A public finance vignette

Here's a short story, simple but true, that illustrates a lot of public finance: from public choice to Ricardian Equivalence.

I live on a cul de sac. Many of my neighbours wanted our gravel road paved, and were prepared to pay for it. The municipality held a neighbourhood referendum, and the motion passed by more than the required two thirds majority. They hired a contractor to pave the road, and split the cost equally among the 60 households. And today I got a letter asking whether I wanted to pay a lump sum of $6,050 or 15 annual payments of $583 added to my property taxes (which includes interest at 5%).

The first question is why did we need the government to do it? Why didn't we just hire the contractor ourselves?

I expect the answer is that the paved road is a non-excludable good. If one of the neighbours refused to pay, we couldn't really stop him using the paved road. Only the municipality could enforce payment. We couldn't prevent "free-riders". We might also add that the paved road is a non-rival good; it's a quiet street, with no congestion, so one extra car or household using the paved road has a marginal cost of zero, so it wouldn't be efficient to exclude anyone. Non-excludable, and non-rival; you could say it meets the classic definition of a "public good". But I share Frances' fear that the "public good" concept is a pedagogical bad (pdf). It's so easy to confuse "public good" with "publicly provided good".

A Coasian would argue that if the transactions costs were low enough, we could still have gotten the street paved without needing the municipality to intervene. If the sum of the neighbours' Willingness To Pay exceeded the cost of paving, we would have been willing to pay the costs. And if it didn't, the road shouldn't be paved anyway. But of course it's hard to get people to reveal their true WTP if what they actually pay depends on their announced WTP. I'm not up to speed on the latest findings in the design of revelation mechanisms which might solve this problem. But aren't they vulnerable to "hold-up" problems: where someone commits in advance to refusing to pay (if they can do so credibly)? Or arguing about which of several potential mechanisms will be used?

In any case, we didn't take that route.

But there was an earlier free-rider problem. Things don't just happen by themselves. Someone had to go around to organise the neighbours to lobby the municipality to hold a vote. Like toilet cleaning and department chairing, it's a job that many wanted done, but everyone would prefer someone else to do. Who would be the one to do it?

Simon lives near the end of the cul de sac; has two young boys who wanted to rollerblade; and likes to keep his car clean. It was therefore common knowledge that Simon was the one who most wanted the street paved. Simon was also unable to pre-commit to not doing the job of organising the neighbours, which would force someone else to do it. So Simon must have reasoned as follows: "if an equilibrium exists in which one person does the job, that person will be me; so if I want the job done, I will have to do it myself; and so I had better do it".

Or maybe he is just civic-minded.

The vote was nearly unanimous. That puzzled me at first. Surely some people wouldn't personally care whether the road was paved. Some might even prefer it unpaved. But then the paved road should increase the values of the houses on the road. Even if I personally didn't care whether or not I was living in a house on a paved or unpaved road, if it increased the value of my house by more than the cost of paving the road, I could still benefit by selling the house, pocketing the capital gain, and moving to the next street over. What matters for the house prices is not the value that current residents place on having a paved road; it's the value that the marginal potential resident would place on having a paved road. According to the Tiebout model, the personal preferences of the current residents wouldn't matter at all; population flows ensure that every municipality should provide the optimal mix of goods and taxation. There are transactions costs of trading houses and moving, of course. But some might have been considering moving anyway.

So now we get the bill. But we have a choice of how to pay it. We get to choose, as individuals, whether the government expenditure will be "tax-financed" (one lump-sum payment), or "bond-financed" (15 annual payments with the same present value as the lump-sum, to retire the debt plus interest).

Ricardian Equivalence says that the method of finance of government expenditure doesn't matter. You can see the point. If I have $6,050 cash, I could either pay the lump-sum, or I could lend it to the municipality (or lend it to the bank which in turn lends it to the municipality), pay $583 per year extra taxes to the municipality, which gives it straight back to me (perhaps via the bank) to pay down the loan. Or if i don't have the $6.050 cash, I could borrow it from the bank (or from the municipality, which in turn borrows it from the bank), then pay the bank (or the municipality, which in turn pays the bank) $583 per year to pay off the loan.

