already, LLC v Nike, Inc

Posted in Uncategorized

Le Blog De Jean-Paul Sartre

This is immensely humorous and I can only empathize with the last post.

(HT: Eugene Volokh)

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Matt Yglesias’ game theory is missing something.

Yesterday, Matt Yglesias treated us to a game theoretic analysis of the recent statements by John Boehner. I think he’s using the wrong model.

By the end of this year, the Bush tax cuts are going to expire. That means an automatic tax increase for everybody. Barack Obama wants to partially offset that tax hike. John Boehner wants to completely offset that tax hike. Yesterday, John Boehner put out a statement which basically says he isn’t willing to compromise much and not at all on the all-important-to-Democrats issue of increasing progressivity.

Matt’s analysis is assuming that this is similar to the Ultimatum Game. In the Ultimatum game, players A and B have to split $100. Player A offers a split (let’s say 90 for player A and 10 for player B) and player B decides whether to take the split or reject the split. If player B accepts, the split goes through (player gets 90, player B get 10), but if player B rejects, nobody gets anything. The stable equilibria is that player A offers $1 for player B and $99 for themselves. Player B is then faced with $1 or $0, they off course pick $1.

That’s why Matt says that the Republicans are being stupid. In his model, Barack Obama has picked a split: a small tax hike. Now, John Boehner has to pick between taking Barack Obama’s offer or rejecting it. A small tax hike or a big one. According to Matt, this is a no-brainer. Take Barack Obama’s offer: a small tax hike. It’s better than a large one. I think this is a bad model of what is going on here.

They instead are playing something like chicken. The traditional game of chicken involves 2 cars and a lot of testosterone-fueled stupidity. The two players drive the cars head-on towards each other. If one swerves while the other doesn’t the one who swerves is the chicken and are ridiculed. If they both swerve, everybody has demonstrated some manhood, but gets to go home. If neither swerve, the cars crash and everybody dies.

This is what is happening here. There is no order of operations. At any point, either Boehner or Obama can swerve by accepting the compromise offered by the other side. But if they don’t, they crash and we all pay higher taxes. (something neither of them wants to see happen for electoral and other reasons)

So now we get to why John Boehner would make such a statement: he’s trying to win. How do you win at chicken? It’s simple, you grab a screwdriver, pull out your steering wheel, and prominently throw it out: you transform the game from Chicken to Ultimatum. Once your steering wheel is removed, the other guy knows you actually can not swerve. You’ve given him the choice: everybody dies or he looks stupid. Obviously, he doesn’t want to die, so he swerves and you win.

In politics however, there is no actual steering wheel. So what John Boehner is trying to do is raise the cost of swerving for his side. He makes statements, his people sign pledges, etc… If they cave, they will look stupid. This all has the same aim: change the payoffs of the game such that swerving for them will be worst than not swerving. They want to setup a situation where they can go to Obama and be able to truthfully say: “Look, we are worst-off agreeing with you than we are just letting the tax hike happen.” Of course, Obama is trying to do the same thing. In the end, they might all swerve. Or not.

What about us, the people? Oh, we lose. Why do you ask?

Posted in Politics | Tagged , , , , , | 1 Comment

Why I’m once again taking Brad DeLong off my reading list

When I first got into econ blogs, I put a couple of blogs in my RSS feed: Cafe Hayek, EconLog, Conscience of a Liberal and Brad DeLong’s blog. By now, my RSS feed is a scary monster which never gets down to 0 unread. Some time ago, I cut out Paul Krugman mostly because I don’t like having to click through to read the articles and Brad DeLong because I felt he was a jerk. I’ve never met him in person and he might be a very decent human being, but his writings painted a picture of a very unpleasant fellow whom I would avoid unless absolutely necessary.

More recently, however, Daniel Kuehn’s links to DeLong compelled me to put DeLong back in my RSS feed. I even went and tried to comment. However, it appears that posting a list of cases where SCOTUS was neither “hippy-punching” nor furthering the Republican agenda was against his commenting policy. (I suppose evidence against what he says is “misleading information.”) I figured that as an adult, I can just ignore his comment section and his generally obnoxious tone and focus on the interesting information he passes along.

Just today, I found such a gem. A link to a very interesting Reuters article on a case against Standard & Poor for their role in rating complex securities. I highly recommend reading the article in question. It is very good and as I was reading it, I found myself very interested by what was being said. But simultaneously, I also found myself highly skeptical. Much more so than I could intellectually justify. It didn’t take long for me to realize that the problem was where I had found the article. De Long fills his blog with so much contemptuous bile that I’ve come to instinctually assume that if he posted it, it must be highly biased and without much redeeming value. So I’m again dumping him. Hopefully, Daniel Kuehn, David Glasner, Nick Rowe, etc will link to him when he has something interesting to say and I can find it that way, but I find his writing to be actively harmful to intellectual exploration. I suggest you also drop him from your reading list.

