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“The Middle Class” Tax Reform and Why it is So Difficult to Achieve

There is a new tax reform proposal making its way around Washington, which means that the silly season for misinformed statements about what constitutes “the middle class” is upon us. This debate has been going on for years, and, over the next few weeks, you are about to hear how every aspect of the tax reform proposal or today’s current tax structure either helps or screws the middle class. An unsolicited word of advice for all of you: ignore the rhetoric that is being spewed on this issue. Why? First off, it’s almost all politically charged nonsense primarily because there really is no middle class – at least not in the sense that the politicians would have you believe.

What makes me say that? Primarily, regional inequality. There was once a national middle class but, in today’s world, the concept doesn’t work very well on a national level. Let’s look at things on a historical basis first. I’ll use California and Ohio as examples. I’m also going to use housing as the first example. As early as the 1950s median home prices in California were only 15% greater than those in Ohio. Even as late as the 1970s the median California home was only 31% more expensive than the median Ohio home. However, today, those numbers are far different. Per Zillow, current median home value in Ohio is $128,700 and current median home value in California is $509,600, a whopping 296% premium. Keep in mind that these numbers are state averages and become much more dramatic if you were to look at a region like San Francisco or LA where median prices are nearly double the statewide average versus, say Cleveland.

What about median household income? I was only able to get data that went back to 1989, but in this case, I was able to get a bit more state-specific by comparing San Francisco County, CA to Cuyahoga County (Cleveland), Ohio thanks to The St. Louis Fed’s excellent FRED economic research tool. In 1989 median household income was around $28,262 in Cuyahoga County and $30,166 in San Francisco County, a difference of around 7%. By 2015 households in San Francisco were making a median $90,527 while Cuyahoga residents were making only $45,506 or a difference of 99%. My broader point here is that it was far easier to craft tax policy that centered on helping the middle class in the 1950s through the early 1990s because regional differences were relatively minor. Any Federal tax reform impacted your average San Franciscan and average Clevelander roughly the same. That isn’t close to the case today.

Heather Long of the Washington Post took one of the more honest and straightforward looks at the middle-class question in an article entitled Is $100,000 middle class in America? (Emphasis mine):

The majority of Americans — 62 percent — identify as “middle class,” according to a Gallup poll conducted in June. It’s the highest percentage of people feeling that way since 2003. But a lot of Americans are like Osegueda: They feel middle class, but they aren’t sure what it means.

Just who exactly is middle class is in the national spotlight again as President Trump and Republicans in Congress craft tax cuts for individuals and corporations that they say will primarily benefit the middle. Vice President Pence called the plan, which is still being fleshed out, a “middle-class miracle” this week. But amid this discussion, the middle class has been defined in different ways. Gary Cohn, Trump’s top economic adviser, recently discussed how a “typical family” making $100,000 a year would benefit. Trump has espoused the value of the plan to truckers, who make around $41,000 a year.

So what is the middle class? In America, an income of $59,000 a year (before tax) is smack dab in the middle, according to the U.S. Census. But it’s not that simple.

There is no exact definition of middle class, and a deep look at the data shows a wide variety of individuals could be part of it, depending on where they live and how big their family is. The middle class in San Francisco, where Osegueda lives, is not the same as it is in Peoria, Ill.

The WAPO article contains a tool where you can put in your annual household income and county of residence and it will spit out the range of what could be considered a middle class for that region. The results are quite striking: middle class in the lowest income counties ranges from $18,138 – $66,250 in household income. However, in the highest income counties, it ranges from $43,402 – $127,633 and goes up substantially more than that in regions like San Francisco and New York. With spreads that large, it’s no wonder that politicians are so comfortable making claims about what helps or hurts the middle class – pretty much every argument is technically correct depending on what regional demographic they are referring to. In other words, it’s a magnet for bull…..

The United States has always had some degree of regional inequality but it has reached extreme levels in recent years. It’s nearly impossible to craft effective Federal tax policy that doesn’t advantage someone in Cleveland over someone in San Francisco or vice versa. What’s worse is that a lot of this was avoidable. Sure, dynamic economic engines like San Francisco, NY and LA were always going to draw more people in today’s dynamic global economy at the expense of old rust belt cities like Cleveland, but there are certain aspects that could be handled much better to avoid the point that we have arrived at today.

