David R. Henderson  

Jared Bernstein Gets Efficiency Wrong

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Jared Bernstein, formerly chief economist for Vice-President Joe Biden, argues for a measure that I agree with him on, but ends up arguing, on one criterion, against the measure. He doesn't know that this argument goes the other way, which is why I titled this post as I did.

The measure: getting rid of the home interest deduction. You can see his argument here. He gives three arguments for it: revenue foregone, efficiency, and fairness. We pretty much agree that the revenue foregone is substantial. Where we would disagree is that I would want the measure to be combined with a cut in the top marginal rates to make getting rid of the home interest deduction more fair. Based on one past discussion with him and on having read many of his posts, I'm guessing that he and I will never agree on fairness.

We also agree that the tax break is inefficient. But even though he titles his post, "Here's What an Inefficient Tax Break Looks Like" and claims that the tax break is inefficient, his own actual argument is that it's efficient. He writes, "The MID [mortgage interest deduction] is widely believed to subsidize home purchases that would mostly have been made anyway, so it scores high on the inefficiency criterion." If the deduction subsidizes "home purchases that would mostly have been made anyway," that means that the deduction does not distort much. Which would mean that it scores high on the efficiency criterion and low on the inefficiency criterion. What makes a tax or a tax break highly inefficient is that it does alter behavior. If I bought Jared's argument that it doesn't much affect purchases of houses, I would be less opposed to the mortgage interest deduction than I am.

Ht to Mark Thoma.


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CATEGORIES: Tax Reform , Taxation



COMMENTS (11 to date)
Ted Levy writes:

He's using "inefficient" to mean "unnecessary", and by unnecessary he means unnecessary to modify people's behavior in the way he thinks desirable.

David R. Henderson writes:

@Ted Levy,
You could be right, but then in this case that would mean that an efficient tax break for mortgage interest would be one that DID cause people to buy a house when they otherwise wouldn't have or to buy a more expensive house than they would have. I doubt that he would defend this.

Jim Glass writes:

A matter of definition, I think.

He seems to be saying that as the high revenue cost does not affect behavior as desired (by increasing home purchases) the revenue lost through the tax expenditure is inefficiently spent. That's reasonable to say and a lot of other people would say the same thing.

You are using another definition, that as it doesn't much affect behavior in the market it does not create a market inefficiency. That's true too, but it is a different use of the same word.

(As a person with a little bit of professional education in both taxation and econ, I appreciate both uses. In fact, I make part of my living by translating the various dialects of English used by tax people, economists, accountants, business owners ... all of whom often use the same words for different purposes, too often leading to mutual aggravation.)

Kevin Driscoll writes:

If we think housing is a near-competitive market, then absolutely less distortion means more efficiency.

I suspect, though, that a number of people (still!) believe that purchasing a home is more expensive than it ought to be and that more people ought to own homes. If we assume that their economics is right, then the market for houses must not be competitive and there is some kind of inefficient underconsumption. So, an efficient tax would boost consumption and decrease deadweight loss. I don't think these people have a conscious economic argument for their claims, but based on their statements we can infer what kind of argument they would have to make.

Jim Glass writes:

I doubt that he would defend this.

No, *he* wouldn't defend it on those grounds, but a lot of other people would, and he is addressing them.

"Get rid of this, it is costly and it is a bad idea in principle. But even if you think it is a good idea in principle, it is costly and just doesn't work. So you should still want to get rid of it."

MingoV writes:

The tax deduction for home mortgage interest distorts the housing market. Many home buyers look at tables of house prices, mortgage interest rates, and their corresponding monthly payments adjusted for income tax savings. This determines how much the buyers will pay for a house. The claim that buyers would purchase the same house without the tax deduction is unproved and almost certainly incorrect.

Mike W writes:

I don't get the "revenue foregone" argument. Doesn't the deduction just result in a lower effective tax rate? What's the difference between that deduction and a lower marginal tax rate? Yes it is targeted at homeowners but since the percentage of homeownership in the U.S. is high it is a broadly utilized deduction and therefore effectively the same as a lower marginal tax rate. Even renters should get the benefit passed through in lower rent. "Foregone revenue" sounds too much like the government is entitled to the revenue but for the deduction.

Bob Murphy writes:

David,

Obviously, you are 100% correct if Bernstein is using "efficiency" the way an economist would normally use it. But if you click all the way through to his testimony, it seems he is being consistent. He's just using an odd definition of the word. Look at this:

--Tax Expenditures Are Often Inefficient: the regressive aspect of many tax expenditures just noted also makes them inefficient. By disproportionately subsidizing higher-income households that are relatively less income constrained, these tax breaks help offset the costs of economic activities that would likely have occurred even without the subsidy. Both theory and evidence support the view that to be most effective in incentivizing desired behaviors, whether that’s home ownership, saving, work, or investment, tax policies must reach those most likely to respond to the incentive.

Here, the “upside down” design of the credits contributes to their inefficiency. Since wealthier households are more likely to purchase a home, save, invest in capital assets, send their kids to college, and so on, without any incentives relative to lower-income households, tax expenditures that disproportionately reach the wealthy, as most do (see Figure 3 below), are inefficiently targeted.

Tax expenditures are also inefficient in that they can distort prices and production in sectors of the market where they channel significant tax breaks. The mortgage interest deduction again provides a good example of the impact of these inefficiencies on the housing market. Analysts widely agree that in its current structure it subsidizes home purchases that would be made anyway, and thus leads to an inefficient subsidy that artificially inflates both the market prices and the size of home purchases, particularly among the most well off.

David R. Henderson writes:

@Bob Murphy,
Thanks. That last paragraph gets at what I was getting at with the term. I should have read it.

Brandon Berg writes:

Broadly, efficiency means achieving a desired goal at minimum cost. In economics, it usually goes without saying that this means maximizing aggregate wealth, or, with a bit of hand-waving, aggregate utility.

But public choice theory tells us that government is likely to have other goals. If the government, for whatever reason, views promoting homeownership as a desirable goal, then it will regard a tax incentive as more efficient the more it increases homeownership and the less it reduces total tax revenues.

Mike Rulle writes:

It always struck me as absurd to argue against the mortgage interest deduction. If an individual invests in mortgages one pays tax on interest earned. If a corporation borrows money it receives a deduction on interest paid and pays taxes on interest earned.

I can go either way as long as it is symmetric. Why is this rarely raised as the key issue?

The reality is that the tax code is a cherry picked mish mash of rules for favored groups. We are all probably in many of the groups favored or disadvantaged. Why play along by arguing about the "efficiency" of the mortgage deduction.

It is like arguing about parking rules in a ravaged city.

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