Friday, August 29, 2008

More on tax cuts (pun intended)

Economist Jason Furman (real economist, not self-proclaimed, he has a Ph.D. in economics from Harvard and served as Special Assistant to the President for Economic Policy in the Clinton Administration.) notes that the Congressional Budget Office, the Joint Committee on Taxation (JCT), and academic researchers have found that tax cuts that are financed by borrowing, hurt the economy over the long run; please see here for more.

So in other words, tax cuts that are financed by just increasing the deficit mean more national borrowing, which lowers net national savings, and thus investment. And as any family knows, the less you save and invest, the poorer you are over the long run. Thus, the serious unbiased studies that have been done show that a dollar in tax cuts ends up costing more than a dollar over the long run, not less, if it's financed by government borrowing.

What if it's financed by cutting government programs? Well, as I wrote in my last post, many of those government programs have extremely high social returns, like alternative energy, infrastructure, education, basic scientific and medical research, etc., and are things that the free market will grossly underprovide (provide at a level far less than that which yields maximum growth and welfare) due to market imperfections that are well established and proven in economics (real, scientific academic economics, not screaming talk show host, propaganda tank economics), like externalities, asymmetric information, impracticalities of patenting, large economies of scale and monopoly issues, the zero marginal cost of information and ideas, the inability to price discriminate well, and many more available in any university introductory and intermediate economics texts.

Tax cuts, on the other hand, it has been found, tend to eventually be spent, by and large, on short term consumption items of little or no productive or investment value. If you cut your spending on productive infrastructure, alternative energy, education, etc. to give big tax cuts to Paris Hilton and friends so they can buy more million dollar Ferraris, and have more nights in $50,000 hotel rooms, you end up far poorer as a nation over the long run, not richer. These things have little or no productive or investment value. They're consumption, not investment. A dollar in tax cuts ends up costing you far more than a dollar over the long run, not less, as the Republican machine would like us to believe.

What if you cut wasteful government spending? Well, that should be cut no matter what, with or without tax cuts, but history has shown that cutting of waste actually decreases -- and greatly -- when we have Republican administrations and these giant tax cuts tilted massively towards the rich. There are several reasons for this. First, Republicans dislike and disrespect government, so they put little or no effort into learning how to run it well. Second, cronyism is ingrained in the party (update: please see here.), and third, there is a culture of corruption, and this is largely necessary if Republicans are to maintain power. With positions that are so harmful to the vast majority of Americans, they need to please rich corporate and individual donors in order to raise the money necessary for large scale advertising and propaganda to mislead and distract.

So the tax cuts end up being financed by government borrowing and cutting of government programs that have high or extremely high returns. You don't get richer by "saving" money by cutting your investment in your education, your mutual fund, and your government bonds, so you can spend it on a five star vacation or a new SUV.

Finally, what about Republican claims that tax cuts will make people work more hours because it increases their pay per hour? First, people today, by and large, work so hard, and spend so little time with their families by historical standards and compared to people in other countries, that it's not at all clear that this is desirable, and it's not even physically possible to work many more hours at this point. In addition, there is a point where production is decreased from more hours, because eventually it really hurts the quality of work. People become tired and burnt out. Competence and creativity are hurt. But aside from any of this, it has been shown in economics that in fact there is little long term relationship between tax rates and work hours. For most of the 20th century real wages per hour went up greatly at the same time that hours worked dropped. There's little long term effect, and what effect there is can easily go in the other direction. Cutting taxes can decrease work hours. A key reason is the long ago established and accepted in economics, income and substitution effects, which you can find in any university microeconomics text.

The idea is this: If you raise someone's wage from $8/hour to $12, they may go from 40 hours/week to 45, because they get $4 more for giving up an hour; that's the substitution effect. But if you raise their wage from $8/hour to $1 million/hour, they will probably work like 40 hours per year! And then spend the rest of the year enjoying all of that money. That's the income effect. When you raise someone's wage per hour, they don't have to work as many hours to live in a way that they consider well. Empirically, it appears that with taxes at about their current level, the income effect becomes greater at about the middle class level, and then we get what's called a backward bend to the labor supply curve. Cornell economist Robert Frank has a nice brief New York Times Economics Scene article explaining all of this, "In the Real World of Work and Wages, Trickle-Down Theories Don’t Hold Up".

A dollar spent on tax cuts costs more than a dollar over the long run, a lot more.

