Category Archives: New Publications

The Home Mortgage Interest Deduction: A Bad Deal for Taxpayers

A new policy brief released by the Mercatus Center and co-authored by Jeremy Horpedahl and Harrison Searles analyzes one of the most popular—and therefore one of the most difficult to reform—subsidies in the tax code: the home mortgage interest deduction. This study touches on many of the points that Emily talked about in her op-ed on the subject last month; namely, this policy’s failure to achieve its intended effects and the fact that a lion’s share of the benefits go to high-income homeowners. Despite widespread enthusiasm for the home mortgage interest deduction, the authors argue that the benefits of this policy are overstated and the consequences are understated.

The home mortgage interest deduction is one of the largest tax expenditures in the U.S. tax code, second only to the non-taxation of employer-provided health insurance and pension contributions. Proponents of the home mortgage interest deduction argue that this policy provides needed tax relief to the middle class and encourages the oft-invoked American dream of homeownership. These folks may be surprised to learn, as Horpedahl and Searles point out, that a mere 21.7% of taxpayers even claim this benefit. What’s more, most of these benefits don’t go to the middle class, but rather to households with incomes of over $200,000. Here’s a breakdown of the tax savings from the brief:


The claim that this policy is necessary to encourage home ownership is dubious as well. The authors explain:

Empirical evidence supports the claim that the mortgage interest deduction has little effect on homeownership rates in the United States. Between 1960 and 1997, homeownership rates stayed within a narrow range of 62 to 66 percent, despite the fact that the implicit tax subsidy fluctuated dramatically. During the recent housing bubble, the homeownership rate rose to 69 percent, but it has since returned to the historical range. This rise appears to have been unrelated to the mortgage interest deduction, though it was almost certainly related to other housing policies that encouraged the bubble. More sophisticated analysis suggests that the homeownership rate would be modestly lower without the deduction, by around 0.4 percent.

Ironically, the home mortgage interest deduction likely creates the perverse effect of discouraging homeownership by artificially raising home values. Economic intuition suggests, and empirical studies have supported, that the deduction does not provide much in the way of savings at all since the value of the deduction is simply capitalized into the value of home prices. The artificially higher house prices prevent would-be home owners on the margins of affordability from purchasing a home within their price range. This effect, combined with the low rates of deduction claims and concentration of benefits to high-income earners, likely contributes to the inefficacy of the home mortgage interest deduction to boost homeownership to the degree that its proponents envisioned.

Additionally, countries like Canada and Australia have managed to produce comparable rates of home ownership as the US without the crutch of a mortgage interest deduction.

While the home mortgage interest deduction doesn’t do much for increasing the number of houses, it has a knack for increasing the size of houses, as a study by Lori Taylor of the Federal Reserve Bank of Dallas pointed out. The deduction has had the unintended consequence of directing capital and labor to high-income residential housing projects that might not have been taken without government intervention—and the benefits overwhelmingly go to the wealthy.

This is all before considering the regressive effects of the policy by design: low- and middle-income renters are made to subsidize the increasingly opulent residences (and sometimes the extra vacation homes!) of their more well-off peers while they struggle to make ends meet in a sometimes-inhospitable economy. This injustice, combined with the inefficacy of the tax deduction to increase homeownership in any meaningful way, causes the justifications for the mortgage interest deduction to grow scarce.

In fact, it is becoming increasingly clear that this policy, which evaded the fate of its similar counterpart—the credit card interest deduction—during the tax fight of 1986, continues as law not because of good economics but because of bad political incentives.

Horpedahl and Searles offer three proposals for scaling back the home mortgage interest deduction: policymakers could 1) eliminate the deduction entirely, 2) eliminate the deduction while simultaneously lowering marginal income tax rates to compensate for the virtual tax increase, or 3) stop the deduction and replace it with a tax credit that taxpayers could redeem upon purchase of their first house. Horpedahl and Searles demonstrate that while this deduction is popular with the public and the real estate industry, it is simply a bad deal for most taxpayers.

