Price Controls Are The Wrong Response to High Rents. There Is A Better Answer
By David Grace (www.DavidGraceAuthor.com)
The Call For Rent Controls
Every time soaring rents cause homelessness, long commutes, and urban poverty a bunch of people advocate rental price controls as the solution. Those people are wrong.
You can’t efficiently fix a disparity between supply and demand with price controls, rationing, or product allocation schemes.
All of these tactics lead to corruption, black markets, system rigging, slow, complicated and expensive bureaucracy and an even further reduction in supply.
When rents are capped, sellers have far less incentive to increase the supply of rental property.
There Is Another Way
There is no magic bullet that will easily fix a shortage of supply that’s driving up the market price for any scarce, vital good. But, there is a mechanism that can
- Prevent profiteering in the sale of vital goods, that is deter sellers from electing to charge prices that are far above a cost-plus-a-reasonable-profit price, and also
- Still encourage producers to increase the supply of the product in question.
Even though rent control is a bad response to high housing prices, that’s not to say that reliance on the unrestricted market is a better solution. It’s not.
Shortages Of Vital Goods Encourage Existing Producers To Try To Further Restrict Supply In Order To Raise Prices Even Higher
In fact, the profit motive causes existing producers to respond to a shortage in the supply of a vital product by, if possible, engaging in schemes that reduce supplies even further.
Why?
The prices of vital goods are highly elastic, which means that the increased revenue derived from a higher price grows faster than revenue decreases from lower unit sales.
As long as a higher price per unit sold brings in more money than the reduction in the number of units sold reduces income (i.e. as long as the price is elastic), higher prices will yield higher gross revenues until, eventually, the price become inelastic, which is the point where further increases in the price will so reduce sales volume that the higher price will be offset by an even greater reduction in sales volume.
When there is a tight supply of a vital good whose price is elastic, existing sellers know that they will make more money from an even greater reduction in supply because a further reduction in supply will drive prices even higher and those higher prices will increase the sellers’ gross revenues even though the number of units they sell at that higher price may decrease.
If possible, existing sellers will always try to reduce the supply of vital goods until the market price has risen to the level of the monopoly price, that is until it has risen to a price of unit elasticity, otherwise known as the maximum-revenue price or the monopoly price.
We’ve seen this when
- During the “energy crisis,” Enron and others took power plants off line to increase electricity prices
- Oil companies reduced refining capacity to increase gasoline prices
- Airlines reduced the number of flights to raise prices and fill planes to capacity
- Generic drug manufacturers raised drug prices by 5X to 10X.
For a detailed discussion of how scarcity affects price see my column: A Pragmatic Look At Market Pricing. Market Pricing Both Efficiently Allocates Scarce Resources And Also Increases The Scarcity Of Those Same Resources
How Sellers Can Make More Money
There are fundamentally only two ways that the sellers of any product, including rental space, can make more money:
- Increasing the profit per unit sold by some combination of higher prices and/or lower costs, and
- Making the same or less profit per unit sold and increasing the number of units sold.
There Are Two Problems When Demand Exceeds Supply
When demand outstrips supply we have two fundamental, distinct problems:
- How do we allocate the limited supply among the many potential buyers? and
- How do we give producers an incentive to increase the supply and thus, eventually, see a reduction in the market price?
The two solutions to these two problems are:
- Allocation of the existing supply among competing buyers by market pricing, not rationing or price controls, and
- Giving sellers an incentive to increase supply and reduce prices by limiting their choice on how to make more money to only option two — by selling more units rather than by option one, increasing the profit per unit sold.
Sellers Always Prefer To Increase Profits By Selling Fewer Units At A Higher Price
Producers always want to make more money by cutting costs and raising prices because, so long as they still enjoy the economies of scale, capital costs, overhead costs, labor costs and materials costs decrease when the producer sells fewer units.
Once you have enough sales volume to benefit from the economies of scale, if you can make as much money, or more money, by selling fewer units, that’s always what you will want to do.
So long as you have enough sales volume to benefit from the economies of scale, labor costs are cut in half, materials costs are cut in half, overhead costs are drastically less and capital costs are drastically less if you sell half as many units at twice as high a price instead of selling twice as many units at half the original price.
Selling 1,000,000 units at a cost of $1 each and a price of $2 each will make you $1,000,000 in profits.
Selling 500,000 units at a cost of $1 each and a price of $4 each will make you $1,500,000 in profits, and also, manufacturing only 500,000 units instead of 1,000,000 units will reduce the size of your factory, the cost of your capital equipment, the number of your employees, the amount of your line of credit, your insurance costs, maintenance costs, your marketing budget, etc. and, until you lose the economies of scale, your cost per unit will end up being reduced.
Consumers Want Exactly The Opposite Of What Producers Want
When sellers can make more money by increasing the price per unit, existing sellers will be motivated to do whatever they can to restrict supply in order to cause the price to go up until the market price has risen to equal the monopoly price.
This is the opposite of what consumers want.
Consumers want producers to make more money by selling twice as many units at half the price per unit rather than by selling half as many units at twice the price per unit.
As consumers, we want to create a mechanism that only allows sellers to make more money by selling more units at the same price or a lower price rather than sellers having the ability to make more money by selling the same or fewer units at a higher price or lower quality per unit.
The mechanism that makes sellers forgo increasing profits by selling fewer units at a higher price is an excess-profits tax.