UPDATE: Brad DeLong came into the comments to challenge my characterization of his blog. I must make amend for having hyperbolized my characterization of his blog. It is unfair to say that he “fills his blog with […] contemptuous bile”. However, I find that he does pepper just enough of it (see examples in the comments) in addition to his general style that I for one have a hard time reading his stuff without assuming it must be, as I said above, highly biased. Maybe the failing is mine.

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Taking apples from future generations with no time travel and no debt.

The Great Internet Government Debt War Ceasefire was breached  by Nick Rowe last week and I thought I would jump in. (I’m a red shirt, I don’t expect to survive.) Daniel Kuehn yesterday expressed confusion as to how Gene Callahan was imposing a burden on future generations without any debt. I will try to explain.

We’ll use the Standard Internet Government Debt War Model: Each generation is composed of 100 people who each own an apple tree which produces exactly 1 apple per period. Apples are eaten at the end of every period. Planting new trees is impossible. The government only imposes lump-sum taxes. There is no time-discounting. (because it makes the math much simpler) There is no time travel. With this highly realistic set of assumptions in mind, let us crank through the numbers.

Period 0, Young Als eat their 100 apples.

Period 1, the government taxes Young Bobs 50 apples and gives them to Old Als.

Period 2, the government taxes Young Carolines 60 apples and gives them to Old Bobs.

Period 3, the government taxes Young Daniels 70 apples and gives them to Old Carolines.

Period 4, Young Daniels eat their 100 apples.

Als ate 100 apples at P0 and 150 apples at P1 for a total of 250 apples.

Bobs ate 50 apples at P1 and 160 apples at P2 for a total of 210 apples.

Carolines ate 40 apples at P2 and 170 apples at P3 for a total of 210 apples.

Daniels ate 30 apples at P3 and 100 apples at P4 for a total of 130 apples.

Als, Bobs and Carolines ate a total of 70 apples more relative to the baseline and Daniels ate a total of 70 apples less. It sure does look like apples traveled back in time and without any debt just like Gene Callahan said. (I can’t remember where Gene Callahan posted this.)

But really, it’s not that the debt is impoverishing future generations. It is simply every old generation impoverishing the young generation. Als take from Bobs and Bobs are now poorer.  But Bobs themselves make up for that by taking from Carolines and making Carolines poorer. But Carolines themselves make up for that by taking from Daniels and making Daniels poorer. The reason why Daniels are poorer is not because Als got a transfer. It’s because Carolines decided to take apples from Daniels.

Now, the big difference with debt is the following: those who buy the debt (loan the money) choose to do so and so presumably they get a good deal. So Bobs are not impoverished by Als and Carolines are not impoverished by Bobs. But in the end, retiring the debt requires that somebody who would rather have kept their money send it in and get nothing in return. So again, it’s not the debt that impoverishes. It’s the tax.

Posted in Uncategorized | 4 Comments

Partisanship on the Supreme Court?

Tomorrow morning, the Supreme Court of the United States will most likely announce its ruling on the challenges to the Patient Protection and Affordable Care Act or “ObamaCare”. Many people on the left of the political spectrum have said, sometimes not in so many words, that if the Court rules against the PPACA, it will be because of its supposed conservative political leanings. In other words, that the conservative Justices rule based on politics rather than law.

However, I did notice a pattern. Look at all the commentary on the case and especially predictions on the way individual Justices will vote on the minimum coverage provision. (individual mandate) Everyone is looking at Justice Kennedy as the swing vote. Justice Roberts’ vote is also considered to be largely up for grabs. There are also many who read Justice Scalia’s opinion in Raich and wonder if he might vote to uphold the mandate. I’ve even seen speculation that Justice Alito might vote to uphold the mandate. Of all the conservative Justices, there is only one whose vote is a sure thing: Justice Thomas. On the other hand, I have yet to hear anyone claim that any of the liberal Justices might do anything but vote to uphold the mandate.

Sure, one could argue that this is because the mandate is clearly constitutional and that the liberals are just the sane people in the room, but that story has been quite weak since courts started ruling against the mandate’s constitutionality. Now, I’m not arguing that the liberal Justices are biased. They have a judicial philosophy and interpretation of the Constitution that is favorable to the mandate and I don’t doubt their honesty. But I find it quite odd that the liberal Justices are said to be impartial and yet are also believe to be impossible to sway with arguments while the Justices who might be influenced by arguments are said to be ruling based on preconceived political agendas.

For what it’s worth at this late hour, my prediction is 5-4 ruling the minimum coverage provision unconstitutional (though I’m close to 50-50 on this issue). The community rating and mandatory issue provisions will fall with the mandate, but the rest of the act will stand. The Medicaid expansion will be held up 8-1 with Justice Thomas dissenting. Alea Jacta Est.

Posted in Law