Wednesday, March 11, 2009

The Utility of Wealth Redistribution

How much happiness can someone receive from $100? If you are poor and that $100 is the difference between eating for a week instead of starving, then that $100 might make you very happy. A wealthier person, on the other hand, might receive utility from spending that money on a new pair of shoes. Higher levels of wealth or income are generally assumed to lead to greater utility, but there is also an assumption of diminishing marginal utility in that each additional $100 provides less and less utility. This would suggest that an additional $100 matters more to a poor person than it does to a rich person. That is the basic argument in favor of welfare – that the decine in the rich person’s utility is less than the gain in the poor person’s utility. However, there are many factors associated with utility, and it would be wrong to assume that wealth redistribution would always lead to greater total utility.

The first critique involves the fallacy of interpersonal utility comparison. Money has different effects on different people. Some people don’t care about money and prefer a minimalist, almost monastic, lifestyle. These people may smugly scoff at other people who receive great utility from their conspicuous consumption. Some people are very proud and would lose more utility from accepting a handout than they would receive from accepting that money and spending it. Other people are miserly and greedy and feel the loss of every penny. A transfer of wealth from the miserly and the greedy to the proud and monastic would reduce total utility. I think it’s fairly safe to assume that wealthy people are more likely to place a great value on money in the same way that you assume that someone with a lot of cats probably likes cats. Thus the total utility associated with a transfer of wealth depends on both the level of wealth and the attitude of the giver and the receiver.

Some people could make more money, but they would rather have a life or equate wealth with being a sell-out. Suppose you have two equally able people but one goes into banking because she is materialistic and the other writes poetry because it nourishes his soul. Is it really fair to take money from the banker and transfer it to the poet? Would it be fair to take some of the poet’s soul and give it to the banker? Maybe you think it would be good if the banker had some more soul, but it wouldn’t last. She’d probably just waste the soul to make more money anyways.

The process by which the exchange occurs will also affect utility. Some people may be very charitable and receive greater utility from donating $100 than they would receive from either spending or keeping the money. In the best of both worlds, a wealthy person might gain utility from giving money to a poor person while the receiver gains the utility of $100 worth of food. Now suppose the poor person steals the $100 from the rich person. This has the exact same wealth effect as the charitable donation – the rich person is $100 poorer and the poor person is $100 richer. The utility effect, however, is completely different. The poor person has $100 but may also have the disutility associated with guilt (assuming that the poor person has a conscience). Meanwhile, the rich person has not only lost $100, they’ve lost their sense of security, their power, their independence. In short, they feel violated. Government enforced redistribution of income presumably falls in between the two extremes of theft and charity.
Wealth distribution may also have negative incentive effects. As long as the redistribution involves the fortunate helping out the less fortunate, then it probably increases utility. However, as soon as it crosses that line into punishing the people who made good choices and sacrificed for the future in order to support people who wasted opportunities and ended up poor, then redistribution becomes a utility-reducing activity. Furthermore, it could exacerbate the problem if people become less likely to make good choices and more likely to make bad choices.

This leads to the question of what is done with the money. If the money helps the poor individual get their life on track and eventually out of poverty, then the money is well spent. However, if the money allows them to continue along their current failed path, then the money is wasted.This is not to say that all wealthy people worked hard for their wealth and all poor people are lazy and irresponsible. Some people clearly have better opportunities than others and some people clearly take better advantage of whatever opportunities are given to them. I would personally rather help someone who ended up poor even though they made the most out of their minimal opportunities rather than someone who ended up poor because they wasted the opportunities they had. Unfortunately, it is difficult for government programs to make that distinction. People qualify for help based on their present state, not based on how they got into their present state. Private charity is better able to distinguish among potential beneficiaries in order to determine who most deserves help and who can benefit the most.

Overall, I think these factors cause the utility effects of wealth redistribution to be about half of what a straight analysis would suggest. Basically, you would want to compare the utility loss of $100 of a wealthy person to the utility gain of $50 to a poor person. I have no scientific data to back up this statement, but I’m going to use it as an approximation unless I find reason to change.