Part 2: Infrastructure

Part 1 of this article focused on how it has essentially become impossible to craft policy to benefit the middle class on a nationwide basis due to massive regional inequality. I concluded by saying that there were steps that could have been (and still can be) taken to mitigate the high housing cost and high barrier to entry issues that plague so many of our vibrant large cities. If you assumed that my solution was something along the lines of “build baby build” you would be correct…..but only partially. To be clear, we do need a lot more housing units in our urban cores, – especially on the west coast – and it will be impossible to craft a long-term solution to the housing affordability crisis without a substantial ramp-up in construction of additional units. However, there is another element essential to maintaining a vibrant middle class in a dynamic, global city that often gets overlooked: infrastructure. When discussing how regional inequality distorts the middle class, a common argument is that people do not need to live in San Francisco, Beverly Hills Beach or Manhattan. This is correct and is also the reason that I think it’s better to gauge middle class by county rather than city or zip code. However, moving further away from the urban core while still having the ability to utilize it is far easier said than done in some regions – unless, of course, you don’t have an issue with 3-hour commutes.

When confronted about their opposition to development, a common retort from NIMBY’s is to point out that Manhattan is incredibly dense and still incredibly expensive. While this argument has merit, it also misses a larger point: New York City does not have a middle-class crisis – at least not in the same way that coastal cities in California do, and the reason is infrastructure. Justin Krause made this case very effectively in a post on Medium entitled How To Save San Francisco (emphasis mine):

New York City has faced similar problems — economic booms, affordability crises, and bodies of water. And while nobody would say New York has solved all of its problems, it has done better in a key area: diversity. In fact, it may be getting more diverse.

Teachers, firefighters, artists, and people in different income brackets can find housing in New York.They may not be in Soho, but they are accessible to the urban core. This is the key difference between San Francisco and New York: New York has a broader range of housing that is integrated.

It’s not just about affordability, it’s about integration.

Take a look at the maps below. Both New York and San Francisco have expensive cores, with one bedroom units fetching rents of $3k+. But both also have less expensive areas, mostly across bodies of water. In New York, you can find a one bedroom in Bushwick for $1k per month. In the Bay Area, you can find similar deals in parts of the East Bay and pockets of the Peninsula.

But in New York, if you live in Bushwick, you are still in New York. If you live in the East Bay or even in Daly City, you aren’t in San Francisco.

The next maps show places you can reach using public transportation within 45 minutes. If you live in Bushwick, you can access a large swathe of Manhattan and Brooklyn. In the Bay Area, you’re unlikely to have easy access to San Francisco at all if you’re not in San Francisco proper.

This is not to say that NYC doesn’t have any problems of its own. I’ve been there a couple of times in the last few months and that’s far from the case. New York is currently massively overbuilt in the high-end condo space, its mass transit is governed by an alphabet soup of competing city and state agencies that are often at odds with each other and much of its prime retail space has become a ghost town thanks to landlords pushing rents to levels that are completely unsustainable. Still, NYC is able to maintain a large, economically diverse population while San Francisco, Los Angeles, and other west coast cities increasingly are not, and the reason is that NYC’s infrastructure is far better and the region is far more integrated. Krause explains why this is the case (emphasis mine):

It’s true that the San Francisco Bay is bigger than the East River. And Brooklyn is denser, with more rental units, than many Bay Area cities. And, crucially, that “San Francisco” isn’t the only urban core in the Bay Area (Oakland and San Jose are also urban cores).

But the simple fact is that in New York you have the option of moving to a less expensive “fringe,” still accessible to your friends, work, and community. In San Francisco, you have the option of moving to a different city — a different community, entirely. And that’s not an option at all.

Options don’t exist because the Bay Area is not integrated. BART, the entity that should connect us, doesn’t. It doesn’t go to San Jose or North Bay. It’s very expensive and doesn’t offer a monthly pass. It barely runs at night. We’re talking about building bullet trains and hyper-loops to Los Angeles, but there is no easy way to get from Oakland to Palo Alto. Or most of San Francisco to San Jose. Or North Bay to anywhere. Even commuting from Oakland to most of San Francisco is difficult and expensive. In fact, according to SPUR, no new transportation capacity has been added across the Bay since BART’s Transbay tube opened in 1972.

Transit has gotten so bad that tech companies are contracting private bus fleets. This is the opposite of openness and integration.

It seems absurd, but this is the choice that we’ve made. Expanding and improving regional transportation to better integrate the Bay Area isn’t rocket science— it simply requires cash, commitment, and political will.

The Bay Area has cash. It’s the second two pieces that are missing. But it’s not necessarily intentional; it’s a function how we’re governed.

In New York, Los Angeles, and Chicago, communities are tied together under central leadership. Powerful mayors can address systematic issues broadly and holistically. And citizens have someone they can hold accountable.

In the Bay Area, we have a collection of fiefdoms. Villages are parading as cities, addressing problems myopically. For example, Brisbane (a city of 5,000 people between San Francisco and SFO) is currently blocking a large housing development for local reasons. It’s NIMBY-ism on a broad scale – a regional tragedy of the commons.

Decentralized decision-making and local governance are important, but a complete lack of high-level vision and executive authority is hurting all Bay Area cities (including Brisbane). All Bay Area cities are struggling with housing and affordability. All Bay Area cities are worried about fraying community, rising inequality, and how to manage change.

