Conservation Easements

“Charitable Contributions of Conservation Easements,” by Adam Looney. Economic Studies at Brookings, May 2017.

In Michael Lewis’s 1998 book Losers about the 1996 Republican presidential primary, he remarks that upon hearing candidate and orator par excellence Alan Keyes speak for the first time, he was torn between being outraged by Keyes’ message and feeling compelled by Keyes’ arguments to quit his job and work for Keyes’ campaign.

Likewise, the treatise on conservation tax easements by Adam Looney—a fellow at the Brookings Institution and a former economist for the Council of Economic Advisers—filled me in equal measures with anger over the existence of a costly and unproductive tax break and visions of exploiting the break to bilk the Treasury and make millions for my family.

A conservation tax easement essentially awards property owners a tax benefit in exchange for the owners permanently extinguishing the right to develop a property. The intent of the deduction is to provide an incentive for landholders to preserve pristine land that they might acquire. For instance, the hills surrounding the childhood home and presidential library of Calvin Coolidge in rural Vermont all have conservation easements applied to them, precluding future development and maintaining the area just as it was in the late 19th century.

However, an easement can also be granted to a golf course or a backyard, which illustrates the rub with this tax provision: most of the time it is used to stop development in places where development was unlikely to ever occur.

For instance, many homes in Georgetown have been granted a type of conservation easement that precludes owners from altering or removing the façades of their houses. The easement affords the owner a charitable deduction—ostensibly worth the reduced value of the home that results from the easement—of as much as $100,000, which represents a substantial savings for the homeowner.

Of course, the notion that someone who owns a stately townhome in this wealthy enclave could ever get the local Area Neighborhood Council, city government, housing commission, and pitchfork mobs to allow any sort of change to its façade is laughable. It’s unlikely that a single façade was “preserved” by this conservation easement. I suppose it can be argued that the easement is just compensation for all these political bodies usurping the development right, but most if not all affected property owners were aware that the development right was lost long before they purchased their properties.

It can be argued the easements are just compensation for lost development rights, but the property owners know those rights were lost long ago.

In the case of the conservation easement Looney describes, the property owner must donate the right to develop the land to a nonprofit. Many of these properties are small: backyards instead of open land.

The conservation easement is not terribly common: only about 2,000 taxpayers claimed it in 2016, Looney determined. But it is becoming increasingly costly: the Treasury lost $5–$7 billion to it in 2016.

Looney reached the latter estimate by going through Internal Revenue Service forms 8283 and 990, although the latter documents—a standard for all nonprofits—were not terribly useful for this purpose. Of the top 21 organizations in terms of the amount of easements received, only six actually bothered to report them on their 990s. He suggests that this omission may obscure the fact that some of these charities are not, in fact, charities in any real sense of the word but instead act more or less as private foundations, and that closer scrutiny by the IRS would force them to conclude as much. This is now among the IRS’s most litigated tax issues, despite the low number of taxpayers who claim the deduction.

This lack of transparency may persist indefinitely, Looney laments. An entity called Partners for Conservation lobbies to prevent any sort of mandated disclosure of such transactions. A provision that would prevent such reporting was included in a draft of an appropriations bill in 2016.

Greater transparency on such transactions is important because the tax revenue losses from conservation easements have been accelerating over the last few years. What’s more, such easements occur most often in a few select geographic areas, most notably Georgia. Looney attributes this mainly to the fact that a small legal community there has figured out how to game the system, rather than any surfeit of land in need of conservation in the Peach State. In contrast, the states we commonly think of as being leaders in acres conserved—Wyoming, New Mexico, Maine, Montana, New Hampshire, Washington, and Arizona—have virtually no conservation tax easements.

These benefits from the easement are also highly concentrated. The top 2% of all transactions amounted to 43% of the cost of all easement tax breaks, and the top 10% amounted to fully 70% of the cost. The valuation of the land in these easements ranged from $10,000 an acre to over $100,000. Prospectuses published by lawyers hoping to earn fees for creating new easements suggest an investor can obtain $6–$9 of tax deductions for every $1 invested in an easement.

Our tax code has many such dubious tax breaks ostensibly designed to promote conservation of some sort that accomplishes little in this regard. For instance, a great number of summer lake homes in Wisconsin come attached to relatively large lots, the preponderance of which are just over 17 acres. This is because 17 acres once was the minimum size for a property to be considered a tree farm in the state. Being a “tree farmer” was a great tax dodge because tree farmers had to show a profit from the activity only once every 17 years, instead of every three years for other businesses. The thousands of “tree farmers” in the state could deduct a variety of expenses related to the upkeep of their cabins, and every so often they would have someone harvest a few trees that paid them enough to show a profit for the year.

Wisconsin now has a Managed Forest Law that was crafted to avoid the abuses of the tree farm law. The new law greatly reduces the property tax on land that’s at least 40 acres, available for recreation, and undeveloped. But, unsurprisingly, there are easy ways to still put a house on the land, deny access to hunters and hikers, and get the low tax rate just the same.

Many people still have a perception that giving a tax break to induce behavior is somehow inherently different and less expensive than a government expenditure. However, the distinction is meaningless, and when most of a tax break fails to affect any salutary behavior at all while costing the public fisc billions a year, it is an abomination. We should all be outraged by the results of Looney’s research. —Ike Brannon

Investment Advice

“The Misguided Beliefs of Financial Advisors,” by Juhani T. Linnainmaa, Brian T. Melzer, and Allessandro Previtero. December 2017. SSRN #3101426.