Friday, March 6, 2009

The Primacy of Voluntary Exchange

In discussing the role of government in our lives, I am of the opinion that government should try to increase the general happiness (in economic terms we call this utility) of its citizens. But what makes people happy. The government doesn’t know what makes you happy and therefore can’t provide you with happiness. Only you can determine what makes you happy and you display your preferences with your actions. Everything you voluntarily choose to do, you do with the expectation that it will make you happier. Otherwise you would not do it.
Sometimes you make mistakes and take actions that fail to make you happy. Sometimes the actions have both positive and negative consequences. Sometimes the action benefits others as well as making you happy. And sometimes the action harms others while making you happy. Regardless, people voluntarily act in ways that they expect to make themselves happier.
This idea, this Primacy of Voluntary Exchange, is the Hippocratic Oath of Kinky Economics – First, leave people alone. Therefore, any restriction on voluntary behavior, including requirements of involuntary behavior, must be clearly justified, which leads us to the role of government in maximizing utility.
Government, what is it good for? Absolutely nothing. Well, maybe not nothing, but government is the very antithesis of voluntary exchange. It restricts what you can do through laws and regulations and enforces your involuntary support through taxes. Perhaps I am being too harsh. Not everything government does is wrong. Laws that prohibit murder may restrict the voluntary behavior of killers, but they increase the happiness of would be victims. I may not like paying taxes, but I also want services that only the government can provide (or that they can best provide).
Although government does not know what makes you happy, there are some things that government can do to increase overall happiness. Certain responsibilities are clearly the role of government as even the most ardent libertarian will agree. National defense is a government responsibility, although there are differences in regards to the optimal amount of national defense. The legal infrastructure is a government responsibility including both criminal and civil disputes among individuals and legal entities. There is an economic role in providing public goods, adjusting for externalities, and even wealth redistribution. The difficulty is in finding the right role.

Scarcity and the Laffer Curve

Much has been made about President Obama’s efforts to raise taxes on high income individuals in order to fund additional spending programs such as health care, energy, and the stimulus. Critics cry class warfare and complain that the wealthy shouldn’t be punished in order to provide a welfare state. Defenders say that the rich can afford higher taxes without any big impact on their well-being. The bigger concern to me, and one that isn’t getting the attention that it deserves, is this – it won’t work.
Raising taxes on high income individuals will not raise as much money as expected and may raise even less money than before. This top 2% includes business owners, professionals, doctors, lawyers, and anyone in the highest income levels probably has some control over their career and how much they work. They have the option of taking more vacation, retiring earlier, sheltering income, deferring income, or take some other action that reduces the amount of tax revenue that the government takes in. Any reduction in the amount of work done by these people, and therefore their income, will result in lower tax revenues.
The idea behind this is known as the Laffer Curve and it basically argues that work effort is a declining function of tax rates and that there is some tax rate that maximizes the amount of revenue collected. At low tax rates, people work but the government gets very little tax revenue. As tax rates rise, tax revenues will rise but at a decreasing rate. At some point, tax revenues will begin to fall as the reduced work effort dominates the higher tax rate. At extremely high tax rates, people won’t work and no money will be collected. If you wish to draw it, the Laffer Curve looks just like an arch.
The revenue-maximizing tax rate balances the reduced work effort with the higher tax rates. If you are below this point, then raising tax rates will raise tax revenues, but not by as much as expected. If you are beyond this point, then raising tax rates actually reduces tax revenues. Keynesian economists (Democrats) tend to always believe that we are below that point while supply-side economists (Republicans) believe that we are always beyond that point.
I wouldn’t wager a guess as to where we are on the Laffer Curve, but I do know that raising tax rates on the top 2% will not raise the kind of revenue that Obama is hoping for and there is no way to raise more revenue once you are at that optimal tax rate. Therefore, the only way to reduce the deficit is to cut spending, which does not seem to be in the cards given his ambitious plans. The President must remember one thing about Economics – Scarcity exists.