We’re facing regional problems, but we don’t have regional leadership or an effective regional plan for fixing them. San Francisco, Oakland, and San Jose can only do so much on their own. We need a commitment and a strategy that encompasses the entire neighborhood.

The article quoted about is about the Bay Area but could just as easily be about greater Los Angeles. Every small city in these regions declines to deal with the housing crisis and claims that providing more units is the job of its neighbors. Also, the region isn’t well connected because mass transit is mostly expensive crap. It’s relatively easy and cheap to commute in NYC even if you are coming to Manhattan or Brooklyn from a far-flung neighborhood or even a neighboring state. In the Bay Area or LA, a middle-class commuter may have to drive for hours in order to reach a price point that they can afford. This is one of the primary reasons that regional inequality has gotten so bad along the west coast. People and business want to be here but no one can afford to move here except for high earners, leading to an ever-upward skew in median incomes, home prices and rents.

Perhaps the most unfortunate part of this state of affairs is that the problem could be addressed if leadership was merely competent. California is spending billions of dollars on a bullet train that will initially take (very few) riders from nowhere (Bakersfield) to nowhere (Fresno). Our leaders are pushing this because it’s a large, sexy, legacy type of project if it can ever be completed, linking LA and San Francisco. However, our regional infrastructure is absolute garbage. Improving light rail, commuter rail and subways may not be sexy or legacy-defining for politicians but it is actually substantially more environmentally friendly than a largely un-needed bullet train and would make our cities far more efficient. It would also allow for development in more far-flung suburbs where land is cheaper and blue collar workers could actually afford to rent or buy which would help to alleviate many of the issues that have exacerbated cost of living pressures and pushed regional inequality to record levels. Functional infrastructure would not bring the cost of living in San Francisco and LA in line with rust belt cities like Cleveland – we’re way past the point of no return on that one – but it would go a long way towards reversing the cost of living spiral that we now find ourselves in. A spiral that could be exaggerated further under the new tax reform proposal.

Part 3: This is the final part of this article about “the middle class,” tax reform and why it is so difficult to achieve in today’s environment.

Primum non nocere is a Latin phrase that means “first, do no harm.” It is often incorrectly attributed to the Hippocratic Oath which many medical school students take before they become doctors. Unfortunately, politicians, in addition to doctors, are not required to take such an oath before taking office. If they did, perhaps some of our laws would be more beneficial to society as a whole. Take for example the latest tax reform proposal and the impact that it would have on high-cost housing markets. Virtually every high priced housing market in the US (certainly on the west coast) has a problem – too little inventory is driving prices up to the moon. Not enough new, desirable product is being constructed to entice move-up buyers to sell their house and upgrade. As a result, spending on renovations is through the roof (it’s a great time to be a Home Depot stockholder!) and resale inventory is at historically low levels. Given the above, and its impact on an affordability crisis and growing homeless population, one would think any new tax proposal should have incentives to increase the inventory of both rental and for-sale housing – or at the very least not contain provisions that would explicitly create incentives to drive resale inventory even lower. Sadly, one would be wrong.

Merrill Lynch came out with a timely research note a couple of weeks back about the concept of tax cuts “paying for themselves.” It’s important commentary because it focuses on the notion of incentives and how they determine the effectiveness (or lack of effectiveness) in tax policy achieving its stated objectives. From Merrill Lynch (emphasis mine):

“President Clinton worked with Republicans and cut the capital-gains tax rate from 28% to 20% in 1997. Capital-gains tax cuts are among the most likely to generate greater revenues because taking a capital gain is optional. If the tax on the gain is 20%, you are more likely to realize the gain and pay taxes than if the tax rate is 90%. If you don’t take the gain, there are no tax revenues. The booming stock market in the late 1990s generated a wealth of potential gains, and more were realized at lower tax rates. While it is common to hear pundits in the financial media say something to the effect that “no respectable economist believes that tax cuts can pay for themselves,” the late-1990s experience is a case study in why “respectable” economists are so often wrong.

Indeed, that was the last time that the U.S. government ran a fiscal surplus and the bounty of capital-gains revenues was a major factor behind the budget surpluses of the late 1990s.”

When taking a look at the current bill as proposed, ask yourself: what type of behavior does it encourage and what does it discourage? When it comes to housing policy, the answer should be obvious. The tax bill as proposed by House Republicans would be an absolute catastrophe for housing, especially in high priced markets where it would undoubtedly hurt the so-called “middle class” that politicians of all stripes profess to want to help (side note – this post is only addressing market rate for sale housing – but things do not look positive or subsidized affordable development either).

