The economics of the Car Allowance Rebate System (CARS) and the First-Time-Home-Buyer Tax Credit (FTHBTC)

A student in my managerial economics course asked me a very interesting question today concerning the U.S. federal government’s “Cash for Clunkers” (also known as “CARS”, which is an acronym for “Car Allowance Rebate System”) program.  Specifically, she was interested in knowing how to assess the social costs and benefits of government programs like CARS from an economics perspective.

Let’s look at CARS and its cousin, the so-called “first-time-home-buyer tax credit” (FTHBTC).  It’s worthwhile reading the October 28 article about the economics of CARS.  Apparently the net cost to taxpayers of CARS, per marginal sale, was $24,000.  Coincidentally, MIT economist (and former IMF chief economist) Simon Johnson published a Washington Post article about FTHBTC earlier this week which reports a net cost to taxpayers of FTHBTC of between $43,000 to $80,000 per marginal sale.  Thus the net effect of both policies has been to create a rather muted, temporary, and highly inefficient stimulus at a substantial cost to the taxpayer (the same points could be made about any number of other stimulus measures taken this year by the U.S. government, but I digress).  Professor Johnson notes (and I agree) that “Putting cash in pockets does have a stimulative effect because some of that cash will turn into consumption. But as far as stimulus measures go, it has a low multiplier (the ratio of new economic activity to stimulus spending).” 

In the case of CARS, a social cost of $24,000 provides a maximum net private benefit of $4,500 (note that the clunker would have to be literally worthless in order for the net private benefit to be equal to $4,500!), and in the case of FTHBTC, a social cost of $43,000 – $80,000 provides a maximum net private benefit of $8,000 (note that since the FTHBTC is means-tested, the average net benefit must be less than the $8,000 maximum).  In the case of FTHBTC, Professor Johnson asserts (and I agree), that most, if not all of the private benefit (i.e., additional “surplus”) is enjoyed by the seller of the home in the form of a higher price than she would have otherwise received from the buyer in the absence of the FTHBTC.  With the FTHBTC, the buyer will naturally become less reticent about paying top dollar for owner-occupied housing because up to $8,000 of the price is covered by taxpayers (also note that other public policies such as the tax deductibility of mortgage interest and mortgage securitization by the likes of Fannie Mae, Freddie Mac, the FHA, et al. have similar effects with respect to inflating the value of our nation’s housing stock).  For these very same reasons, I also suspect that much of the “surplus” associated with CARS ended up benefitting sellers by making new car buyers less price sensitive than they otherwise would have been.

Finally, bringing this question “closer to home”, I often think about the economic effect of government subsidies on higher education.  To the extent that the government subsidizes tuition (e.g., in the form of scholarships and below-market interest rates on student loans) this also has the effect of increasing the producer surplus enjoyed by universities by making students and their families less sensitive to price.  I am convinced that an important reason why education costs generally and higher education costs specifically have been increasing faster than overall inflation for some time now is due to the role played by government subsidies.  There’s also an obvious cautionary tale in all of this for health care reform, but I’ll leave that to a future discussion.

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