The Volokh Conspiracy

Last week I blogged about a very interesting article in the Manhattan Institute’s City Journal by Claremont Review of Books contributing editor William Voegeli titled “The Big-Spending, High-Taxing, Lousy Services Paradigm” (Autumn 2009).  It compared the tax-services models of California and Texas.  VC commenters were spirited as ever and raised a number of important questions.

Although I haven’t had the pleasure of meeting William Voegeli, I took the liberty of contacting him through the Claremont Institute and asked if he might have any additional thoughts for us, particularly responding to VC commenters.  Mr. Voegeli was kind enough to say yes, and has sent along the following response, below.  Let me add, on behalf of the VC community, myself as well as readers and commenters, our great thanks for engaging with us.  And let me add to the VC commenting community, that in the spirit of the original article, you might call Volokh Conspiracy a ... Low-Taxing, High-Services blog!  Mr. Voegeli:

Dear Prof. Anderson:

Thank you for bringing my City Journal article (http://www.city-journal.org/2009/19_4_california.html) on California and Texas to the attention of the Volokh conspirators, and for your generous and thoughtful analysis (http://volokh.com/2009/11/02/the-california-versus-texas-model-and-public-choice/) of the piece.  Your post elicited many . . . spirited comments.  It would be cumbersome to address them individually, but I can offer a few points that speak to some of the general questions your readers brought up.

My essay argues that it’s not enough to look at how much states and localities spend because how well they spend is very important.  I understand several people in the comments section to be saying that this principle applies to the tax side of the equation, too.  Thus, California’s problem is not so much that it is a high-tax state but, as one commenter says, that it is a “constrained-and-erratic tax” state.

That’s a fair point.  The combination of direct democracy and the state’s belief that vast optimism could overcome mundane realities left Californians believing they could somehow be “taxed like libertarians, but subsidized like socialists,” as Troy Senik recently said (http://www.nationalaffairs.com/publications/detail/who-killed-california) in National Affairs.  Not only did it prove impossible to achieve the best of both worlds, but the political impotence created by undertaking the effort helped bring about the worst of both: “In a grim irony, Californians are now being taxed like socialists and subsidized like libertarians.”

Proposition 13 is certainly not beyond criticism.  Some things need to be said in defense of the law and its advocates, however. Lots of poorly drawn laws and state constitutional amendments have been passed at the ballot box.  The ballot initiative is never going to be a precision instrument, however, and it’s unfair to hand the voters an axe and then judge their work as if they possessed a scalpel.

The best way to have averted the enactment of Proposition 13 would have been if California’s political establishment in 1978 had put forward a better alternative, one that addressed Californians’ anxieties about tax escalation without 13’s flaws.  Instead, Gov. Jerry Brown and the Democratic legislature held off for as long as possible in offering any sort of response to the people angry and fearful about rapidly rising property taxes, in the hope that the political problem would blow over.  When it didn’t, they finally devised a tax limitation alternative to 13 whose distinguishing feature was that it didn’t guarantee that anyone’s taxes would be limited.

In the 31 years since Proposition 13 was enacted that bait-and-switch problem crops up over and over.  When people here complain that taxes are too high, especially given the doubtful quality of the public services they purchase, the enlightened response is always that taxes aren’t high so much as they’re arbitrary and complicated.  The correctives proposed to enhance the quality of the citizen’s tax-paying experience all purport to make taxes fairer and simpler, but their one clear outcome is that taxes would be higher.  Thus, the reforms that would streamline how California’s governments collect money would have the consequence of relieving those governments of any obligation to devise better, smarter and fairer ways to spend it.  It takes a trusting spirit to believe that this outcome would be an accidental byproduct of tax reform.

A final note.  One commenter argued that government is expensive in California largely because housing is expensive, thus disproving the idea that California governments spend their money in undisciplined, ineffective ways.  Two points:

• 1) California’s state and local employees are the best compensated in the country (http://www.census.gov/compendia/statab/tables/09s0448.pdf) and the differences between them and their counterparts in states that are also expensive are not trivial.  Local government employees make 11.5% more in California than Connecticut, and 21.4% more than those in Massachusetts.  State workers in California make 13.1% more than New York’s and 19.9% more than those in Massachusetts.
• 2) The high cost of living in California, especially the high cost of housing, is a problem for government, in that it puts pressure on it to increase the pay scale for public employees.  That fact does not preclude the possibility that the high cost of housing is, in significant measure, a problem caused by California’s governments.

