Subsidies and waste

It is possible to spend $100,000 on a luxury car. Most people don’t do so, and not just because they cannot “afford” one. Even among Americans with over $100,000 in wealth, only a tiny fraction would choose to spend $100,000 on a luxury car.

You can also spend $35,000 on a luxury car, something like a Toyota Camry. You might object that a Camry is not a luxury car. Actually, it is. Car manufacturers have basically perfected the art of building a high quality car. Today, the quality difference between something like a Camry and a $100,000 car is so slight as to be hardly worth commenting on.

What would get me to buy a $100,000 car? Perhaps if the government paid 95% of the cost of my new car. In that case, I might prefer to spend $5000 (out of pocket) on a fancy Mercedes rather than $1750 on a new Camry.

It would be extraordinarily wasteful if price distortions caused our economy to switch from producing $35,000 cars to producing $100,000 cars. In other sectors, however, we’ve done something very much like that—because of subsidies.

What would get me to spend $100,000 on a medical procedure rather than $35,000 on an almost as good procedure? Subsidies. If I only had to pay a small percentage of the cost out-of-pocket, then the highest quality procedure would become much more attractive. That’s one reason why America spends 17% of GDP on medical care.

This Bloomberg story caught my eye:

Trump’s economic advisers are considering doubling the state and local tax deduction, a popular — but expensive — tax break that could deliver big savings to many residents of New York, New Jersey, and California.

Economist Stephen Moore, a member of President-elect Donald Trump’s economic advisory transition team, told Bloomberg Thursday that the group has discussed expanding the tax write-off limit from $10,000 to $20,000.

In my view, the decision to cap the SALT deduction at $10,000 was the single most successful economic policy initiative of the past decade.  It had two important benefits:

1. The deduction greatly simplified tax preparation for many taxpayers (including me.)  Now you could simply take the standard deduction, avoiding lots of time-consuming paperwork.

2. The SALT cap took away a major subsidy to spending at the state government level.  For people in the 40% federal tax bracket, the SALT deduction meant that the federal government effectively paid 40% of their state income tax bill, at least in those states that have an income tax.  In the period since the change, a number of states have begun reducing their state income tax rates, which is exactly what I would have expected.  If the cap goes up to $20,000, then states will have a strong incentive to do additional wasteful spending.

PS.  Of course, the claim “single most successful economic policy of the past decade” is a very low bar, as the past decade has been one of almost unrelenting policy mistakes.