Thursday, April 2, 2015

Housing Tax Policy, A Series: Part 25 - Human Capital and Low Risk Assets

Following up on yesterday's post, I would like to ponder how the blossoming of human capital plays out in modern capital markets.

If the expansion of home values is a product of an expanding pool of human capital, then this suggests that the growth of capital in this area isn't coming at the expense of other forms of physical capital and it isn't due to a surplus of capital.  This is simply a transfer of capital from a form of capital that wasn't being measured (human capital) to a form of capital that is measured (home equity and mortgages).

In addition to this issue, we also have the issue of international capital flows, which Ben Bernanke discussed recently at his new blog.

In addition to the human capital issue, developing market economies are also creating new demand for low risk investments.  Capital holders in those economies previously earned rents through limited access.  As those economies have liberalized and joined the global economy, they have entered a transitory period, where capital is expanding strongly, but risk is still considered high, and elites cannot capture the rents that they had when the economies were more closed.  So, these economies are producing a tremendous amount of new capital, much of which is reinvested in local, at-risk productive ventures.  But, there is a demand for low risk investments, and those economies have not developed trust and institutions to supply it.

So, there is a large amount of emerging market capital looking for low risk outlets in the developed world.  Bernanke's post includes a table of current account balances, which essentially shows a flow of capital into the anglosphere.  This spiked to an incredibly high level in the US in 2006, then fell back again to the level seen in 2000.  Canada, Australia, and the UK have continued to see high or increasing capital flows.  Some of the decrease in capital inflows to the US is surely related to new oil and gas production, which has reduced our need for foreign fossil fuels.  But, I think it is interesting to note that all of the other anglosphere countries had a housing boom, but none of them had a housing bust.

I suspect that if we can manage to allow our housing and mortgage markets to fully recover, some of the decline in our trade deficits that has seemed to have come from the US petro-boom, may actually reverse, as foreign investors find access to US real estate more accessible.

I don't think there is anything unsustainable about this.  US corporations are investing in at-risk, high return operations overseas, and foreign capital holders are investing in safe, low return securities in the US.  This is a symbiotic relationship.  Foreign capital enjoys a risk profile that matches its needs and US capital owners earn profit by taking on that risk.  This essentially funds our trade deficit while foreign capital continues to pour into the US.

So, there is not so much a glut of capital as there is a transfer of capital between foreign and domestic and between human and physical.  This makes sense to me.  Interest rates on treasuries are usually treated as the measure of returns to capital, but I think this is misleading.  I have described what I think is a better way to think of required returns to capital.  Instead of thinking in terms of returns to risk-free debt, and adding an equity premium on top of that, I think it may make more sense to begin with a total return to unleveraged at-risk capital, and consider interest rates on debt to reflect a transaction between equity holders and debt holders about how to share those returns.  The equity premium, in that framing, is more of a discount accepted by debt holders to avoid volatility in cash flows.

The reason I think this is a better framing is because total required returns to corporate capital are pretty stable over time.  Whatever cultural and economic factors create an expectation of returns for putting capital to work in productive enterprises, they seem to be pretty stable and unrelated to the discount that debt holders are willing to accept for cash flow stability.

The first graph to the right is an estimate of required returns to the S&P 500.  The second graph is a similar estimate for all nonfinancial corporations.  (In both cases, I have simply used the GDP deflator to adjust from nominal bond yields to real yields, so part of the dip in the 1970s and the rise in the 1980s likely comes from the fact that inflation expectations lagged actual inflation.  In either case, the recent drop in real risk free yields is not associated with a drop in total required real returns.)

As I have outlined in my housing series, the implied returns to housing from rent tend to move over time along with long term real interest rates.  So, we have 4 major asset classes. (1 & 2)  Treasuries and corporate debt, which have yields that are somewhat related, and whose outstanding value does not particularly respond to demand by moving inversely to yields. (3) Real estate (equity and mortgage), which have yields that tend to move with other debt, and whose total value does rise and fall with real yields (inversely). And (4) corporate equity, which has "yields" that are fairly stable and value that is very volatile through the business cycle, but relatively stable over time.

So, the capital inflows coming from the conversion of human capital and from the inflow of foreign capital only have two outlets, on net.  One outlet is in an expanding real estate market, and the other outlet, in an open economy, is the expansion of corporate assets into foreign markets.  If there was some surplus of capital searching for yield, then shouldn't we expect all yields to fall, including corporate assets (equities)?  Instead, we are simply seeing the transfer and trading of different forms of capital - foreign and domestic, human and physical.  So, the total returns to corporate capital are stable because there isn't any particular change in the supply and demand of total at-risk capital.  There is just an expansion of US corporate capital into foreign markets as part of the trade with foreign capital that is bidding up the discount on US debt.  And there is an expansion of anglosphere real estate, reflecting both foreign capital and the time arbitrage of human capital.  Both of the capital inflows (foreign and human) push down the risk free rate (or stated differently, push up the discount from total required returns on at-risk capital), but total returns to corporate equity remain fairly stable, even if they need to search abroad for those returns.

There is no unsustainable imbalance in international capital flows.  And, I doubt if low real interest rates reflect any great stagnation, beyond some changes in production growth coming from fluctuations in the working population.  Stable total returns to corporate assets suggest that we don't have secular stagnation.  Low risk free interest rates are related to the foreign capital trade and diversification of human capital, which are both products of a productive, growing, and hopeful world economy.

PS: I neglected to mention in yesterday's post the thought I had first had in one of the inequality posts that I linked to yesterday.  It so happens that we do have some housing taxation policies that might make sense in this human capital framework.  If we think of redistribution in terms of the illiquidity of human capital, we would want to subsidize the formation of human capital.  But, since outcomes of human capital can't be diversified, and are highly variable, we would want to tax earned human capital.

There are four main tax policies in home ownership. (1) Property taxes, (2) mortgage tax deduction, (3) capital gains exemptions, and (4) nontaxability of imputed rent.

In yesterday's post, I described mortgages as a shadow of future expected returns to human capital.  The Mortgage tax deduction is a subsidy of expected future human capital.  So, in this framework of thinking about housing and human capital, the mortgage tax deduction would encourage the development of future human capital.

I described home equity as a shadow of earned human capital.  Property taxes, then, are a tax on earned human capital.

The combination of high property taxes and a mortgage tax deduction would create a sort of public diversification of human capital by redistributing gains away from those who are fortunate enough to have had high returns to human capital.

The capital gains exemption and nontaxability of imputed rent are large subsidies to home equity, so these are highly regressive policies, giving even higher gains to those who won the human capital lottery (receiving higher returns than they had expected).  These would most effectively be eliminated by eliminating corporate and capital taxes.  Since some arguably large portion of those taxes do not fall on the capital owners themselves, but are passed on proportionately to workers and consumers as prices and required returns equilibrate, the elimination of these taxes would eliminate these highly regressive real estate tax subsidies with little or no downside, even before factoring in international tax competitiveness.

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