New Research on West Virginia’s Medicaid Reforms

Today, the Mercatus Cetner released a new policy brief by Tami Gurley-Calvez on Medicaid reforms implemented in West Virginia, based on a working paper she wrote this fall.  In 2007 the state enacted a Medicaid redesign with one objective being to reduce the rate at which Medicaid patients visited emergency rooms for non-emergencies. Additionally, the plan, called Mountain Health Choices, was intended to incentivize healthy behaviors among Medicaid recipients.

The “choice” in the new plan was an option for women and children to opt into an enhanced plan or default into a basic plan. The enhanced plan offered greater benefits but required participants to agree to “doing [their] best to stay healthy’ and to agree to visit their primary care physician for non-emergency treatment. The objective of reducing ER visits was to both reduce healthcare costs for state taxpayers and to improve healthcare outcomes.

Gurley-Calvez finds that with the Mountain Health Choices reforms, patients on this enhanced plan did visit the emergency room at lower rates. However, patients who defaulted into the basic plan began to visit the emergency room at a higher rate, potentially because they were not eligible for treatment for some illnesses with a primary care doctor. She explains:

Based on this research, states should consider whether they can create a greater connection between health providers and members’ involvement in their own health care. However, policymakers must be cognizant of what drives member decision making in their policy designs. In the West Virginia case, a majority of members did not enroll in the enhanced plan in the short term despite additional health coverage and no direct monetary costs to enrollment. Further, states should consider the possible costs, both near term and future, of restricting treatment options by limiting coverage levels.

This case of attempted cost savings by changing incentives represents an ever-present challenge in public policy. Predicting how people will react to new policies in a changing world is difficult, and policymakers should not be overly confident that the incentives that they design will result in the outcomes that they anticipate.

New Research on Streamlining Commissions

Tomorrow I’ll be at the Association for Public Policy Analysis and Management Fall Research Conference to present research on streamlining commissions with Carmine Scavo. Carmine and I have written one paper developing a methodology for studying these commissions, and we’re now working on case studies of commissions in nine states.

Well over half of states have appointed one or more streamlining commissions in efforts to find budget savings or to improve state programs. We’re studying streamlining efforts in California, New Mexico, Louisiana, Alabama, Colorado, New York, Maine and Virginia. We hope to get an idea of how effectively these commissions have reduced the size of state government and found efficiencies in existing programs. We also hope to identify the characteristics that make commissions most likely to meet their goals.

In our first paper, we hypothesized that commission success would depend on the following characteristics:

1) clearly defined objectives regarding their final product;

2) a clear timeline for this deliverable with an opportunity to publish interim advice. Preliminary findings indicate that the commission should have at least one year to work;

3) adequate funds to hire an independent staff to study some issues in depth;

4) a majority of the commission members from outside the government. The commission chair certainly should be from outside the government in order to help to get around the challenges that inherently restrict the ability to find streamlining opportunities while working in government. Preliminary findings indicate that representatives from the state legislature and administration should be involved as a minority of the membership to ensure that the commission’s recommendations have buy-in from policymakers.

So far, our research indicates that funding for commissions may not be as important as we’d though. Some commissions have achieved successes with essentially no budgets while others that were well-funded developed recommendations that didn’t go anywhere.

Tomorrow we will be presenting our preliminary findings on the California Commission on the 21st Century Economy, the Colorado Pits and Peeves Roundtable Initiative, and the Virginia Commission on Government Reform and Restructuring. Once we finish this research I will write up our findings in more depth here. If any of you will be attending the APPAM conference, I hope to see you there.

New Research on Dedicated Taxes

Earlier this week, George Crowley and Adam Hoffer published new Mercatus research on dedicated tax revenues in the states. The practice of dedicating tax revenues to a specific purpose is popular among both politicians and voters. Dedicating new taxes to a specific program gives the illusion of fiscal discipline by making it appear as if the new revenue is not contributing to the overall growth of government.

As an example, policymakers may implement a cigarette tax dedicated to funding public health programs. On the surface, such a program appears to achieve many laudable goals. It could curb smoking rates and improve health without a big increase in the size of government or increasing the tax burden for nonsmokers.

