It’s obvious: “Tax incentives are effective tools for managing economic behavior.”
Investing in the creation of tax breaks is just one among many economic investments in political outcomes. Others include the usual suspects: market protections and indirect or direct subsidies. Examples of such outcomes are, respectively, favorable treatment of capital gains (protects securities markets and participants), prohibitions against wine, beer and spirits producers selling directly to consumers (protects middlemen), regulation (or lack thereof) of certain types of financial derivatives (protects money management and participants), or awards of service slots to airlines at public airports (protects airlines and airports), and research or professional education programs at public schools, colleges and universities (subsidizing professions and businesses that hire those professionals; indeed, the first federal earmark for a specific program was for a research institute at Tufts University). Additional subsidies include expressway interchanges, local development rights, water use rights, roads, railroads, airports, road and rail rights-of-way, and zoning law changes. Individuals and organizations invest large amounts of money in such outcomes because they pay off. For example, the location of an expressway interchange may affect the value of a tract of land more than its development. A farmer may earn more money by leaving his land fallow than by planting it (ask lobster fishermen in Maine, this year). In this post, I look at how federal, state and local taxation drive economic behavior and whether they are effective tools at achieving desired outcomes.
I doubt that there is any question as to whether tax incentives drive economic behavior. Investments in favorable tax treatment of income from transactions or work appear to be quite profitable. Corporations and associations invest billions of dollars each year in lobbying programs to achieve such treatment, and, it’s easy to point to examples of classes of businesses and individuals receiving tax breaks. The difficult question is whether they achieve the outcomes desired. First, however, to talk intelligibly about desired outcomes, we must ask, “Desired by whom?” and, “Which outcomes?”
Some outcomes are good for me, some are good for you, some are good for extraction companies (oil and gas, coal, copper, other mining companies), software companies, manufacturers, transportation companies, construction companies, etc.; some are good for homeowners, railroad workers, farmers, the chronically ill, parents of minor children, working parents who pay for child care, and many other groups of people. Sometimes, however, outcomes that are good for one group are bad for another, or, outcomes that are good for particular groups or classes of people are bad for the population as a whole. In the state of Florida, for example, the state insures properties in flood plains or on ocean front property, properties for which owners can’t get private insurance, at rates competitive with private insurance rates for properties that are not in flood plains or waterfront. After every major storm, state and local governments pay to clean up the mess, i. e., the other residents of the state pay most of the cleanup costs. Polluting businesses are a similar case of subsidized activities. State and local taxes, which in Florida consist entirely of flat and regressive taxes, subsidize ownership of property whose ownership benefits the owners, but is costly to the rest of the population. By subsidizing the market for oceanfront property, state government drives prices of that land up to levels above unsubsidized price levels by shifting the cost of this risk to everyone else. This outcome is good for owners, bad for buyers, and worse for everyone not involved in the transaction, except for the state government officials who are elected from oceanfront districts. The net effect is to transfer wealth from state residents to owners of oceanfront properties whether their owners reside in the state at all. These officials receive campaign contributions or other non-monetary benefits from those owners who can afford to buy and own these properties after their prices have been inflated artificially by tax subsidies.
This analysis is focused narrowly, I agree. There’s a lot going on here; no economic behavior is isolated from broad outcomes. That’s part of my point: Economic outcomes and other behavior due to tax policy are never influenced by tax policy alone and the outcomes are difficult, in not impossible, to predict. At a minimum, each rule benefits someone at an economic cost to someone else or to everyone else. In addition, the nature and extent of outcomes are impossible to foresee well enough to manage them in any robust way. In our example of Florida’s subsidized insurance company, we don’t know the costs to beachfront environments of oceanfront development, of its effects on wildlife or the cost to the public of restricting access to beaches and estuaries. We do know that hurricanes destroy buildings or damage them seriously. We do know that oceanfront development accelerates beach erosion. We do know that wildlife is affected radically by habitat destruction. Their costs are hard to assess, especially over long periods. To assess the net costs of ocean front development, we have to identify and assess the benefits and alternatives to it, too. These tasks are by no means easy.
Tax policy, as an instrument of behavior and outcome management, looks attractive. The causal links between policies and outcomes appear direct and obvious. To stimulate construction of single-family homes and home ownership generally, just exempt interest expense on mortgage loans from taxation. A greater portion of income is, thereby, available for debt service; so, a prospective borrower can borrow more money with which to buy a home. Demand for homes rises, land purchases and development and construction rise to meet this new demand. Former landowners become wealthier and their wealth is more liquid and less expensive to deploy. This newfound liquidity takes the form of deposits in demand deposit accounts in banks, which then lend it to new borrowers (including homebuyers, car buyers, businesses, etc.). The money supply increases because banks need to keep only a small percentage of deposit obligations on hand in cash. Voila! A tax exemption for mortgage interest payments stimulates borrowing and demand for construction, which in turn stimulates job growth and the money supply, etc.
However, there is no free lunch…-L. As people buy houses and move out of rentals, rents decrease and, guess what, home prices increase. To what price do home prices increase? They increase to the price at which the monthly cost of home ownership equals the monthly rent you would pay for equivalent space, after tax. Typically, to determine whether to buy or rent, prospective home buyers estimate their long-term top marginal tax rate and estimate their expected mortgage payments by multiplying their expected monthly loan payment by 1 – marginal tax rate, then compare it with their expected cost to rent an equivalent property. The effect of this calculation is to increase the purchase price of the home by the present value of the savings due to the mortgage interest deduction. The net effect of the mortgage interest deduction on the wealth of individuals and on the wealth of the population is zero, except to transfer wealth from buyers to sellers. Home prices may be higher than they would be without this deduction, but, when the loan principal is deducted from the value, the equity remains unchanged. The advantage in buying a home is supposed to lie in its long-term price appreciation. But, real estate prices are cyclical and the long-term rate of appreciation of real property equals the rate of inflation. So, here we are in 2012, with housing prices that have collapsed after a period of ridiculous optimism and price inflation, some of which is due to the availability of the mortgage interest deduction.
The upshot of this analysis is that tax policy rewards some people some of the time, punishes other people at the same time, benefits society as a whole some of the time, and costs society as a whole some of the time. Although it appears to be applicable surgically, it cannot. We just don’t know enough to predict enough of the ramifications to assess the reasonableness or desirability of probable outcomes. Tax policy is a blunt instrument; when we use it to effect outcomes, we always get run over by a train we never saw coming. Before I started thinking about this issue, I assumed that homeownership was just another tool of wealth accumulation. After living through three boom and bust cycles in different geographies around the U. S., I know better from experience and from analysis.
Okay, we shouldn’t use tax policy as a behavior management tool, i. e., as a tool to manage our economy. How, then, should we raise taxes in an equitable manner that will fund the federal, state and local governments?
 Of course, this subsidy drives such prices up to artificial levels, but some of the benefit of subsidized insurance is captured by elected officials in the form of monetary and non-monetary compensation for their cooperation in creating and sustaining this subsidiary. There are other benefits to other groups, such as construction and design firms, too.
 The money supply increases in a geometric series, , where r < 1, a = original deposit amount and r = the percentage your bank can lend. For example, if banks can lend 80% of your $100 deposit on hand, then the money supply increases by a multiple of .