Hypocrisy and McMansions

Happy Thanksgiving Weekend!

With the national economy sputtering and unemployment around 9%, many Americans will need to tighten their belts this holiday season. Meanwhile, Democrats and Republicans in Washington teamed up to serve up a big order of Hypocrisy on a silver platter.

On November 18, President Obama signed into law a bill that reinstates higher conforming loan limits for the Federal Housing Administration through 2013.

In plain English, home purchasers can now receive cheaper financing on home loans up to $729,750. The financing is "cheaper" because it's effectively guaranteed by the federal government (i.e., taxpayers). The interest rate on non-conforming jumbo loans is roughly 0.75% higher that the interest rate on conforming loans.

Hypocrisy...

Gee, isn't this a sign of progress? Team Obama was finally able to hammer out a bipartisan consensus with Republicans. The House passed the bill with a healthy 298-121 majority. Of the dissenters, 101 were Republicans and 20 were Democrats.

The main progress here was the blatant display of hypocrisy. Politicians didn't hold their noses against the stench and enact this bill in the dead of night. They transparently abandoned their "core principles" in broad daylight.

Let's start with the Democrats. The Obama administration and Congressional Democrats have relentlessly spun the following narrative:

The Great Recession was brutally difficult for lower- and middle-income Americans. But upper-income Americans emerged largely unscathed. And many of them actually profited from the economic downturn. The top 1-2% have "unclean hands" because they have not suffered the harshest effects of the economic downturn. And it is time to "spread around" some of their wealth by creating or expanding government programs funded by increased taxes on the top 1-2%.

Rhetoric aside, these tireless advocates for the middle class understand where their bread is buttered. The most expensive real estate in the United States is concentrated in Democratic strongholds on the East and West Coasts. Wealthy liberal enclaves provide enormous financial support to Democratic politicians. Note that House Democrats overwhelmingly supported the legislation.

A middle-class American cannot afford a million-dollar McMansion. She does not need a $700,000 jumbo loan, conforming or non-conforming. This legislation was nominally intended to keep an ailing real estate market on life support. But the main people hurt by a softer real estate market are the affluent real estate brokers and financial institutions that service upscale local markets. To quote tax blogger James Maule, "boo hoo" for affluent real estate brokers. Democrats howl about cuts to services for the "most vulnerable" Americans. Yet when push comes to shove, they prioritize subsidies to affluent real estate brokers by propping up home values in the wealthiest communities.

How about the Republicans? Most Republicans argue that free markets work, and that government intervention tends to cause more problems than it solves. Many Republicans have criticized government policy for exacerbating the housing bubble that burst in 2007 with such a devastating effect.

But Democrats do not have a monopoly on wealthy political donors in expensive homes. The "crony capitalism" that riled up the Occupy Wall Street crowd has deep roots on both sides of the political aisle. The main Republican advocate of the bill was John Campbell (R-Calif), whose constituents in Orange County have taken large haircuts on million-dollar homes. Republicans lose all credibility when they argue that certain sectors of the economy should remain on taxpayer-funded life support.

Republican also like to play the "certainty" card. They frequently argue that the economy is sputtering because individuals and businesses are uncertain about the future of government policy. But in this case, Republicans reversed course on a prior aspiration to scale back the federal government's role in residential housing finance. The acting director of the Federal Housing Authority bluntly criticized the legislation as "sending the wrong signal."

...and McMansions

The federal government (i.e., you and me as taxpayers) provide two main subsidies to the residential housing market. The first involves federal loan guarantees, which shift risk from private lenders to the government and, ultimately, taxpayers. Federal loan guarantees make it cheaper for homeowner to borrow money, which means that they can bid more for homes.

The second involves the deduction for home mortgage interest. Effectively, the mortgage interest deduction is a tax subsidy for home owners. Although the mortgage interest deduction is capped, it has the same overall effect as the federal loan guarantees. By reducing tax liabilities, the mortgage interest deduction frees up cash to service home mortgage principal and interest payments.

Here's the funny thing about the federal subsidies. They are nominally intended to make home ownership more accessible. But they don't make housing more affordable. On the contrary, the subsidies make housing less affordable, because they permit home buyers to qualify for bigger mortgages and pay for more expensive homes than would be possible without the subsidies.

Okay, if homes aren't more affordable, then who benefits from the subsidies? In other words, who benefits from government policies that increase the cost of housing above market rates?

Primarily the housing lobby, comprised of home builders and real estate agents. The former group (home builders) employs large numbers of union and other blue-collar workers in the construction industry. No surprise that Congress might want to direct economic subsidies to this group. In addition, local governments benefit from higher real estate prices, which translates into higher property tax revenues. Many local governments jumped on the bandwagon during the bubble years, assuming that real estate prices and property taxes would increase in perpetuity. They developed long-term budgets and entered into contractual obligations with service providers (teachers, police officers, bureaucrats) that have become unsustainable after the bubble popped.

