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Housing Affordability and Supply Side Economics

Housing affordability in Los Angeles, California—and elsewhere—is more than just a supply problem.
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Los Angeles as seen from Griffith Park. (Photo: Kumar Appaiah/Flickr)

Los Angeles as seen from Griffith Park. (Photo: Kumar Appaiah/Flickr)

My second post in this series about weighing demand and supply as a function of higher housing costs takes an unexpected turn. A few hours ago, I got wind of an article that characterizes housing affordability in Los Angeles as only a supply problem. The experts quoted deserve my attention and respect. I think the positions voiced typify the supply side argument. Quoting another expert, Dr. Doom, about supply side economics:

In the late seventies, the label "Supply Side Economics" was applied to the argument that lower tax rates would improve private sector incentives, leading to higher employment, productivity, and output in the US economy. George Bush, in the days when he was an opponent of Ronald Reagan in the 1980 primaries, referred to an extreme version of this theory espoused by Reagan as "voodoo economics." In this version a cut in tax rates was predicted to result in an increase in tax revenue, and thus not increase the government deficit (the famous Laffer Curve effect). We're going to run through the arguments for such incentive effects, and try to evaluate the policy.

Taxes enter many decisions, but the two most important are probably that they discourage work, since they lower the aftertax return from work, and they discourage saving and investment, since they lower aftertax returns. (A third, which we will not explore here, is that taxes distort investment decisions by taxing different types of capital unequally. Housing, for example, gets a free ride.) We know that the countries that invest the most (measured as the ratio I/Y) also grow the fastest, on average, so maybe this is important (or maybe the causality goes the other way, with the US investing less because it has fewer good opportunities). Whatever the case, let's examine the effect of taxes on wage and capital income.

A lower tax rate on wage income should increase the labor supply. Given the labor demand function, this increase in labor supply will increase employment, reduce the pre-tax real wage and increase the post-tax real wage.

I'm Gen X and old enough to remember "voodoo economics." When I read about greater housing supply acting as a fire hose to cool red hot real estate prices, I flashback to Ronald Reagan. That's my cultural baggage talking. I defer to Dr. Doom:

There is some question about the magnitude of these effects, and the theory was way oversold at the time. Many "supply siders" argued that the incentive effects were so large that a reduction in tax rates would actually raise tax revenue, since the tax base would grow so much. There's no sign that this happened, and indeed most economists were pretty skeptical of this prediction at the time. Quite to the contrary, the budget deficits exploded in the 1980s after tax rates were cut by Reagan in 1981. The response of private savings and labor supply to the Reagan tax cuts was minimal: the labor supply did not increase and the effect on private savings was swamped by the reduction in public savings (the increase in the budget deficit). Since labor supply and savings increased only marginally, government revenues did not increase (relative to GDP) and the budget deficit became very large. The Laffer curve hypothesis was flatly contradicted. Moreover, the 1980s tax cuts did not increase the rate of growth of GDP and productivity, nor the investment and savings rates.

Don't shoot the messenger. I didn't write the above. Economist Nouriel Roubini did. I'm introducing an expert opinion on the folly of addressing market problems from the side of supply. Consider my review of Dr. Doom's take on supply side economics as a friendly rebuke, something to chew on before you flame my post. I'm intimate with your certitude.

Your certitude:

The Los Angeles project highlights what economists and housing experts call a major contributor to Southern California's housing affordability problems: Developments routinely get delayed, scaled back or killed amid strong opposition from community groups.

The phenomenon cuts back the supply of new homes and drives up prices, said Christopher Thornberg, founding partner at research and consulting firm Beacon Economics.

"The problem is every single major development goes through that same process: from 800 to 400; from 600 to 300," he said. The high cost of housing is "a supply issue — period." ...

... In Los Angeles and elsewhere, large-scale plans often need special approvals that give neighborhood groups a venue to push back against development. Little land has been zoned for high-density housing. And much of the region has been set aside for the single-family homes that many Southern Californians prefer.

"It's sort of the desire to keep L.A. a certain way — that is not compatible with it being affordable," said Richard Green, director of USC's Lusk Center for Real Estate. "You can have sprawl or you can have density or you can have very expensive housing."

Certitude: "[H]igh cost of housing is 'a supply issue — period.'" Certitude: "You can have sprawl or you can have density or you can have very expensive housing." Thornberg is guilty of hyperbole. I dismiss his comment. I disagree with Richard Green's comment.

I'm wary of geographic ultimatums. We can have sprawl and density, density in sprawl. We can have geographic arbitrage. Business can move from labor expensive Rust Belt to labor cheap Sun Belt, feeling the love at price per square foot. Don't shoot the messenger. Migration messes with the supply and demand in a given market.