With regard to Mark Thoma's August 27th post, "The Whole Analysis Sounds Pretty Fishy":

So the the right wing propaganda tank, Tax Foundation, claims that tax cuts recover up to 40% of their costs through so-called dynamic effects, while Bush's own Treasury Department estimated less than 10%.

Even if it actually were 40%, are tax cuts a good idea, especially tax cuts going predominantly to the rich and extremely rich? They're still costing the government 60% that can't go to many extremely high social return projects that the free market won't undertake due to market imperfections that are well established and proven in economics (real, scientific, academic economics, not screaming talk show host, propaganda tank economics), like externalities, asymmetric information, impracticalities of patenting, large economies of scale and monopoly issues, the zero marginal cost of information and ideas, the inability to price discriminate well, and many more available in any university introductory and intermediate economics texts.

Suppose we consider continuing Republican policies and spending another 1 trillion on tax cuts for the rich. Even if 40% were recovered (and in the long run, as opposed to just looking at short run effects, the dynamic effects go in the opposite direction -- a dollar in tax cuts ends up costing a lot more than a dollar in government revenue if that means a dollar, or even 60 cents, less in investment in high return government projects.).

The vast majority of the tax cuts, it has been shown, will eventually be spent on consumption items of little long run investment value -- leaving little to show or to grow. If instead, even just 60% of that 1 trillion were spent by the government on extremely high social return investments like infrastructure, education, basic scientific and medical research, alternative energy, etc., then 10 or 20 years from now that 600 billion could result in many trillions, or even tens of trillions more in national wealth, as opposed to having the whole 1 trillion spent on rapidly depreciating Ferraris and yachts, and ultra luxury vacations and other things for the rich that have little or no productive value.

In the long run, a dollar spent on tax cuts for the rich, instead of badly needed social investment puts us one more step closer to losing our status as the most wealthy and modern nation, and over the long run, like any other decision to increase frivolous consumption at the expense of high return investment, it costs us a lot more than a dollar, not less.

Wednesday, August 27, 2008

Housing prices can't drop too much. The good far outweighs the bad.

In response to Mark Thoma's post today, Wishful Thinking:
"Are we near the bottom? Is the end near? I wish I could answer yes"
Mark, please think very carefully about this. Do you really wish housing prices would stop falling? Do you really think it would be better to have housing be more expensive? Do you really think the costs of lower housing prices outweigh the benefits? Do you really think it's better to preserve the wealth of a minority of wealthier homeowners and investors, at the expense of the middle class and poor, who are really hurt by high home prices? I know most of the middle class own homes, but they can't benefit from higher home prices unless they move to a smaller or otherwise less desirable home. Their children, on the other hand, can be devastated by high home prices.
Harvard bankruptcy and personal finance expert Elizabeth Warren points to high home prices as the primary (later stage) reason for our epidemic of financial distress, and the primary reason why over the last generation family fixed expenses have gone from 54% of gross income with just one spouse working to 75% for two (from Warren's book, The Two Income Trap, pages 50-53), with the inflexibility of this leading to debt spirals and today's epidemic of financial distress.
As Warren notes in her 2007 testimony before the Senate Finance Committee, "In 2004 the median homeowner was forking over a mortgage payment that was 76% larger [in real inflation adjusted dollars] than a generation earlier." (page 6). So now with home prices dropping, maybe it's down to 50% higher, so we should stop making something as fundamental as housing more affordable? That would be a good thing?
Lowering of housing prices, over the long run, does immensely more good than bad. It's a great thing. They can't go too low. What if they went to 1 cent for the average home? That would be bad? Over the long run that would make almost all families and individuals immensely more financially secure, to have just a trivial mortgage or rent payment. The lower the better for housing prices. The good this does far far outweighs the bad (although I certainly agree with well constructed aid for deserving homeowners at risk of, or in, foreclosure, and for other deserving people in financial distress). For more details, I have a brief paper regarding this.

Wednesday, August 20, 2008

It's not just the economy in general that's far better under Democrats; the market's excess return has been higher by 9 percentage points

Jonathan Chait, in his current New Republic article, "Bush 36,000", notes "A recent Wall Street Journal editorial argued that, if the economy was sinking, it must be in part because markets fear the prospect of Barack Obama winning and raising taxes. (You thought Obama was up because the economy was bad? Turns out you had it backward.)"

As Chait has noted in his writings, historically, and for very good reason, the economy has been far better under Democratic administrations, and there are many sources reporting this, for example, two posts on the blog of Princeton Economist Paul Krugman, here and here.