Thursday, March 5, 2009

The Mortgage Shuffle

The current housing market is a mess, at least it is in California, Nevada, and Florida. One in five homeowners owes more than their house is worth and one in eight are either in foreclusure or behind on their monthly payments (a total of 5.8 million homeowners). However, the housing plan currently proposed by President Obama has several flaws, not the least of which is that it rewards people and banks who acted irresponsibly. Banks are "encouraged" to accept lower payments equal to 38% of the homeowners income while borrowers only have to pay 31% with the government stepping in to make up the difference. This ignores how much the house is worth originally or how much it is worth today.
The justification for the plan is that not stepping in will result in further declines in home value for people that are paying their mortgages. Preventing foreclosures and forcing rescheduling of payments through cram-down bankruptcies is not the only solution. A better solution matches owners with homes that they can afford and encourages homeowners to increase, or at least maintain, the value of their home.
There are really two issues involved: how much are homes worth and how much home can a person afford. Both of these factors are important and we must distinguish between them. Homes sell in an illiquid market and it is difficult to measure home values unless there is activity in the housing market. The second issue is how much house someone can afford. Traditional measures suggest that housing payments should be no higher than 31% of income, although that may be adjusted for the amount of other debt and the level of wealth.
One in five homeowners are upside down in that they owe more than the house is worth. This results from some combination of putting little to no money down on their house, having an interest-only loan, and declining home values. Upside-down (or underwater) homeowners that can still afford their house by conventional measures must be encouraged to keep making their payments – any plan that encourages default will only lead to more problems. They also need to have an incentive to maintain the value of their home through general upkeep and maintenance.
If they can’t afford the payments, then they will have to sell the property. Foreclosed homes lose value both for themselves and their neighbors. However, the problem is not the foreclosure, it is the vacancy. Empty homes fall into disrepair, become an eyesore in the community, and discourage current and potential residents. Home values are not independent of the homeowner. Taking care of their property, making needed repairs, and putting on a good face (Sweat Equity) may not turn a home rightside up, but it can keep it from sinking further. Instead of foreclosing on the house, the bank needs to encourage the upkeep and selling of the house, perhaps by hiring a realtor or contractors to assist in repairs. If a $10,000 investment can bump the home value up by $20,000, then everyone wins.
But who is going to buy the house and what is going to happen to the current homeowners (a term I am using loosely)? To a large extent, that depends on how much the homeowner can afford. Suppose a homeowner buys a house for $500,000 that is only worth $400,000. Unfortunately, the homeowner can only afford the payment on a $300,000 loan. The solution is to let the homeowner pay $200,000 (resulting in negative equity of $100,000) for a house that used to be worth $250,000 but was recently vacated by a homeowner who could only afford a payment on a $150,000 house.
Clearly there is a downsizing effect going on here as homeowners leave expensive houses that they can’t afford for cheap houses they can afford. After the fall out, there will admittedly still be expensive houses that remain unsold and poor people left without a home. Some of these losses will be tabsorbed by banks, some by, homeowners, and some by taxpayers. This is much more viable for the government to step into those situations and help out than the massive undertaking it is currently taking (and which will ultimately fail).
Government can assist in this plan by supporting these negative equity loans as long as they conform to the payments are less than 31% of income. I realize that government support of subprime loans through Fannie Mae and Freddie Mac helped to create the situation in which we find ourselves, but a market for these loans can help get us out. The government can go even further in offering loans directly at a fixed rate of 6.5% (or at the current rate) through their soon to be nationalized banks.
A second change is to allow homeowners and or banks to realize a capital loss on the sale of their homes. Currently home sales are considered personal assets and losses are not tax deductible (and gains are generally tax exempt). In reality, homes are the single largest investment for most homeowners and a tax deduction for losses would relieve some of the current pain. Whether or not to change the exclusion on gains is a separate issue.
This solution achieves a few desirable outcomes that are preferable to the current proposal. First and foremost it matches people with homes they can afford. In doing so it creates a market for homes so that they can be fairly valued. It also encourages the maintaining of home values by encouraging people and banks to put in sweat equity in selling their homes as opposed to just walking away or having banks foreclose on the home. Losses are primarily distributed among homeowners who made bad investments and banks who made bad loans with taxpayers only having limited exposure.