Why You Should Care that Half of Your Fellow Citizens Pay No Income Tax

Filed Under (U.S. Fiscal Policy) by Jeffrey Brown on Apr 15, 2010

April 15 – tax filing day.  Undoubtedly, the newspapers will be full of the usual debate about whether the rich pay too much or too little in taxes. 

A Washington Post article (reprinted here) written by my fellow economists Rosanne Altshuler and Roberton Williams last week has received a fair amount of press coverage by pointing out that “about 45 percent of households will owe no federal income tax in 2010.”  This has led to the usual debates about whether this is “fair” or not.  But “fairness” is not a particularly well-defined notion, and your view of it probably depends a lot on whether you are one of those paying taxes, or one of those not. 

Rather than get into a debate about fairness, I want to make a point about economic efficiency, and a point about the interaction of politics and economic policy.  

The economic efficiency point is straight out of introductory public finance.  Most taxes have two impacts.  First, they redistribute resources in some way.  Second, they usually change relative prices and therefore distort economic decision-making.  These distortions in economic decision-making lead to real economic costs.  There are many names for it – the deadweight loss of taxation, including the excess burden of taxation, the efficiency cost of taxation, even the Harberger Triangle (named after the eminent economist who rigorously made this point). 

Whatever name you use, the point is simple: when you tax an activity, you not only raise revenue, but you also destroy some economic value along the way.  In other words, to raise a dollar of revenue, you may destroy another 25 or 30 cents of activity in the process of raising the dollar.  These excess burdens are not always easy to see with the naked eye because often it is in the form of something that did not happen – a transaction that never occurs, an hour of labor withheld from the market, an investment not made, and so forth.  Think of the “dog that did not bark in the night.”       

What is particularly important about this is that the size of this excess burden grows with the square of the tax rate.  That means, essentially, that if you double the tax rate, you significantly more than double the excess burden.  In short, each dollar of revenue gets a more expensive to collect.

As a result of this, most economists agree that the most efficient way to raise a given amount of revenue is to have a smaller tax rate applied to a larger tax base.  The Tax Reform Act of 1986 was a particularly good example of tax policy designed to do exactly that – including more sources of income in the tax base, removing special exclusions and exemptions, and then lowering the marginal tax rate.    

The fact that 45% of households face no income tax is one of many indications that we may have too narrow of a tax base, and therefore too high of a tax rate.  (There are many other examples, most of which are even more quantitatively important, including things like the exemption of home mortgage interest or health care insurance premia). When we leave one person untaxed, the tax burden on the remaining individuals must be higher.  And, importantly, the deadweight loss is higher. 

The second point I would make is that when nearly half of the population pays no income tax, what incentive does that half have to control government spending?  As we have learned over and over again in numerous contexts (including 3rd party insurance payments), people are a lot more likely to spend money when the money they are spending is somebody else’s.  After all, who wouldn’t like more public spending if somebody else is going to foot the bill?  

So whatever your views about the “fairness” of who pays taxes, let’s be clear that it has real economic and political consequences.  

You Can’t Diversify Your Investment in Your House!

Filed Under (Finance, U.S. Fiscal Policy) by Don Fullerton on Mar 5, 2010

Jim Berkovec was a colleague and co-author of mine when I was at the University of Virginia.  He then became an economist at the Federal Reserve Board, and later moved to Freddie Mac.  Just a couple of months ago, I got some very bad news that Jim had died in a bicycle accident.  At the young age of 50, he was out for some exercise near his home in the Washington DC area.  He was going too fast down a hill and around a curve, and hit a slippery patch.

So in honor of my friend Jim, I want to tell you about our joint research project, a 1992 paper in the Journal of Political Economy, called “A General Equilibrium Model of Housing, Taxes, and Portfolio Choice.”

This research starts with the observation that a wise diversification strategy would include not only U.S. stocks and bonds, but also real estate (and even assets in other countries).  You don’t want all your eggs in one basket.  And for real estate, diversification would mean spreading your investments across properties in many different locations.  That kind of diversification might be possible for rental real estate, but for two reasons it is not possible for your owner-occupied house. 

First of all, you can’t live in all those diversified locations.  The fact that you own the house where you live means that you must have all your eggs in one basket.  And the federal government encourages people to own their own homes, through tax advantages for homeownership, so the government is discouraging diversification.  When a bad event occurs, the homeowner loses the whole basket.

A second reason the homeowner cannot diversify properly is that the amount of the housing investment must be tied to the amount of housing one wants to consume.  You can’t pick the house size that is best for your investment portfolio, if you have to choose the house size that fits your family or other life style choices.  Some people like to spend their money on vacations or electronics, while others like to live in a great house.  Choosing based on those preferences means not balancing your investment portfolio. 

Having an unbalanced portfolio means taking extra risks, and it makes us worse off.  If you invest in one stock or one asset, you get the normal expected rate of return and a large variance (large risk).  If you invest in a diversified portfolio, you still get the same normal expected rate of return, and low variance (low risk).

That might all seem like an unavoidable fact of life, if folks are to own their own homes.  But government policy can make it better or worse.  Just compare the following alternatives.   If government were to take away some housing incentives by disallowing property tax deductions or mortgage interest deductions, then you would still own your whole house.  Those measures do not help share this risk.  But suppose that government were to treat housing just like any other asset.  That is, suppose you had to treat yourself as a renter in your own home: (1) calculate the amount your house would rent for, if it were rented to someone else, (2) include that imputed rent as income on your income taxes, and (3) continue to deduct mortgage interest paid and property taxes paid, just as a landlord would do.  You could also (4) take additional deductions for maintenance and insurance, as a landlord would do.

If homeowners were all in a 33% tax rate bracket, then the government would be taking one-third of all returns to all housing investments, and it could then return that money to everybody through some other tax reduction.  We would NOT be paying higher taxes, overall, but the net effect is that we each would “own” only 2/3 of our own home, and we would each – through our government – become part owner in one-third of everybody else’s home.

In other words, we all would be better diversified, effectively sharing in the returns to all real estate all around the country, with less of an investment in the one house we choose to live in.  According to the economic model in my research with Jim Berkovec, that policy would make us all unambiguously better off.

Jim was a pretty smart guy, and a great researcher and friend.  We’ll miss him.  Here is the official “abstract” of the more technical version of this research paper:

We describe a model in which rental and owner housing are risky assets, tenure choice is endogenous, and each household is constrained to consume the same amount of owner housing that it has in its investment portfolio. At each iteration in the search for an equilibrium, we determine the new taxable income for each of 3,578 households (from the Survey of Consumer Finances), and we use statutory schedules to find the marginal rate and tax paid. Equilibrium net rates of return are major determinants of the amount of owner housing, but a logit model indicates that demographic factors are the main determinants of ownership rates. In our simulation, taxes on owner housing would raise welfare not only by reallocating capital but also by the government’s taking part of the risk from individual properties and diversifying it away. Measures to disallow property tax or mortgage interest deductions do not help share this risk. Simulations of the 1986 tax reform indicate a small shift from rental to owner housing and welfare gains from reallocating risk.