At first sight, it's a wash either way. Whether the municipality financed by taxes, borrowing, or gave us the choice between the two, shouldn't matter.

But small things may make it matter. Now we go from public finance to personal finance. I have until the end of May to decide. Here's what I'm thinking about my choice.

If I knew I weren't going to move house in the next 15 years, I would pay the lump sum. I have no debts, am maxed out on my TFSA and RSP, and can find the $6,050, so a tax-free and risk-free return of 5% looks pretty good to me.

But suppose I sold. Would my lump-sum be reflected in the price at which I could sell my house? It ought to be, if the housing market were efficient, but is it? I don't mean "efficient" on any macro-scale, but at a micro-micro level. Would my house in June with the $6,050 already paid be worth $6,050 more than my same house with 15 annual tax installments of $583 still due? I can think of a few reasons why it might not be.

Maybe (some) potential buyers ignore the property taxes. If so I should not pay the lump sum, if I might move soon.

Maybe (some) potential buyers look at the property taxes, but don't look at the fact that the extra taxes last for only 15 years. Then I should pay the lump sum.

Or maybe, (some) potential buyers look at the property taxes, then multiply by (say) 100 to get a rough estimate of the assessed value of the house (we have property taxes based on market value assessment here). Then I should not pay the lump sum.

Or I could just say "To hell with it; financial intermediation is always imperfect, and the right thing for me to do is to minimise the stress on the global financial system, so I should just pay the $6,050!"

Dunno.

Comments

[Frances Woolley]

Interestingly enough, if you go back to Adam Smith and The Wealth of Nations and try to figure out why Adam Smith supported government provision of some public goods, you'll find that his reasoning was very similar to yours. In particular, he pointed to the hold up problem, something that's almost forgotten in much of contemporary public finance.

[Nick Rowe]

Frances: that's interesting. (It seems that everything's somewhere in TWoN). The hold-up problem seems, in principle, amenable to game-theoretic analysis. Without the hold-up problem, it does seem to me that most "public goods" could be provided privately, by negotiation between the beneficiaries.

[Adam]

"The first question is why did we need the government to do it? Why didn't we just hire the contractor ourselves?"

I gather that this discussion simply takes it for granted that if you tried to pave a city road on your own without getting the municipality involved, that you'd get sanctioned (presumably, fined)?

Not that this point changes anything you said, but it's worth mentioning.

[Nick Rowe]

Adam: Since the municipality owns the road, we would have needed their permission. But I think they would have given it. After all, they were prepared to pave it if we paid the cost. There's another question of what it does to the municipalities future costs of maintaining the road. My guess is that it reduces it slightly. Gravel roads (especially ours, with a clay base) needed a lot of ploughing to smooth out potholes whenever it rained. But I did ignore all this, to keep the story simple.

[Neil]

If you might move within 15 years, take it on the tax bill. My guess is that buyers will look at the tax amount, determine whether or not they can afford it, and may not even realise that there's a surcharge that other similar properties might not have. The tax surcharge is not likely to be something that even a real estate agent would think to factor in when looking for comparables.

[Nick Rowe]

Neill: Dunno. When I was shopping for this house, all the real estate agents' one-page flyers showing the key details for each house always listed the property taxes right next to the asking price. Also, I remember reading about cases in England, just after they brought in the new market value taxes in the 1980's, where people appealed their tax assessments demanding to be placed in the higher tax band. Though that might be one of those "man bites dog" stories; the fact that it gets reported in the newspapers means it almost never happens.

[Just visiting from Macleans]

What Renovations Will Yield The Highest Return When I Sell?

Kitchen and bathrooms usually are the top of most cost recovery lists, as they are on this one. I think if you were to get the full list, cost recovery for a paved road is probably right at the bottom, just below delivery of a large boulder in your front yard. So, I'd say load it on the taxes.