Let me close on this point by bringing in an expert witness, Edward Glaeser of Harvard’s economics department and Taubman Center for State and Local Government.  In a Los Angeles Times article (http://www.latimes.com/news/opinion/commentary/la-oe-glaeser4-2009mar04,0,4085382,print.story) earlier this year he said:

Although California is a populous state, it still has plenty of land. Santa Clara County, the home of Silicon Valley, only has about 2.2 people per acre. Even in denser places, such as Los Angeles, there is plenty of room to build.

California’s growth has slowed because the state has made it increasingly difficult to build new homes. There is an almost perfect correlation between the growth of an area and the amount of housing that is permitted in that area. California has some of the toughest land-use regulations in the country, which are often justified as environmental measures. When high housing demand is met with restrictions — not construction — California homes become unaffordable and new construction goes somewhere else.

Best regards,

Bill Voegeli

AP reports on a new Fannie Mae program to allow homeowners who can’t pay their mortgages to rent instead:

Thousands of borrowers on the verge of foreclosure will soon have the option of renting their homes from Fannie Mae, under a policy announced Thursday.

The government-controlled company, through its new “Deed for Lease” program, will allow borrowers to transfer ownership to Fannie Mae and sign a one-year lease, with month-to-month extensions after that.

The program will “eliminate some of the uncertainty of foreclosure, keeps families and tenants in their homes during a transitional period, and helps to stabilize neighborhoods and communities,” Jay Ryan, a Fannie Mae vice president, said in a statement.

But the effort is likely to affect a relatively small number of homeowners. In the first half of the year, Fannie Mae took back about 1,200 properties through this process, known as a deed-in-lieu of foreclosure. That pales in comparison to the 57,000 foreclosed properties the company repossessed in the period. . . . 

The rental program is designed to help homeowners who don’t qualify for a loan modification under the Obama administration’s plan, but still want to remain in their homes. . . . 

Fannie Mae has hired an outside company, which officials declined to identify, to manage the properties. 

In the Depression, when the government took over late or delinquent mortgages, many people just stopped paying because they knew that the federal government usually didn’t have the stomach to foreclose.

With its new rental program and Fannie Mae’s superb record of planning and management, what could possibly go wrong?

William Voegeli, a contributing editor at The Claremont Review of Books, has an excellent essay in Manhattan Journal comparing the economic performance of California and Texas.  (I believe a short opinion page version appeared recently in the LAT.)  Among other things, the article provides a good example for how a public choice analysis can be applied to show, in this case, capture of public revenues and the process of increasing public revenues by public employees in California.

The most interesting feature of the article, however, is that it does not start out from a position of hostility toward California and its high tax model.  On the contrary, it says that there is a tradeoff that different people will make differently with respect to high tax/ high public services jurisdictions and low tax/ low public services jurisdictions.  There is a perfectly good argument for the former as well as for the latter.

It’s true that many people are less sensitive to taxes and more concerned about public goods, and these consumer-voters will congregate in places with extensive services. But it’s also true, all things being equal, that everyone would rather pay lower than higher taxes. The high-benefit, high-tax model can work, but only if the high taxes actually purchase high benefits—that is, public goods that far surpass the quality of those available to people who pay low taxes.

I grew up in California and despite my Upper Upper NW DC address, will always count myself a Californian, product of its public schools and a proud graduate of UCLA.  I was a beneficiary of the high tax/ high benefits model, and gravitate toward it.  The problem, as Voegeli documents, is two fold.  First, California is today a high tax/ low benefits model, while Texas, even with relatively low taxes, has managed remarkably to catch up and even pass California in ways I would not have believed possible.  But Voegeli’s data, as I have discussed it with other Californians and Texans, seems to me pretty robust.  His conclusion?

“Twenty years ago, you could go to Texas, where they had very low taxes, and you would see the difference between there and California,” Joel Kotkin, executive editor of NewGeography.com and a presidential fellow at Chapman University in Southern California, told the Los Angeles Timesthis past March. “Today, you go to Texas, the roads are no worse, the public schools are not great but are better than or equal to ours, and their universities are good. The bargain between California’s government and the middle class is constantly being renegotiated to the disadvantage of the middle class.”

Similarly, the CEO of a manufacturing company in suburban Los Angeles told a Times reporter that his business suffered less from California’s high taxes than from its ineffectual services. As a result, the company pays “a fortune” to educate its employees, many of whom graduated from California public schools, “on basic things like writing and math skills.” According to a report issued earlier this year by McKinsey & Company, Texas students “are, on average, one to two years of learning ahead of California students of the same age,” though expenditures per public school student are 12 percent higher in California.

