Wednesday, June 24, 2009

Taxpayers Get No Respect

A primary theme of behavioral economics is that consumers are poorly informed and otherwise unable to wisely consider the important decisions in their lives. As behavioral economics has gained some academic acceptance, it is no surprise that taxpayers are getting less respect too.

Before the behavioral economics wave, we economists used to say that taxes hurt the economy because they cause people to change their behavior in order to pay less to the Treasury. Virtually all of us agreed that this harm is real, even while we disagreed as to whether that harm was a price worth paying in order to get revenue into the Treasury.

The new wave is to deny this harm in many instances, on the grounds that taxpayers are ignorant of the taxes they pay.

One application of this argument is to means-tested mortgage modification. Coming from the old school, my analysis (here, here, here, here, here, here, here, and here) said that reducing mortgage debt primarily for borrowers with low incomes will only encourage borrowers to earn less income. The new school says that analysis is hardly relevant, because borrowers are ignorant of how things work. Below is my first attempt at a rebuttal.

Means-tested mortgage modifications are based on incomes in the recent past: usually income for the prior calendar year. In theory, taxpayers could have supplied income during year 0 without knowledge that their supply decisions would affect what they would obtain from a mortgage modification or other transaction that would ultimately occur in year 1. In other words, this theory posits that few anticipated that their budget constraint was shaped like the one shown in Figure 2. In this case, the means-tests that are part of mortgage modification and other transactions would not distort the supply of income, or at least not distort it any more than they did prior to the housing crash.

[Figure 1 omitted]

Of course, labor market participants do not have perfect foresight, and may not see things that the experts do. There likely are homeowners who had their mortgages modified who, with the benefit of hindsight, would have supplied less income. However, for several reasons, perfect foresight is not required for means-tests to have an important aggregate impact. Some homeowners may have over-estimated the size of the means test. There may be renters who (incorrectly) expected their rent to be means-tested during a well-publicized recession. Once we admit that foresight is imperfect, we have to recognize that there are also instances when people anticipate a larger means-test than actually occurs. Imperfect foresight can dull some of the detailed implications of the theory of tax effects – eg., that behavior should change more for groups who face the larger marginal tax rate ex poste – even while aggregate tax effects are large. (Raj Chetty and coauthors have a recent paper in this spirit).

Although foresight is imperfect, it is likely that many people did understand that mortgages would be modified primarily for people “in financial trouble.” Means-tested mortgage modification occurred during the 2001 recession (Sichelman 2001). A number of homeowners had their mortgages modified twice during this recession – even if the means-test surprised them the first time, did it surprise them a second time? Many homeowners have a large amount at stake. It is intuitive that mortgage modification would be means-tested – why would a lender reduce mortgage payments for his income rich borrowers? Consistent with this intuition, I have shown that means-tests are lender-profit maximizing even if those tests create labor market distortions. For these reasons, many homeowners should have expected that mortgages would be reduced primarily for those in financial distress.

Data on internet use and other behaviors also suggests that millions were aware. has tens of millions of unique visitors a month,[1] and consistently displays headlines about mortgage modification with links to detailed information about what homeowners can expect from lenders and the modification process. Perhaps ironically, the Bush Administration sought to raise homeowner awareness (Swagel, 2009, p. 12). Among other things, it promoted its national foreclosure counseling hotline (888-995-HOPE). During 2007, its quarterly call volume increased almost tenfold to 143,000.[2] For the months of January through November 2008, cumulative call volume was over 1,000,000.[3] Those calls led to almost 300,000 counseling sessions that “guide callers through a thorough analysis of their financial situation.” Daily call volume tripled again in March 2009 when the Obama plan was announced. Although we may never know exact numbers for homeowner awareness, these bits of data suggest that the number of homeowners aware that mortgage modification is conditioned on financial distress was easily in the millions already in 2008.

Commenters: what do you think?
References “ Traffic Surges in December.” January 22, 2009.

Homeownership Preservation Foundation. “Nation’s Foreclosure Prevention Hotline Shatters Previous Call Records.” Press Release, January 15, 2008a.

Homeownership Preservation Foundation. “Foreclosure Prevention Hotline Helps over 1 Million Homeowners.” Press Release, December 22, 2008b.

Homeownership Preservation Foundation. “Obama Foreclosure Plan Sparks Large Spike in Calls to Homeowner Hotline.” Press Release, March 19, 2009.

McIntyre, Douglas A. “Financial Website June Traffic: Yahoo! (YHOO) And AOL Still Out Front.”

[1] ComScore reported that had 17.538 million visitors in June 2008 (before the financial crisis reached its peak newsworthiness), and that it was the leader among financial websites (McIntyre, 2008). The same report listed’s visitors at 5.797 million. By December 2008, Forbes reported that its website had 20 million unique visitors per month, which was a 46 percent increase from the year before. Thus,’s December 2008 traffic must have been well over 20 million.
[2] Homeownership Preservation Foundation (2008a).
[3] Homeownership Preservation Foundation (2008b). Total call volume for 2008 (including December) was 1.2 million (Homeownership Preservation Foundation, 2009).

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