Now, in Adam Smith's day, you could probably take the cobblestones with you...

[Nick Rowe]

Dang! And I paid $5,000 for that large boulder, as a "conversation piece"!

I'm surprised that any home renovation would recover 100%. Since the new buyer could always do exactly the same renovation himself, if he wanted. Essentially, when you do a renovation you lose "the option value of doing nothing". But it's not so easy for an individual home buyer to get the road paved.

[Alex Plante]

Sadly, with public infrastructure we're stuck with 3 unsatisfactory ways of doing things:

1) Have everything done by unionized public employees, who only work half the time they're paid for and have outrageously expensive pensions.
2) Go to public tender and have everything done by private firms, but you know that more than half of what you pay for goes for "business development", marketting and profits.
3) Do a PPP, which costs the most but the government can pretend it costs nothing.

[Just visiting from Macleans]

I think some of the higher recoveries are compensation for the inconvenience factor- nothing like the taste of drywall dust on your morning cornflakes, or eating Micky D's for two months solid. It seems I've even seen references that home renos are one of the most stressful marriage busting activities one can undertake.

[Adam M]

A timely and relevant blog post given my personal life. Several of my neighbours are seeking to have fences installed. I am living Coase first hand as well. There are a high number of households involved and the transaction costs are starting to creep up. I found Coase compelling as a student and I found myself thinking about it over the last few weeks. Too bad I was never very good at game theory.

Back on topic. On a personal finance note, I know we can't accurately predict this but do you have any expectations as to what inflation will do to your money and salary over the next 15 years? If you think it will have a serious effect on your purchasing power, you could be better off taking the 15 year option as that $585 in 2010 dollars will likely be worth less in terms of purchasing power in 15 years.

I know there are many, many variables to consider when thinking about personal finance (rate of return, transaction costs, inflation, taxes, etc). Anyway, I think inflation expectations are important consideration. I definitely do consider inflation in my personal finance decisions.

[Jim Rootham]

You left out of the calculation the likelyhood that the town could get it done cheaper.

They already have a tendering infrastructure, a good network of contractors, and oversight professionals on staff. Contractors will also look at them as a better payment risk, which will get built into the bid, plus the issue of getting future work.

I strongly suspect that these considerations utterly dominate the local purchase vs government purchase decision.

[Phillip Huggan]

The municipality's planners should've built the development to encourage fewer mental health problems, less porky kids, less infrastructure (pavement) costs...
http://blog.fusedgrid.ca/

Pavement to unsustainable housing is hardly a public good; promotes future AGW and pandemics. $400000 would fund local gardens and canning workshops that would stave off both non-local droughts and crowded stores.

[Nick Rowe]

Adam M: "On a personal finance note, I know we can't accurately predict this but do you have any expectations as to what inflation will do to your money and salary over the next 15 years? If you think it will have a serious effect on your purchasing power, you could be better off taking the 15 year option as that $585 in 2010 dollars will likely be worth less in terms of purchasing power in 15 years."

My guess is for 2% inflation (I think the Bank of Canada won't change its target, and will likely hit its target).

But it really depends on what my other investment options are for the $6,050. If I were planning to buy a series of bonds with 1 to 15 years to maturity, at 5% interest, then it won't make any difference (except I don't get taxed on the returns if I "lend it to myself" by paying the municipality in a lump sum.

If I expected high inflation though, then as you say, I might buy real assets instead.

[Adam M]

Nick: I agree with you. It all depends on what your current investment options are and whether you can sleep at night taking on risk that nets you more than 5%.

While I struggle with the idea that this would be an investment, since it derives no real money returns, I appreciate the need to keep costs low. Personally I would be inclined to treat this as a depreciating asset (like a car, fence, etc.) which would be consumed over time so, in my opinion, why pay the 5%? If you chose the payment option, you would reach $6050 in the first 10 years and for the next 5 years of payments which, in effect, would be unnecessary especially if you plan on living their beyond that.