State and local government expenditures as a whole were 46.8 percent higher in California than in Texas in 2005–06—$10,070 per person compared with $6,858. And Texas not only spends its citizens’ dollars more effectively; it emphasizes priorities that are more broadly beneficial. In 2005-06, per-capita spending on transportation was 5.9 percent lower in California than in Texas, and highway expenditures in particular were 9.5 percent lower, a discovery both plausible and infuriating to any Los Angeles commuter losing the will to live while sitting in yet another freeway traffic jam.

What happened?  According to Voegeli, two things.  One is that scarce tax dollars in Texas are spent on priorities that have broad appeal, while California spends far more of its tax dollars on transfer payments to particular groups with political clout.  Second (and a subset of the first, really) is that the tax dollars in California go to public employees, public employee pensions, public sector unions — nominally to the service providers of the “high benefits” received in exchange for high taxes.  Voegeli reports that they soak up the additional revenue but provide increasingly poor services at an ever increasing cost.

In California, by contrast, more and more spending consists of either transfer payments to government dependents (as in welfare, health, housing, and community development programs) or generous payments to government employees and contractors (reflected in administrative costs, pensions, and general expenditures). Both kinds of spending weaken California’s appeal to consumer-voters, the first because redistributive transfer payments are the least publicly beneficial type of public good, and the second because the dues paid to Club California purchase benefits that, increasingly, are enjoyed by the staff instead of the members.

Californians have the best possible reason to believe that the state’s public sector is not holding up its end of the bargain: clear evidence that it used to do a better job. Bill Watkins, executive director of the Economic Forecast Project at the University of California at Santa Barbara, has calculated that once you adjust for population growth and inflation, the state government spent 26 percent more in 2007-08 than in 1997–98. Back then, “California had teachers. Prisoners were in jail. Health care was provided for those with the least resources.” Today, Watkins asks, “Are the roads 26 percent better? Are schools 26 percent better? What is 26 percent better?”

Watkins is not referring to the mythical golden past in which I grew up outside of LA; this is a mere decade ago.  But Voegeli observes that the task for California is inherently harder for it than for Texas; there is an asymmetry baked in:

If California doesn’t want to be Texas, it must find a way to be a better California. The easy thing about being Texas is that the government has a great deal of control over the part of its package deal that attracts consumer-voters—it must merely keep taxes low. California, on the other hand, must deliver on the high benefits promised in its sales pitch. It won’t be enough for its state and local governments to spend a lot of money; they have to spend it efficiently and effectively.

Agency capture of public institutions, their tax mechanisms and their benefits, is far from an unknown phenomenon.  But I have to say that the idea that California could ever be surpassed on any of the metrics above — education, liveability, transportation, quality of life, etc, — by Texas is ... shocking.

(Note — and before everyone gets all p-o’d in the comments.  I do freely admit and guilty as charged that I feel pretty much about my home state as every Texan I’ve ever known feels about Texas, so no need to abuse me in the comments.  And I will also say that if I were able to move back to California today, and not have to worry about gainful employment as a law professor, I would move to ... Carson City, Nevada, just below the Nevada side of Tahoe, on Highway 395 in the Eastern Sierra Nevada corridor, and have two-thirds the benefits of California (the mountains and the desert, minus the Pacific and the California coastal foothills) without the taxes.  I’m headed out to give a talk at Stanford Law School next week, and while terrifically excited to go talk about robots and war and grateful for the invite, I have serious regrets about not being able stay just long enough to drive over the Sierras.)

In a recent post, I discussed how the Federal Housing Administration’s subsidization of dubious mortgage loans is repeating one of the key errors that helped cause the financial crisis of 2008. In this Wall Street Journal op ed, Peter Wallison (who presciently warned of the danger posed by these policies back in 2005) summarizes the evidence showing that the federal government played a decisive role in promoting the vast majority of the dubious mortgages involved in the mortgage crisis, which in turn helped cause the broader financial collapse:

When Fannie and Freddie were finally taken over by the government in 2008, more than 10 million subprime and other weak loans were either on their books or were in mortgage-backed securities they had guaranteed. An additional 4.5 million were guaranteed by the FHA and sold through Ginnie Mae before 2008, and a further 2.5 million loans were made under the rubric of the Community Reinvestment Act (CRA), which required insured banks to provide mortgage credit to home buyers who were at or below 80% of median income. Thus, almost two-thirds of all the bad mortgages in our financial system, many of which are now defaulting at unprecedented rates, were bought by government agencies or required by government regulations.