The deduction for mortgage interest is second largest tax expenditure (estimated to cost $99 billion in 2012). Eliminating it would tend to make housing more affordable over time (by reducing the inflation-adjusted value of residential real estate). That's a bad result for many existing homeowners, but a good result for new homeowners. If political actions mirrored rhetoric, we would expect that Democrats and Republicans could agree on a plan to phase out the deduction over time. Home prices would become more affordable for the 99%. And individuals would re-allocate capital away from (subsidized) housing into more productive activities.

But political hypocrisy is just as certain as death and taxes.

Searching for the Elusive "Fair Share"

On Monday, David Logan of the Tax Foundation issued a report summarizing the individual income tax data from 2009. Highlights (or lowlights, depending on your perspective):

- Nationally, average effective income tax rates were at their lowest levels since the IRS began tracking them in 1986. The average tax rate for returns with a positive liability went from 12.24% in 2008 to 11.06% in 2009.

- Incomes reported by tax returns at the high end of the income spectrum fell from 2008 to 2009, as did their share of the nation's income and income taxes paid. In 2009, the top 1% of tax returns paid 36.7% of all federal individual income taxes and earned 16.9% of adjusted gross income (AGI), compared to 2008 when those figures were 38.0% and 20.0%, respectively.

- Each year from 2005 to 2007, the top 1%'s constantly growing share of income earned and taxes paid set a record. The 2008 reversal of this trend continued in 2009. In fact, the income share for the top 1% of tax returns was lower in 2009 than in 2000, largely due to differences in capital gains.

- In 2009, as in 2008, the top 1% no longer pays a larger percentage of total income tax than the bottom 95%. This trend was exacerbated by the aforementioned precipitous drop in AGI in 2009. During 2009, the bottom 95% (AGI under $154,643) paid 41.3% of the total collected, a larger share than the 36.7% paid by the top 1% (AGI over $343,947).

- The top-earning 5% of taxpayers (AGI equal to or greater than $154,643), however, still paid far more than the bottom 95%. The top 5% earned 31.7% of the nation's adjusted gross income, but paid approximately 58.7% of federal individual income taxes.

- Since 2001, the IRS has also been presenting data on a small subset of the top 1%, the top 0.1%. In 2009, this top 0.1% filed 137,982 tax returns, reporting 7.8% of all adjusted gross income earned and paying approximately 17.1% of the nation's federal individual income taxes. The average income for a tax return in the top 0.1% was $4.4 million in 2009, while the average amount of income tax paid was $1.07 million, indicating an average effective individual income tax rate of 24.3%.

- Overall, these data on high-income tax returns appear to confirm that the continued economic stagnation had the same diminishing effect on income inequality that most recessions have, and that it occurred for the same reason: a sharp decline in income at the high end. This appears to contradict reports based upon Census data suggesting the opposite that the recession increased income inequality.

Logan's report is particularly timely, in the midst of ongoing Occupy Wall Street protests. However, that's a post for another day, if the protesters keep plugging away despite the blizzard approaching the East Coast.

For today, the data inspire several questions. President Obama and his cheerleaders on the political left want to "spread the wealth" around. They believe that "millionaires and billionaires," defined as working professional married couples with $250,000 in taxable income, aren't contributing their "fair share" to the federal government.

Three questions for the political left:

[Q1] In 2009, the top 0.1% of taxpayers paid 17.1% of all individual income taxes, the top 1% of taxpayers paid 36.7% of all individual income taxes, and the top 5% of taxpayers paid 58.7% of all individual income taxes.

What percentage of individual income taxes should be paid by each sub-group to be considered their "fair share"? The answer should be a simple percentage, for example, 25% for the top 0.1%, 45% for the top 1% and 65% for the top 5% (numbers are illustrative only, not my view).

[Q2] If we increase taxes on the top 5% as you recommend in A1, will that solve the short-term or long-term budget gaps associated with current spending projections? Or will we also be required to increase taxes on the bottom 95% of taxpayers to solve the fiscal imbalance?

[Q3] Do you really believe that increasing taxes as set forth in A1 and A2 will address the wealth imbalance between the wealthiest 1% and the remaining 99%? Note that increased taxes on the bottom 99% or bottom 95% will decrease their ability to accumulate resources and "catch up" to the top 1%.

Tax bloggers on the political left, I look forward to seeing the answers to these straightforward questions.

Government Spending: 2x Inflation

On Friday, I discussed Steve Shay's recent insights on fundamental tax reform. Today, I want to circle back to some interesting numbers in Shay's article.

