„violates the conventional wisdom!“ and who doesn‘t! Discusses elasticity of housing supply & elasticity of substitution of housing supply between owning and renting Answers titel graphically Answers titel mathematically Gives empirical estimations of the benefits Compares assumptions and results with previous research by Michelle J. White & Lawrence J. White published in the Journal of Public Economics, Vol.3, 1977 Discusses elasticity of housing supply & elasticity of substitution of housing supply between owning and renting Answers titel graphically Answers titel mathematically Gives empirical estimations of the benefits Compares assumptions and results with previous research „violates the conventional wisdom!“ 12-11-02 Bjørn Baltzer

The Subsidy BUT: formal incidence vs. effective incidence Owner-occupiers are subsidized by the US federal income tax: mortage interests and locally paid property taxes can be deducted from taxable income Renters are not subsidized: you cannot deduct rent from taxable income The formal incidence of a tax / subsidy can be different from the effective incidence because the burden can be passed on BUT: formal incidence vs. effective incidence

That‘s where we will end …

The Demand for Housing & the Supply for Housing Perfectly elastic? S Q P Perfectly inelastic? S S Somewhere in between! DT DO Q= Quantity of housing supplied / demanded continuous, e.g. measured in square feet P = Price of one unit of housing, in this case of one square foot, per year DR = The aggregate demand for rental housing DO = The aggregate demand for owner-occupied housing DT = Total demand for housing Elasticity of Substitution of housing supply between owning and renting So far: assumption of separate markets: You either build appartment houses for renters or row houses or detached single houses for owners Now: appartment houses are converted in condominium houses, houses can be rented -> Whites‘ assume high substituability between housing units for renting and owning -> one market Perfectly elastic supply? if demand increases due to subsidy -> no change in market price Aaron (1972) and Laidler (1969): prices of building material and wages of construction workers didn‘t fluctuate with level of construction (based on empirical work by Muth) Has the subsidy to owner-occupied housing been fully capitalized (anticipated and included in the price)? subsidy makes owning favorable compared to renting, but price of owner-occupied housing is bid up till individuals are again indifferent between owning and renting -> there is a initial benefit (value of owner-occupied houses increase), but new owners face the higher price -> this requires perfectly inelastic supply no, every year, about 3% are added to housing stock Whites‘ argue upward sloping * as 3% are added to housing stock per year, supply is not perfectly inelastic, but if demand increases more than that, it takes time till new demand is satisfied and prices may rise in the meantime * supply of land is limited: if demand increases, city has to expand -> agricultural rent must be bid up -> rents increase all over the city as some of the new demand is also satisfied by redevelopment at higher density within the city, more construction will take place at increasing cost * if construction is to be increased, more capital is needed -> for this extra capital, higher interests have to be paid: to replace non housing- investments or to induce households to save more money DR

The Subsidy Comes into Play Q P DR DO DT S Let‘s not forget … DO, DT, Deadweight Loss = welfare loss of society due to economic inefficiency Intersection of S and DT determines the price which must be the same for owning and renting Now: Subsidy to owner-occupiers proportional to unit price reduces their effective price -> DO increases -> DT increases Some renters will become owners, so that the rental demand curve should shift to the left and the owners demand curve even farther to the right, but this effect is omitted for simplicity (by the authors, not by me!) Market price rises -> renters consume less at higher price Let‘s not forget that the effective price for owner-occupiers is below the market price: they consume more at lower price P, P QO, QT, QR, PO, QR QO QT

The Traditional Deadweight Loss DO, DT, P P , PO, QR QO QT Q DR DO DT S QO, QT, QR, Traditional Deadweight Loss = the quantity the owner-occupiers consume more at a higher price due to the artificially induced extra demand by the subsidy minus the producers surplus from providing this extra quantity of housing

Loss to renters LR 1 LR 2 DO, DT, P P , PO, QR QO QT Q DR DO DT S QO, DR DO DT S QO, QT, QR, LR1: higher rent they have to pay for less housing=gain of landlords LR2: loss of consumer surplus In addition to that, renters help as general taxpayers to pay for the subsidy

Gains to Owner-Occupiers GO 1 GO 2 DO, DT, P P , PO, QR QO QT Q DR DO DT S QO, QT, QR, GO 3 GO1: decrease in price of their initial housing consumption GO2: increase in consumer surplus GO3: increase in potential rental value of their old housing consumption

More Gains: Gain to producers GP Gains to landlords GL1 = LR 1 DO, DT, PO, QR QO QT Q DR DO DT S QO, QT, QR, GL2 GP= Producers build more housing and sell at higher price, we deducted this to calculate the traditional deadweight loss GL1= higher rents paid by renters, identical with renters loss LR1 GL2= housing that was rented before and now sold to owner-occupiers

Total annual cost of the subsidy program DO, DT, P P , PO, QR QO QT Q DR DO DT S QO, QT, QR, In 1970, it was estimated that the subsidy program to owner-occupiers cost 10 billion dollars a year as foregone federal income tax

The Generalized Deadweight Loss … compared to the traditional deadweight loss As promised, that‘s where we end: RED = deadweight loss on ressources transferred into the housing section BLUE= deadweight loss on reduced consumption by renters GREEN= the deadweight loss from an extra consumption by owner-occupiers The relative and absolute sizes of those areas depend on the slope of the supply curve, and thus on the elasticity of supply Comparison with the traditional deadweight loss: The traditional deadweight loss obviously underestimates the true consequences

Conclusions The Traditional Deadweight Loss underestimates the (true) Generalized Deadweight Loss Reason: a large part of the deadweight loss is generated by the transfer of ressources among different demander groups Consequence: whenever a tax or subsidy program applies differentially to participants in a market (here owner-occupiers vs. renters), then one has to take substitution into account when measuring the societal deadweight loss Authors‘ claim: renters are disadvantaged against owner-occupiers, they should be treated more equally taxwise