As Crowley and Hoffer demonstrate, though, dedicated tax revenues don’t actually go to the programs they are said to support. Say that a policymaker implements a 1% tax on cars to fund bike lanes and that this tax generates $1 million in revenue. Without the tax, the state would have spent $5 million on bike lanes. Without violating any budget laws, the state could spend, say, $5.1 million on bike lanes under the new tax and then spend the rest of the “dedicated” revenue on whatever programs they like.

The practice is perhaps easier to see at the household level. Governments can give low-income food stamps, as a subsidy “dedicated” to food. If a household gets $100 in food stamps per week, it’s easy to sell the program as providing $100 of additional food per week. This is an inaccurate way to look at it though. Without the subsidy, the household will spend some money on food, say $80 on food per week. With the subsidy, they now spend an extra $20 on food and have $80 left over for other goods. At the state level and the household level, this effect takes place because money is fungible. Specific dollars cannot be dedicated to specific uses.

Crowley and Hoffer’s research is important because the revenue from dedicated taxes is difficult to follow. Policymakers can take advantage of this characteristic to mask the growth of state government. Crowley and Hoffer suggest that voters should seek to ban the practice of earmarking tax revenues for specific programs to make the growth of state governments more transparent.

The Appearance of Fiscal Prudence in Maryland discussed on WBAL-TV

Yesterday I did an interview with David Collins of  WBAL-Baltimore on my recently published paper co-authored with Benjamin VanMetre in Maryland Journal on Maryland’s Spending and Affordability Committee (SAC). Set up in 1983, the SAC was put in place to help legislators control the growth of spending. Over the interim, spending has grown beyond the capacity of annual revenues to keep pace. Thus, the SAC, created to ensure spending discipline, has presided over the creation and continuation of a structural deficit in Maryland. In 2010, the effectiveness of the SAC was called into question by the SAC itself. In this TV report the reasons for the SAC’s poor performance are discussed as well as what a rule to control spending might look like.

You can check out the video here.

 

 

 

New Research on Freedom and Entrepreneurship

Here are a few findings from my recent paper with Joshua Hall and John Pulito titled “Freedom and Entrepreneurship: New Evidence from the 50 States”

  • Humans are entrepreneurial by nature. We desire to improve our material well-being, which drives us to innovate, often through new business creation. Despite the ever-present tendency toward entrepreneurship, public policy can have a significant impact on the incentives for entrepreneurial activity. Economists often call these incentives the “rules of the game.”
  • When making the decision to take on a new business, entrepreneurs must weigh the risks against the potential payout. Policy makers have the power to raise the cost of starting a new business by raising taxes or increasing regulatory costs, and they have the power to lower the cost by pursuing stable and consistent public policy initiatives consistent with economic freedom, such as low, broad-based taxes and prudent regulation.
  • Previous research has demonstrated that “rules of the game” favoring lower taxes and limited regulation—as measured by economic freedom indices—encourage entrepreneurship. Studies have found similar results both in comparisons across the states and in comparisons across countries. “Freedom and Entrepreneurship: New Evidence from the 50 States” uses an index of freedom, the Mercatus Center at George Mason University’s Freedom in the 50 States by Will Ruger and Jason Sorens. The study confirms earlier results: economic freedom permits higher levels of entrepreneurship, as measured by the creation of new businesses.
  • Freedom in the 50 States includes measures of both economic and personal freedom. Personal freedom had not previously been studied as a factor in the entrepreneurship level, and this study found that it did not in fact have a significant impact on business creation. Only economic freedom appears to have a positive impact on entrepreneurship, although personal freedom is of course important for other reasons.
  • This additional evidence that economic freedom is correlated with entrepreneurship should encourage policy makers to pursue changes that increase their states’ economic freedom. The evidence suggests that by increasing economic freedom, policy makers have significant power to improve their states’ climate for new business creation. For example, if policy makers in Ohio— which currently ranks 32nd in the Freedom in the 50 States’ Economic Freedom index—increased the state’s ranking to the level of Nevada, which ranks 23rd, Ohio residents could expect to see a 33 percent increase in new business creation. Lower tax rates, lower regulatory burdens, and lower barriers to trade can all encourage citizens to pursue their drive toward entrepreneurship.