Shay notes that federal on-budget expenditures have grown from $807 billion (18.3 percent of GDP) in 1986 to $2.9 trillion (20 percent of GDP) in 2010. Tax expenditures were approximately $1 trillion in 2010. Thus, the sum of on-budget and "off-budget" spending in 2010 was approximately $3.9 trillion.

According to a report by the Tax Policy Center, tax expenditures were approximately $362 billion in 1985. (I can't quickly locate the numbers from 1986, which were excluded from the Tax Policy Center report.) The sum of on-budget and "off-budget" spending in 1985/1986 was approximately $1.2 trillion.

Adjusting for inflation, $1.2 trillion in 1986 dollars is $2.4 trillion in 2010 dollars. Had federal spending kept pace with inflation, the federal budget would have grown by approximately 100% between 1986 and 2010. Instead, the federal budget grew by more than 200%.

I don't have time to poke around the state data, but I'd be surprised if state expenditures grew materially slow than federal expenditures between 1986 and 2010.

Here is the question for the advocates of big government. During the past 25 years, federal spending has outpaced inflation by more than a 2 to 1 ratio. Are we all better off today as a result? Are the "most vulnerable" Americans and the middle class doing better today than their counterparts in 1986? Has the binge of federal spending increased the quality of life of the vast majority of Americans? Has the growth of federal spending increased standards of living commensurate with the resources tapped to fuel the spending?

If the answer is "yes," then how do you explain 9% unemployment? How do you explain the tea party movement and and nationwide Occupy Wall Street protests? How do you explain the frustration over the inter-generational burden that debt-fueled government spending will place on our children and grandchildren (and their children and grandchildren)? How do you explain the general public dissatisfaction with our political and business leaders?

If the answer is "no," then how do you justify demands for increased government spending? Can government spend more money to "cure" problems that are correlated with increased government spending? Government spending has increased at a 2 to 1 ratio compared to inflation over the past 25 years. Would we all be better off had spending increased at a 3 to 1 ratio? A 5 to 1 ratio? How much faster does government have to grow before before it becomes obvious to everyone that government expansion blunts the vibrancy of the private sector?

Ironically, the expansion of government spending has tracked the rising inequality of income and wealth distribution that so agitates the political left. The left does not seem to realize that bigger government creates more opportunity for business and individuals to capture economic premiums by exploiting the "regulatory state." How does a regulatory or tax attorney justify an hourly billing rate of $1,500 ($3 million/year at 2,000 hours/year)? Because he or she helps businesses and individuals navigate the regulatory state. How does a CEO justify compensation of $5 million or $10 million per year? Because he or she pays the regulatory and tax attorneys $3 million per year simply to navigate the regulatory state!

Steve Shay on Tax Reform

Earlier this week, Steve Shay published an article in Tax Notes with his observations on fundamental tax reform. See "Jobs, Deficit Reduction, Revenues, and Fundamental Tax Reform," 133 Tax Notes 213 (Oct. 10, 2011).

I always pay attention to articles written by Shay and Edward Kleinbard. Both are seasoned tax professionals with experience in private practice, government and academia. Shay practiced with Ropes & Gray for 20 years before jumping to Treasury in 2009. He served for two years as Deputy Assistant Secretary for International Tax Affairs. Kleinbard practiced at Cleary Gottlieb for 30 years before serving as Chief of Staff of the Joint Committee from 2007-2009. After grinding away as tax attorneys for decades, and then bashing their heads against DC gridlock for a couple years, Shay and Kleinbard both sought refuge in the ivory tower. Shay teaches and writes from Harvard Law School; Kleinbard from the USC Law School.

As tax attorneys who represented a wide range of domestic and multinational businesses in private practice, Shay and Kleinbard bring thoughtful voices to the dialogue over U.S. tax reform. Politics aside, we need more contributions to the tax policy debate from experienced practitioners who have a more balanced view of the relationship between the private and public sectors. We get way too much loaded rhetoric from business lobbyists and "career academics" on the political left.

A few highlights from Shay's article:

[1] Shay urges policymakers (presumably aiming towards the political right) not to take revenue increases off the table while considering tax reform options. Shay does not advocate "millionaire surcharges" or the "Buffett Rule," whatever his personal view on those proposals. Shay primarily focuses on tax expenditures, and the opportunity to increase revenues "by eliminating tax expenditures and rationalizing the income tax base, as part of an overall plan to restore a sustainable fiscal policy." He's basically following along a trail blazed by Kleinbard, among others.

[2] In Shay's view, fundamental tax reform "should make the income tax code a fairer and more efficient instrument suitable for the economy of today and the future."

The objective of fundamental tax reform should be a more comprehensive income tax base that is simpler and fairer and does not make losers of domestic manufacturers and winners of video game companies with offshore intangibles.

