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Thursday, September 30, 2010

Policy Analysis: The Static vs. The Dynamic

Earlier this year a tax credit incentive ended for homebuyer’s. The short version was that homebuyer’s both new and old who entered a contract by the end of April and closed the purchase by the end of June would receive a tax credit between $6,500 and $8,000 for the purchase of their home. This government policy was enacted in 2009 to encourage and stimulate activity in the Real Estate Market which is often attributed to ‘leading recoveries’ in faltering economies.

So let’s breakdown this incentive, First of all should the government have offered this incentive in the first place? Well is there market failure in the real estate market? And more specifically since it was a tax credit, a form of subsidy, was that market failure a positive externality? Clearly it’s a market based transaction and anyone who received a commission from the exchange or is hired to perform a task related to the sale is done so in a competitive market. And any affect that the sale of the subject property would have had on neighboring property values due to a change in supply or demand is a function of market forces. There is little in a real estate transaction that could be construed as an externality and nothing that really is comes to mind. So now knowing that the incentive probably isn’t warranted let’s look at the potential effects of the incentive.

The tax credit was designed to stimulate market activity and revitalize the market by providing incentives for potential homeowners on the margin to buy homes. Which to some extent it did or at least appeared to based on improving sales figures which in turn showed a gain in home prices or a slowed decent as demand and supply forces moved. That is until June ended. July was the worst drop in real estate sales volume for the month of July (typically 1 of the top 3 homes sale months in the year) in over 20 years. So what happened? Although this is an ad hoc analysis it does offer some economic explanation for the change.

At first glance an incentive of up to $8,000 on the purchase of a new home could be seen as a substantial motivator to purchase a home. Similar to relocation incentives utilized by communities to entice new companies to the area, the $8,000 when compared to an increase in regular liabilities such as home upkeep, increased payment, taxes, etc. is a blip on the bigger picture. So what happened? Real Estate sales shifted, but did not necessarily increase; this is the failure of static analysis over dynamic. Policy makers predicted that demand would increase with the incentive and it did, quantity and price went up for the period that incentive was in effect. But the homebuyer’s operated in a dynamic fashion. Homebuyer’s who would have purchased in the 3rd and maybe the 4th quarter of the year purchased in the 1st and 2nd quarters and now with the tax incentives gone sales have dropped and prices are following accordingly in some areas.
The policy didn’t fix a market failure it created one.

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