So even though I wouldn't treat it as investment in the context you described, I think I still arrived at the same conclusion as you. Pay by lump-sum and you're ahead of the game financially.

[Lord]

Having looked at sales data with varied taxes and association dues and despite property differences that usually outweigh these, buyers generally do take this into account, at least limitedly. Some the reasons they may not is whether they may think this is one time or reoccurring amount even if not explicit, or whether they anticipate future charges even if not pending.

[westslope]

You have $6,000 to invest. You want something rock-solid conservative so you look at an attractive, low-risk corporate bond paying 5% semi-annual coupons that you can buy at face value. The bond matures in 15 years.

Yes? No? I would personally avoid such an instrument in the current macroeconomic environment given that I expect borrowing rates to steadily increase over the near-term. If borrowing rates, increase, the bond will decline in value and trade at a discount.

Let's think about paying the tax as a type of renovation investment. The stylized facts of returns on renovations are not encouraging. Apparently, the typical return is negative. Why? Perhaps because tastes in domiciles and attribute bundles are so idiosyncratic? Yet, according to my first-hand anecdotal evidence, many home owners who renovate sincerely hope to increase the market value of their home.

Are home shoppers fully Ricardian-Equivalent with respect to property taxes? My intuition suggests that is not the case. The great unwashed (including those with graduate degrees in so-called hard science) seem to have great deal of difficulty understanding taxes, and their incidence. So if we drop the implicit assumption of rational behaviour and assume some kind of other behaviour pattern, how will prospective buyers react to the lump sum tax being paid off or the option of let's say another 10 years of additional property-related extra tax payments?

Does the endowment effect pertain to paid up or outstanding tax obligations? I suspect that most ordinary tax-incidence challenged home shoppers would negatively view a future stream of extra tax payments. If that is the case, a marketing-wise seller would want to pay the taxes upfront.

[Just visiting from Macleans]

Hey, no matter how you wish to finance it, or how you wish to discount it, if the retail value is zero, it doesn't really matter.

Then the q becomes - how to stick the next guy with as much of the cost as possible?

Again, I'd argue, put it on the taxes, and when they show the house- invite the kids in the cul-de-sac who normally play road hockey to the nearest Odeon theatre for a matinee show, and spend the saved money on a home "stager" who will place bags of potpourri strategically through your pantry to maximize NPV (or "karma" as they may call it)...etc,

[azmyth]

"the right thing for me to do is to minimise the stress on the global financial system, so I should just pay the $6,050!"

Hilarious - only an economist would say this. I wholeheartedly agree with this sentiment. Given an option, I always try to pick the simpler option if the terms of the agreement are fairly neutral either way.

[Panayotis]

Nick Rowe,
Very interesting post.
In my own work regarding the public vs the private paradigm I have concluded that a public transaction of occurence or the publicity process has different dynamics than a private transaction of occurence or the privacy process. A public transaction orientation is engaged by civic units sharing common attributes/rights formed by symbiosis of parts of occurence or occurences in a community setting. They are triggered by the incentive of duty in solidarity among civic units and in cooperation among common attributes.Common attributes is the result of a mutual arrangement of symbiotic relationships.
A private transaction orientation is engaged by shelf units trading proprietary attributes/rights formed by osmosis of parts of occurence or occurences in a market setting. They are triggered by the incentive of interest in competition among shelf or private units and in synergy among proprietary attributes.Proprietary attributes is the result of a lateral arrangement of osmotic relationships.
Every transaction is the joint manifestation of privacy and publicity processes differing in relative intensity conditioned by the regime situation that favors either common or proprietary attributes/rights.

For example a transaction can be more of a work/reward process/feedback or a donation/grace process/feedback. The difference in dynamics shows that we must analyse transactions taking into consideration the relevant incentives and forces that operate upon the transaction.

[Just visiting from Macleans]

20? 25?

[TGGP]

Interesting you used the example of a road, since that's what Frank Knight argued against Pigou in "Some fallacies in the interpretation of social cost".