Funny how that theme keeps surfacing in discussions of fundamental tax reform. I outline the problem of "multinational princes" and "domestic paupers" in this post (discussing a tax reform proposal by Bill Parks).

[3] Shay gently scolds President Obama for his class warfare rhetoric:

[The President] has acknowledged a need for new revenues, but limiting shared sacrifice to those with incomes of $250,000 and above is inconsistent with rationalizing many wasteful tax expenditures that benefit middle-income earners as well as the very wealthy. In exchange for job-creating stimulus, Democrats should be open to sharing sacrifice more broadly, but without sacrificing a fair distribution of overall tax burden.

Shay doesn't define a "fair distribution of the overall tax burden," but he implies that "shared sacrifice" should include tax increases on all Americans. The top 1% of taxpayers currently shoulder 37% of the total income tax burden. If deemed "fair," policymakers could aim to keep that number constant, while increasing overall revenues from the tax system. By definition, such an effort would require an increased "contribution" by the bottom 99% of taxpayers.

[4] Shay bluntly scolds Team Obama for its lack of leadership on tax reform. But let's face it, this administration has other priorities. President Obama focused on socializing health insurance during the worst economic crisis since the Great Depression. Now he's focused on his 2012 re-election despite a widespread economic malaise and 9% unemployment rate. I'd wager my $100 that Team Obama will not lead us to the Promised Land of Fundamental Tax Reform.

Talk is Cheap

The "Occupy Wall Street" protests are a major topic of conversation these days. Thus far, I haven't been able to discern a specific "cause" motivating the protests.

Some protesters are unhappy about "corporate greed," whatever that means. Some protesters believe that the government is not sufficiently focused on "creating" jobs for grad students. Some protesters want more subsidies for green energy. Some protesters want to do yoga in the streets. Some protesters are just unhappy with authority, like the guy who decided to express his outrage by defecating on a police car. Some protesters -- the college-age types -- are along for the ride, enjoying the privileges of youth, parental support, and the spontaneity that accompanies minimal responsibility. Ahhhh ... to be 20 years old with no bills, no kids, no pets, no mortgage payments.

The political left is struggling to articulate a credible narrative for OWS. Linda Beale linked to an editorial by Paul Krugman. Krugman believes that OWS represents a mass uprising against Wall Street oligarchs who bulked up their personal fortunes at taxpayer expense while triggering the Great Recession. But that's Krugman's gripe, with no connection to anything I've heard trickling up from the protesters themselves.

I've never understood why people invest so much time and effort into protests. In law school, I lived across from a Planned Parenthood center. Every weekend, from dusk until dawn, anti-abortion protesters with billboards and hand-outs marched the street, seeking to discourage young women from entering the center to discuss contraception and abortion.

The anti-abortion protesters were exercising a Constitutional right to express their moral convictions in public. However, it always struck me as a complete waste of time. Why not use the hours spent protesting to counsel at-risk teenagers? Or to help nurture foster children or other troubled children from unfit homes? Or to volunteer in a hospital to nurture babies whose mothers were addicted to drugs or alcohol? If you are opposed to contraception and abortion, and thus favor more children in unstable home environments, why not focus your time and energy to improve the lives of existing children who lack stability, guidance and love? And then, when all children are healthy and happy, living in stable and nurturing environments, get back to protesting against Planned Parenthood?

I have the same reaction to the OWS protesters. They got their message into the media. They are exercising a Constitutional right to express their outrage over the failures of our political and business leaders. But why are they devoting so much time to empty rallies? What is shouting whining, stomping and defecating going to accomplish, besides draining local security budgets? Isn't this the same crowd that protests "cuts" to "services" for "the most vulnerable Americans"? Shouldn't the able-bodied college and grad students be volunteering their time in public schools and after-school organizations? Or helping out underprivileged children as Big Brothers and Sisters? Or assisting non-profit organizations that provide meals to seniors and other individuals with limited mobility? Or cleaning up public parks? Any of us can think of hundreds of organizations that would welcome a small army of enthusiastic volunteers with open arms.

But talk is cheap, as the saying goes. Volunteering for a non-profit organization, or a run-down public school, or a foster home, or a senior center, requires people to commit time and effort. It's a drain, physically and emotionally. Let's face it, that doesn't sound nearly as appealing as a "spontaneous" street rave, fueled by Twitter and Facebook, to stomp around and shout about the Great Unfairness of the world. If you can't join Dumbledore's Army, perhaps the hippest substitute is Krugman's Army. But the hipsters aren't making a difference, and Dumbledore probably wouldn't be impressed.

So I'll keep half an eye on the protesters, to see if they develop a coherent message before the winter hits. Meanwhile, my respect goes out to individuals like Larry Powell, whose actions speak louder than their words.