Even some of the bad mortgages that were initiated by the private sector acting independently may have been influenced by Fannie and Freddie’s apparent willingness to purchase them at a later time should things go bad. Obviously, some private lenders and borrowers made mistakes of their own, and there were plenty of errors that cannot be blamed on the feds. However, absent the federal policy of promoting dubious mortgages and offering implicit government guarantees for them, the number of such mortgages would have been far smaller, and it is highly unlikely that a major crisis would have occurred.

I should note that the title of Wallison’s op ed “Barney Frank, Predatory Lender” is somewhat misleading. Frank did indeed play a key role in promoting policies under which government-backed firms issued and guaranteed dubious mortgages. But he was far from the only one. Members of Congress from both parties supported the same policy, as did the Bush Administration. It would be convenient if these policy errors could be blamed on a few individual villains, such as Frank or nefarious Wall Street executives. In reality, however, they arose from perverse systemic incentives of the kind I discussed in my last post on this subject.

The Federal Housing Administration seems intent on repeating one of the key policy errors that played a major role in causing last year’s financial crisis. One of the main causes of the mortgage crisis that led to the broader financial crisis of 2008 was government subsidization of risky mortgages for people who were unlikely to be able to pay them back if real estate prices fell. Investors bought up dubious mortgages supported by Fannie Mae and Freddie Mac because they correctly perceived these “government-sponsored entities” as having an “an implicit government guarantee.” See this account by Charles Calomiris and Peter Wallison. Wallison also presciently warned of the possible dangers back in 2005. Government backing for dubious mortgages was a bipartisan policy backed by many Republicans as well as Democrats. President Bush, for example, sought, in his words, to “use the mighty muscle of the federal government” to expand homeownership by giving GSEs incentives to ease credit requirements.

Unfortunately, policymakers have still not learned their lesson. As columnist Steve Chapman points out, the FHA is again subsidizing the same types of dubious mortgages that the federal government backed with disastrous results in the years leading up to 2008:

Watching Washington policymakers in action, I sometimes think they make mistakes because of unrealistic goals, flawed thinking, blind obedience to party, or dubious information. And sometimes I think they make mistakes because they are—how to put this?—clinically insane.

There is no other way to explain what is going on at the Federal Housing Administration, which provides federal guarantees for home mortgages. Given the collapse in real estate prices, the weak economy, and the epidemic of foreclosures, banks are acting with more caution than before. They now commonly require home buyers to make down payments of 20 percent to qualify for a loan. But the FHA often requires only 3.5 percent.

That’s the equivalent of playing pool with a guy named Snake, and it’s had two predictable effects. The first is that the agency is insuring about four times as many home loans as it did just three years ago. The other is that the number of FHA-approved borrowers who are not repaying their loans is climbing. Since last year, the default rate has jumped by 76 percent.

Another likely consequence looms: you and I eating the losses. A former executive of mortgage giant Fannie Mae told a congressional subcommittee that the FHA “appears destined for a taxpayer bailout in the next 24 to 36 months.” Commissioner David Stevens had to assure the subcommittee that it would not need help—well, unless there is a “catastrophic home price decline.” But who says there won’t be? It’s not as though anyone at the FHA foresaw the housing bubble or the housing bust. Yet now it feels confident betting its $30 billion cash reserve that prices won’t fall. 

Unlike Chapman, I don’t think the policymakers are “insane.” They are responding rationally to perverse incentives. If another mortgage crisis occurs, they hope to shift the blame to a supposedly insufficiently regulated private sector — which is more or less how many of them managed to escape blame the last time around. The public did punish the Republican Party in the 2008 presidential election. But most of the members of Congress and federal bureaucrats who supported the GSEs got off scott-free. Moreover, the full negative effects of risky government-backed lending may not become evident for years to come — perhaps at a time when some other administration and Congress will be in office. In the meantime, the administration, the FHA, and key members of Congress can reap the political benefits of getting support from grateful borrowers, real estate developers, and other interest groups that benefit from easy credit. This vicious circle could be forestalled if voters understood what is happening and punished the offending pols at the polls. However, widespread voter ignorance of both the details of federal policy and Economics 101 makes this unlikely.

I wish there were an easy solution to the problem of recurring bad policy caused by perverse political incentives. Sadly, I fear there is not. However, the beginning of wisdom is to at least recognize the nature of the problem.