Click here to read the paper in its entirety.

Reforming State and Local Pension Plans

The Government Accountability Office recently issued a report that provides a nice analysis on the changes that have been taking place in state and local pension plans over the past few years. According to the GAO’s tabulations, the following reforms have been implemented since 2008:

 • Reducing benefits: 35 states have reduced pension benefits, mostly for future employees due to legal provisions protecting benefits for current employees and retirees. A few states, like Colorado, have reduced post-retirement benefit increases for all members and beneficiaries of their pension plans.

• Increasing member contributions: Half of the states have increased member contributions, thereby shifting a larger share of pension costs to employees.

• Switching to a hybrid approach: Georgia, Michigan, and Utah recently implemented hybrid approaches, which incorporate a defined contribution plan component, shifting some investment risk to employees.

The reforms listed in this report seem to indicate that some states and localities are taking a step in the right direction in regards to pension reform. There is, however, a lot more work that needs to be done. One reform, for example, that we need to see more of is shifting public sector pensions from defined benefit to defined contribution plans (see Scott Beaulier’s recent paper for more on this topic). As the GAO report points out, roughly 78 percent of state and local employees participated in defined benefit plans in 2011 – compared to 18 percent of private sector employees.

Another important topic that this report touches on is the discount rate debate. That is, whether or not states should base the discount rate on the expected return of plan assets or on relevant interest rates in the bond market (Eileen Norcross has done some valuable research on this topic here and here).

 

New Medicaid Case Study Highlights the Role of Politics in Policy

Last week, Scott Beaulier and Brandon Pizzola released new research on Medicaid, conducting case studies of five states that have implemented reform measures designed to control program costs. They find that the political climate is essential to the success of reforms.

Medicaid is a cost driver in state budgets for several reasons, but an important factor is that most states have designed the program so that a formula determines the amount of federal money they receive based on state-level Medicaid spending. Reforms which move to essentially a block grant program, as implemented in Rhode Island and Washington, have so far successfully reduced Medicaid spending by eliminating this incentive. These two states have moved to a system where the federal government pledges a fixed yearly amount toward their Medicaid spending. If the full amount is not spent, the remainder can be transferred to the general fund. This reverses the incentive from spending as much as possible to searching for cost savings. Both states have also introduced measures of individual patient responsibility, requiring, for example, that Medicaid recipients do not rely on emergency rooms for routine care. While it is too soon to tell if Rhode Island and Washington will manage to control costs in the long run, both states appear to have achieved improved incentive structures for doing so.

These states passed reform bills not by making a gradual transition to new policies, but by moving decisively. In contrast, Florida lawmakers attempted to test reforms in two counties before expanding them to apply to the rest of the state. This time lag served as an opportunity for interest groups to block further changes. Rhode Island and Washington developed support from these interest groups by framing the issue as the state against the federal government rather than one of winners and losers within the state. In Tennessee reform has not been successful because key interest groups like the Tennessee Medical Association did not get behind proposed reforms, making them unworkable in practice.

Despite the apparent successes in Rhode Island and Washington, the federalism research that Ben and Eileen explored last week reveals that block grants are not a panacea. Block grants, like all intergovernmental spending, carry with them fiscal illusion. This obfuscates program costs to taxpayers by spreading the funding across multiple layers of government. While moving from a matching funds formula to a block grant is an improvement in transparency, total spending is still obscured. Furthermore, while neither state has failed to keep spending within the the budgeted block grant so far, it’s hardly inconceivable that program costs will outpace grants at some point, leading states to seek bailouts after implementing reforms.

The demonstrated reasons to be pessimistic about the viability of programs whose costs are shared across state and federal governments leave reason to question whether or not block grants are successful tools for curbing costs in the long run. However, Rhode Island and Washington have chosen a path that is at least more sustainable than other states, which face incentives to increase Medicaid spending with no limit in sight.

Why Are Cell Phone Taxes So High?

Nationwide, combined federal, state, and local taxes on cell phone services average more than 16 percent. That makes a cell phone one of the highest taxed goods around. Cell phone taxes are even higher than beer taxes.