How Does An Excess-Profits Tax Do What We Want?
An excess-profits tax takes away profits that exceed a set percentage of deductible costs.
This tax takes away any extra money that a seller might earn by increasing the profit earned per unit through reductions in quality or increases in price.
When an excess-profits tax takes away any additional profit a seller might make by increasing its profit per unit, the only remaining way that a seller can make more money is by selling more units at the same or lower level of profit per unit, which is exactly what consumers want.
When sellers cannot make more money by charging a higher price, when the only way sellers can make more money is by selling more units, sellers are strongly motivated to increase the available supply so that they will have more units available for sale, which is exactly what consumers want.
How Does a Producer Sell Additional Units?
A producer sells additional units by increasing quality or features, better marketing, or decreasing the price, to which consumers say, “Yippee, that’s great for us!”
What Consumers Want
If sellers cannot make more money by raising rents and reducing costs (reducing maintenance, skimping on repairs, etc.) then sellers will have to make more money the only way that is left to them, by renting more units.
We want to motivate sellers to increase both the supply of rental units and the quality of those units and we also want to remove any motivation that sellers would have to increase the price of rental units or reduce maintenance or repair expenditures.
We accomplish both goals with an excess-profits tax.
How Would An Excess-Profits Tax Work?
In their best years Google, Apple and Microsoft earned a ratio of profits to costs of about 25%, so we know that a ratio of taxable profits to deductible costs of about 25% is absolutely high enough to energetically drive strong investment, entrepreneurship and innovation.
Although accountants would need to carefully design the definitions of profits and costs, in general, taxable profits in excess of 25% of deductible costs would be taxed at 99%. Of course there would be a cap on the amount of salaries paid to shareholders, directors, executives and related parties that would be used to calculate the amount of deductible costs.
So, if the costs of operating an apartment house were $30,000/month then the owner could charge a total rent of $37,500/month ($30,000 X 125%). Any rent collected in excess of $37,500/month would be taxed at 99%.
If the landlord’s costs increased, the rent and the allowable profits would also increase proportionately. In this way, the landlord would make more money by improving the property and spending more on maintenance, security and repairs, all things we want to encourage.
An excess-profits tax always allows the landlord to earn a good return over and above costs, but it removes any incentive for the landlord to simply raise rents to a level where tenants would feel that the landlord is getting an excessive return, e.g. if the building’s costs were $30,000 month and the market rate for the units was $50,000/month, the landlord would most likely choose to avoid raising the rent to $50,000/month and paying a tax of $12,375.
Instead the landlord would either keep the total rents at $37,500/month and be far more selective in which of the many applicants he/she chose to rent to, or the landlord would increase its costs by making improvements and spending more on maintenance, security, energy efficiency, etc. until its costs rose to $40,000 which would support a total rent charge of $50,000.
Of course, in addition to making a profit on the operation of the building, the landlord would also get an income-tax deduction for depreciation and would accrue an untaxed-until-time-of-sale capital appreciation.
Landlords with higher costs could charge higher rents, but they would still be limited to a profit equal to 25% of costs, so every landlord would have an incentive to incur additional costs, e.g. keeping their property in top condition, and bringing as many rental units to the market as possible.
On the other hand, no landlord would have an incentive to raise rents to an “all the market will bear” level because the excess profits tax would simply take away any rents above the 25% of costs level.
Flaws
There are problems with this mechanism.
Landlords would have an incentive to refinance their properties and pull out as much money as possible, knowing that the higher mortgage payments from the new, bigger loan would justify an increase in the rent and a consequent increase in the dollar amount of allowable profit.
Landlords might use that extra money to fund the construction or purchase of additional rental properties which would increase supply, but they also might simply invest that additional cash in other investment vehicles.
Countering this strategy would be the fact that many landlords have an aversion to taking on more debt than necessary given the potential volatility of the real estate market and incurring additional interest costs.
High rents and high debt might be of little concern today, but if the market softened, vacancies increased, or rents fell, then the higher mortgage would put the landlord in danger of going “under water” and possibly losing the building if rental income became insufficient to cover the payments.
A clever landlord might refinance, raise rents to cover the new, higher mortgage, and place the cash pulled out in the refinance in relatively liquid assets that would be available to pay the mortgage back down in the event of a future increase in vacancies or a drop in rents.
Of course, it might be possible to draft the excess-profits tax to exclude from the definition of “costs” any increase in mortgage payments resulting from an increase in the amount of debt secured by the building at any time after the landlord acquired the property.
While this would avoid rent increases tied to landlords drawing cash out of the property, it would also take away the landlords’ ability to use the equity in their properties to fund the construction of new buildings or for any other purpose.
Also, when a landlord with a relatively small mortgage and high equity sold the property at a substantial profit, the new owner would be able to greatly increase rents charged to existing tenants because of the much higher monthly payments required to pay the loan taken out to buy the property at that much higher price.
Thus, as older, lower-rent buildings with small mortgages were sold, rents for those properties would substantially increase to cover the new owner’s much higher purchase-money loans.
So, an excess-profits tax is not a magic bullet. It would, however, lower some rents, prevent many rent increases, and give landlords a strong incentive to improve the condition of their properties while also giving investors a strong incentive to build more rental properties, all without the bureaucracy, complications and reduced incentive to build more rental units common with standard rent-control schemes.
–David Grace (www.DavidGraceAuthor.com)