What's much less known is that the stock market does tremendously better historically under the Democrats than under the Republicans. UCLA financial economists Pedro Santa-Clara and Rossen Valkanov report this in a 2003 paper published in arguably the most prestigious journal in academic finance, the Journal of Finance. The paper is "The Presidential Puzzle: Political Cycles and the Stock Market".

In the abstract they report just how amazingly better the market does under Democrats:
The excess return in the stock market is higher under Democratic than Republican presidencies: 9 percent for the value-weighted and 16 percent for the equal-weighted portfolio. The difference comes from higher real stock returns and lower real interest rates, is statistically significant, and is robust in subsamples. The difference in returns is not explained by business-cycle variables related to expected returns, and is not concentrated around election dates. There is no difference in the riskiness of the stock market across presidencies that could justify a risk premium.

Friday, August 8, 2008

Real home prices still need to drop to return to the historical trend level

The Case-Shiller graph shows real estate prices going from 100 to 130 between 1/2000 and 4/2008. Shiller has a highly respected data set of home prices going all the way back to 1890. He finds that although there are plenty of bubbles, busts, and flat periods, the average real (inflation adjusted) return (price appreciation) is just 0.4% per year (See Shiller's book "Irrational Exuberance", 2nd edition, Chapter 2).

If home prices had kept following that average trend they would only have risen to 103.38 rather than the 130 they had risen to over that 8 year and 4 month period. For prices to deflate to the average trend level they would thus have to drop from 130 to 103.38, a 26% drop. This is a good piece of good evidence pointing to a further drop in home prices of about one-quarter over the next few years.

Why over the next few years? Because Yale Professor Shiller's home price data also shows that home prices deflate slowly. Owners take a long time to admit that they are going to have to lose a lot of money if they are going to be able to sell their homes. They hold out. It also takes a long time to absorb excess building.

While a 1/4 drop may not seem that bad, you have to keep in mind that it's a 1/4 drop on a lot of money. Consider buying a $200,000 home now versus waiting 3 years. If you bought now and the price did drop by 1/4 you would lose $50,000 from the home price depreciation, but also, if you bought the home for cash, you would not have the $200,000 to invest in, say, a well diversified stock portfolio. The historical average return on such a portfolio is about 10.5% compounded annually. So over 3 years that $200,000 you spent on the house would have produced $69,847 in return, so your total loss from buying instead of waiting would be $69,847 + $50,000 = $119,847. Now, you would save on rent over 3 years, so that should be subtracted out. Suppose you would have rented an $800/month apartment. Over 3 years, with foregone return on a stock portfolio, that's $33,718; but subtracting it from the $119,847 still leaves you better off from renting by $86,129, a huge amount of money for most individuals or families.

What if a well diversified portfolio of stock doesn't have it's average historical return? There is risk to stock investing, but I think it's reasonable over the long run (in a well diversified portfolio), and low relative to the very high historical average return. I, like Wharton investments expert Jeremy Shiller, and many other top experts, think that a well diversified stock portfolio is a great way to invest most, or in some cases all, of your long run savings. Nonetheless, owning your own home with no mortgage is normally a great idea; it adds a lot of security, and in today's America that's really important, but it looks like it would be better to wait at least a year or two right now and keep saving, because it looks like home prices will drop substantially.

What if you don't buy for cash? What if you take out a mortgage? Then you only forego about 6% in mortgage interest (with good credit), not the 10.5% in average historical stock price return. Plus, you get the mortgage interest tax deduction.

In response to that, first, for most families the mortgage interest tax deduction is close to outweighed by having to pay property taxes, although this depends a lot on your particular tax situation. In addition, when you own you have to pay for maintenance and homeowners insurance, and these are substantial. There's also risk to a mortgage too, especially a large one (Remember the crucial personal finance advice of Harvard Professor Elizabeth Warren, never let your total Must-Haves (fixed expenses) exceed 50% of your take-home income.) If something goes wrong (job loss of a spouse, high medical bills, etc.), and that's a lot more likely in today's America than in the America of a generation ago, you risk foreclosure, or having to sell the home quickly at a fire sale price.

For most individuals and families, when you run the numbers it will still favor waiting, especially if the alternative is a significantly smaller and/or less opulent apartment or rented house. The bachelor living in a $600 apartment will probably be far wealthier three years from now if he stays there, and invests all of the money he's saving over buying in a well diversified stock portfolio, than if he purchases a $300,000 house.