Why?

Image by Carlos Porto

My colleague, Thomas Stratmann, and I attempt to answer that question in our latest working paper. Most of the conventional rationales for above-average taxation just don’t apply: cell phones don’t have obvious negative externality characteristics, they are no longer luxury goods, and consumers are not particularly insensitive to price changes.

So why would policy makers choose to tax them so much? Part of the answer is that no single politician does choose to tax them that much. Instead, the high taxes that we pay on our cell phones are the sum of lots of little taxes imposed by several different political entities. Consider, for example, the tax bill of a typical New Yorker. It includes a federal USF fee, four state taxes, five city taxes, and a local 9-1-1 fee. Each of these is relatively small, but when you add it all up, the combined rate is over 22 percent.

We believe that this pattern of taxation is characteristic of what Columbia Law School Professor Michael Heller has called a “tragedy of the anticommons.”

In the better-known tragedy of the commons multiple parties have the right to use one resource and tend to over-use it since they fail to account for the way that their use harms others (think of the ocean; it’s owned by everyone and is over-fished). In a tragedy of the anticommons, however, multiple parties have the right to exclude others from using a resource by taxing or somehow regulating its use.

Heller points to the Rhine river as a classic example. Under the Holy Roman Empire only one party–the Empire–had the right to tax trade on the river. The government was careful, then, not to over-tax (over-exclude) trade. But once the Empire fell, multiple barons gained the right to tax trade (p. 3):

The growing gauntlet of “robber baron” tollbooths made shipping impracticable. The river continued to flow, but boatmen would no longer bother making the journey. . . . For hundreds of years, everyone suffered—even the barons. The European economic pie shrank. Wealth disappeared. Too many tolls meant too little trade.

Like the barons on the Rhine, multiple parties have the power to tax cell phones: Federal, state, county, city, and special district coffers all tax the base. In many cases, multiple taxes apply even at one level of government (e.g. five taxes levied by the city of New York).

We test the anticommons theory using variation in tax rates and taxing entities across the states. We write:

The anticommons problem has two dimensions. First, the mobile-service tax base funds numerous distinct projects at each level of government. Second, the base is taxed by numerous overlapping levels of government. We use state-level data from three years to examine the possible economic, demographic, and political factors that might explain the variation in these rates. We find that wireless tax rates increase with the number of overlapping tax bases.

New Tax Foundation Study on Unemployment Insurance across the States

On Monday, the Tax Foundation released a new study by Joe Henchman on Unemployment Insurance policies in the 50 states. The study highlights that while the federal-state program is supposed to be counter-cyclical, in reality states do not use periods of high growth to prepare their unemployment trust funds for recessions. At the beginning of 2008, most states were prepared to pay less than one year’s worth of high unemployment benefits, leading to quick insolvency for many states’ funds in recession.

In order to provide benefits, states have had to borrow from the federal government. Henchman explains:

Beginning on September 30, 2011, states must pay approximately $1.3 billion in interest on those outstanding balances; in many cases, businesses and employees in those states will also face increases in federal unemployment insurance tax rates as a result of those federal loan balances. These new interest obligations and tax increases, if they ultimately occur, come at a time when private sector hiring is already at a low level and states are under significant fiscal pressure. These unemployment insurance fiscal policies may exacerbate negative job growth and tax trends, instead of operating countercyclically as the program was intended.

The study also provides analysis of the different taxes and benefits across the states. The compilation of the variation of tax rates, duration of benefits, funding gaps, and other policy factors makes this paper an excellent jumping off point to look at state level reforms based on states that have performed relatively well in this program compared to the neighbors.

In a more ambitious policy proposal, Henchman recommends Individual Unemployment Benefit Accounts as an option for reform. These accounts, which Chile adopted in 2002, provide a measure of income stability during periods of unemployment. Unlike state-administered UI programs, though, private accounts do not carry the perverse incentives that may dissuade people from finding work while they are receiving these benefits because money which goes unused during unemployment can be accessed upon retirement. In 2010 Eileen Norcross and I did a brief analysis of the incentives that the current UI program provides and came to the same general policy recommendation.