The provisions that would most impact housing affordability in high-cost markets are:

  1. Property tax deductions capped at $10,000
  2. The $500k capital gains exemption currently available to those who sell a house that they have lived in for 2 of the last 5 years will now only be available to those who have lived in their house for 5 of the last 8 years.
  3. The mortgage interest deduction will be lowered from interest deductibility on a home loan of up to $1 million to interest deductibility on a home loan of up to $500k.

Point one above would make owning a home less affordable in high cost (i.e. California) or high tax (i.e. New Jersey) markets. However, since there is no grandfather clause for existing owners, it is unlikely to have a material impact on the housing shortage, IMO. I wish that I could say the same for the other two provisions.

The supply problem that we face today is brought on by two factors that are limiting mobility: 1) There aren’t very many units being built, and 2) People don’t move as frequently as they used to. As recently as the mid-2000s, Americans moved every 6 years on average. Today, that average has increased to nearly 10 years. When people move, they tend to make other large purchases which act to stimulate the economy, while opening up entry-level units for others. Having good housing mobility is generally good for the economy – not just realtors and home builders – which is part of the reason that it’s been an incentive in the tax code. However, extending the capital gains exemption time-frame and reducing the mortgage deduction as noted in points 2 and 3 above would reduce, not increase mobility.

First, let’s look at the capital gains exemption. The new provision of requiring people to live in their house for 5 of the last 8 years before being eligible explicitly incentivizes homeowners not to move as frequently. However, as stated above, mobility has been falling for the past decade. This provision will simply give would-be movers a reason to hold on for a few more years in order to take advantage of the tax break rather than selling today.

Second, let’s look at the consequences of lowering the mortgage interest deduction. It may be hard to believe for those who live in other parts of the country, but it’s nearly impossible to find a home that’s more than a studio for $500k in many high priced coastal regions. The immediate impact is simply that this provision would negatively impact the affordability of a house in a high priced area and make renting more attractive on a dollar-for-dollar basis. However, that’s not the aspect of this provision that I think will lead to reduced inventory. The mortgage write-off reduction comes with a grandfather clause that keeps the deduction at a $1MM cap for those who already own a home. Homeowners who are grandfathered in will be able to keep the cap until they either sell and buy a new home or refinance their existing home. It’s already expensive enough in many markets to sell a home and trade up. Typically that move comes with an increased basis, higher mortgage payment and a new higher tax bill (especially with Prop 13). This is yet another reason to do nothing and stay put. Laura Kusisto, Christina Rexrode and Chris Kirkham addressed the likely fallout recently in the Wall Street Journal (emphasis mine):

Economists said the changes come at a sensitive time for the housing industry.

Single-family home prices rose on an annual basis in 92% of 177 U.S. metropolitan areas in the third quarter, according to a Thursday report from the NAR. That was the largest share of metros notching price gains in more than two years.

But the gains were driven by a shortage of homes for sale. At the end of the third quarter, there were 1.9 million homes on the market, 6.4% fewer than the same period last year. The average supply during the third quarter was 4.2 months, down from 4.6 months a year earlier. Economists say six months is typical of a balanced market.

“We have affordability issues as it is. If you make it more difficult for people to put money toward the house, or take away the economic benefits of them owning a house, it really, really could be a major problem,” said Rick Sharga, executive vice president of Ten-X, an online marketplace for real estate.

Mr. Howard of the NAHB said the tax overhaul could cause a housing recession because of a potential drop in home values. States with high housing costs, including California, where more than a third of homes are valued above $500,000, would be particularly hard hit, he said.

“Republicans have always claimed that they don’t want to pick winners and losers in the economy,” he said. “They are clearly picking large corporations over small businesses, and they are clearly picking wealthy Americans over the middle class.”

To be sure, the $500,000 cap on the mortgage interest deduction would apply only to loans made after Nov. 2, which protects existing homeowners. But experts said that is likely to exacerbate the current stagnation in the housing market.

Homeowners in high-cost cities like New York, Boston, Los Angeles, San Francisco and parts of Miami are less likely to trade up to larger, more expensive homes if they know that means losing the protection on the mortgage interest deduction, which in turn makes it difficult for younger buyers to enter the market.

“In those expensive markets that already have an inventory crunch it’s probably going to make the situation worse,” said Ralph McLaughlin, chief economist at Trulia. He said this is likely to drive up prices.

I tend to think that the initial response, should this be signed into law may be a relatively small decline in prices. However, I would also guess that the intermediate to long-term consequences are less inventory, lower affordability, and ultimately higher housing costs. To be 100% clear, we do indeed over-incentivize home ownership in many ways under the current tax code. In fact, I would propose that if we were starting the tax code from scratch there are elements of the new proposal that make more sense than what is currently in place. However, politicians have to deal with conditions in the real world, not an idealized version. As such, making these sort of sweeping tax reforms at a time when we are already facing an unprecedented housing affordability crisis is just bad policy.

And, damn I wish that I owned stock in Home Depot right now.