Monday, September 16, 2019

Rent control is totally normal price-cap regulation

Bernie Sanders has smashed the Overton window. Rent control is going global.

Unfortunately, this means that the economics 101 brigade has come out in force to smugly Vox-splain their incorrect model of rent control and housing market dynamics.
Regulating housing rents makes economic sense because homes are attached to land monopolies. Monopolies are inefficient, and regulations can improve outcomes. The two classic regulations are 1) a tax on monopoly super-profits, which is common for mineral and energy resources, and 2) a price cap, which is usually applied to network infrastructure, like rail, electricity, and water. If price caps sound to you a bit like rent control, then you would be spot on. They are rent control.

Rent control is not weird or unusual for regulating monopolies. The weird thing is that land is no longer considered a form of monopoly.

Let me explain how these two classic regulations would work in housing markets to socialise monopoly profits from housing locations.

A super-profits tax would work like this. When a new home is constructed, the owner would be able to seek the market rent. That first year’s market rent would become the regulated price that would attach to that home in a rental database. The home would still be allocated in the rental market using open market prices. But any gap between the market price and the regulated price would be 100% taxed. This is shown in the figure below.

If the market price fell below the regulated price for some reason, that loss would accumulate as a credit against future tax obligations when the market price increased again.

With a super-profits tax system housing resources, including new construction, are always allocated by market prices.

Since the financial crisis, rents have increased by roughly 25% in the United States. A quick guess-timate suggests that around a trillion dollars of rents are paid in the US each year. Had such a tax been implemented ten years ago it would now raise about $250 billion a year with no efficiency loss. In Australia, total housing rents have increased from around $30 billion to $45 billion in that period, meaning a housing super-profits tax would now raise around $10 billion per year (after adjusting for the increased housing stock).

The second way to regulate the land monopoly in the housing market is with price caps (rent controls). Here, the sitting tenant is protected from price increases that are not the result of additional housing investment or renovation but arise due to the favourable location-monopoly of the owner.

As before, market prices match tenants to housing and provide incentives for new construction. However, a sitting tenant is protected from price increases that arise from the location-monopoly. This only works if their tenure is secure, and they cannot be evicted as a way to change the rental price back to the market price.

The image below shows how the gap between market price and rent-controlled prices is a transfer to sitting tenants. If market prices fall below the regulated price, the tenant can have the option to renegotiate or move to pay the lower market price. Again letting markets decide resource allocations. It is only in periods of rapid price growth that sitting tenants are protected.

On balance, this type of regulation transfers some monopoly super-profits to tenants in the short-term but gives them back to owners as tenants relocate and homes are again allocated by market prices.

Either system of regulations will socialise some of the monopoly rents in housing markets. In fact, it is widely acknowledged that a reduction in volatility of returns can accelerate new housing investment. Recent studies also show that owners of older housing choose to accelerate redevelopment into more dense housing if their rents are regulated.

Both regulations are common in other monopolistic sectors of the economy. The main issue is that these regulations will transfer billions of dollars of value away from landlords, and landlords won’t like it. And the economic 101 brigade will always find a way to argue that policies to help the poor are bad for them.

Sunday, September 8, 2019

Housing subsidy and UBI confusion

When the Australia government introduced a cash grant for first home buyers, the aggregate effect was to increase home prices by roughly the amount of the grant, quickly negating its effect on affordability.

This observation has led many people to mistakenly believe that giving cash grants in any form will pass through one-to-one into higher home prices (or rents). In discussions of all types of welfare—from UBI, to traditional welfare payments—this error comes up.

The error comes about because people fail to see that when given a choice, people spread their extra buying power across all the different types of goods they consume. An income subsidy is not the same as a subsidy for a particular type of expenditure.

Economists have been studying the way spending patterns vary with income for over 150 years. Ernst Engel noticed in 1857 that as incomes rise, households spend a lower proportion of their income on necessities like food. This observation became known as Engel’s Law, and the income-spending relationships for different goods became known as Engel Curves.

Housing, like food, is a necessity. As such, the share of income spent on housing usually falls as incomes grow. The Australian data shows that even for private renters—where one would expect competition from higher-income renters to bid up housing rents—the share of income spent on rent falls from nearly 50% of gross income for the lowest income quintile households to just 13% for the highest-income households.

This data might seem to imply that it is possible for up to 50% of a cash welfare payment to “pass through” to landlords for low-income households. But remember, this is not the marginal amount that would come out of extra income. Because the share of spending on housing falls as income rises, the spending on housing out of the extra income must be far lower than the average. In fact, across income quintiles in Australia, the marginal additional spending on housing per dollar of additional income sits tightly in the 5-7c range. It may be possible that long-run adjustments mean that more than this marginal amount is spent on housing out of extra income, but it will always be less than the average amount.

The story is rather different, however, if welfare payments are tied to a particular type of spending. This even more important in the case of housing, where the total stock changes extremely slowly and where landowners have monopolistic incentives to prefer price gains over investing in additional supply.

An example is if everyone received a fixed $1000 per month that could only be spent on housing. Because this money cannot be spread across the consumption basket, people would soon learn that they are best off using it to bid up the rent to access their preferred housing location. The macroeconomic reality is that this additional buying power will chase roughly the same number of dwellings, increasing their price.

The difference between a “general income subsidy” and a “housing expenditure subsidy” can be shown using Engel curves. The chart below shows three Engel curves for a household, with the orange representing housing. Blue represents other normal goods, where expenditure rises with income, but a bit faster than for necessities (as per Engel’s Law). The green curve is an inferior good. Household spend less on these goods after their income reaches a certain level.

A “general income subsidy” shifts the household up to a higher income level, and they spend more on all the types of goods in their consumption basket. The effect on housing expenditure is relatively small, as expected by our previous 5-7% assessment of marginal housing expenditure.

The next chart shows the effect of a “housing expenditure subsidy”. The total income of the household is unchanged. They are only able to direct the subsidy towards their housing expenditure. Here, the effect will be to boost buyer competition for scarce housing locations and increase home rents (or prices). This was the case with the first home buyers grant.

Though it is tempting to see them as quite similar, subsidising household incomes and subsidising a particular type of expenditure have rather different economic effects.