In 1934 Congress created the Securities and Exchange Commission, which regulated brokers who bought and sold stocks and bonds for investors. In 1940 Congress enacted the Investment Advisers Act, which implemented different legal standards for those who provided financial advice for a fee but do not sell financial products. Interestingly, the 1940 law holds financial advisers to a stricter fiduciary standard, requiring them to recommend the “best” financial product to clients, while brokers under the 1934 law are only required to recommend “suitable” financial products if their advice is “solely incidental” to their service as a broker.

This has produced a legal and political wrestling match over the different regulatory treatment of brokers and financial advisers. The perception is that brokers operating under the looser standard have incentives to steer clients to purchase investments that yield fees and commissions for the brokers rather than investments whose net returns to the brokers’ customers would be higher, and that regulation is required to eliminate those incentives and the resulting financial malpractice.

After the 2008 financial crisis, the original Senate version of financial reform legislation authored by Sen. Chris Dodd would have eliminated the broker exemption from the fiduciary standard. But as enacted, the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 only requires the SEC to study the issue and report to Congress on the problems created by the differential regulatory treatment of financial advisers and brokers.

Given congressional inaction, President Barack Obama instructed the Department of Labor to impose the stricter fiduciary rule on Individual Retirement Account advisers using the DOL’s regulatory authority over company-provided retirement plans under the Employee Retirement Income Security Act of 1974 (better known as ERISA). The DOL did so in 2016, but advisers have not had to comply with this requirement thanks in part to the Trump administration pushing back the compliance deadline to July 1, 2019. This past March, the Fifth Circuit Court of Appeals vacated the Fiduciary Rule, stating that the DOL had overstepped its statutory authority.

The investment advisers traded more, had less diversified portfolios, and paid more in fees for their own accounts relative to their clients’ accounts.

The authors of this paper argue that the “conflict-of-interest” view of financial advice that is the rationale for the fiduciary rule is not consistent with the data studied in the paper. The authors had access to trading and portfolio information on more than 4,000 advisers and almost 500,000 clients between 1999 and 2013 provided by two large Canadian financial institutions. These advisers were not subject to fiduciary duty under Canadian law. A comparison of advisers’ trades for their own accounts and their clients would reveal any systematic differences. If the conflict-of-interest theory is right, advisers’ personal accounts would hold lower-cost, more diversified investments.

The authors conclude that misguided beliefs are the problem rather than conflicts of interest. The advisers trade more, have less diversified portfolios, and pay more in fees for their own accounts relative to their clients’ accounts. And both have net returns that are about 3% less than the market.

The authors present four additional types of evidence to support their argument. First, advisers continue to trade similarly after they quit the industry. Second, the correlation between their behavior and their clients’ increases with the size of the advisers’ personal portfolios. Third, advisers would have been better off had they held exact copies of their clients’ portfolios. Finally, advisers’ trading behavior is stable over their career.

—Peter Van Doren

Environmental Regulation

“Is Pollution Value-Maximizing? The DuPont Case,” by Roy Shapira and Luigi Zingales. September 2017. NBER #23866.

Gary Becker introduced the economic conception of crime deterrence in 1968. According to Becker, prospective criminals compare the expected costs and benefits of crime. That is, they compare the benefits of the criminal conduct to the probability of being caught multiplied by the monetized cost of conviction. If the expected costs of the crime are greater than the benefits, then the crime is deterred. If the expected costs are less than the expected benefits, then the crime occurs.

This paper explores rational deterrence in the context of environmental law. DuPont emitted C8, a precursor to Teflon, into the environment even though it knew as early as 1984 that the substance is toxic. DuPont had the option to incinerate the C8 and thus avoid the emissions, but the firm chose not to. In fact, production doubled after 1984.

The option of abating C8 was relatively cheap and could have prevented the health damages as well as the legal ($617 million in 2017) and reputational damages paid by DuPont. Why did the company choose the option that seems worse for the company and certainly worse for society?

By comparing the present value of DuPont’s actual legal liabilities with the present value of the abatement costs, the authors estimate that it was value-maximizing to pollute if the probability of getting caught was less than 19%. According to the authors:

For decades only DuPont and other chemical companies knew the adverse effects of C8 emissions. Yet, DuPont had powerful incentives to hide that information, or selectively release parts of it to the outside world. By controlling information, DuPont was able to co-opt regulators, delay enforcement, and limit the ability of academics or journalists to chime in.

Because DuPont controlled the information that would have increased the expected costs of pollution, it was reasonable for DuPont’s executives to take the risk. In other words, the decision to pollute was ex-ante optimal for DuPont’s shareholders. —P.V.D.

Market Power

“Is Aggregate Market Power Increasing? Production Trends Using Financial Statements,” by James Traina. February 2018. SSRN #3120849.

Concerns about corporate power and antitrust policy remedies are once again in the news and the pages of Regulation. (See “Debunking the ‘Network Effects’ Bogeyman,” Winter 2017–2018, “The Return of Antitrust?” Spring 2018.) This paper examines the specific question of whether business markups above the marginal costs of production are also increasing over time.

Traina argues that in 1950 markups were about 15% over marginal cost. Over the next 30 years, they decreased approximately linearly, falling to just under 10% over marginal cost at the beginning of the 1980s. From then until today, however, they have increased approximately linearly, returning to the 1950 level.

His estimates of this markup differ from others because of two methodological differences. First, public firms make up only about a third of U.S. sales and employment. Because these firms are often larger than private firms, markup estimates using only public-firm data bias an aggregate estimate upward. Second, neglecting indirect costs of production such as marketing and management, which are an increasing share of variable costs for firms, overstates both the level and growth in markups. As a share of variable costs for firms, these components have increased from roughly 12% in 1950 to 22% today. A significant part of the incorrect markup estimation is misattribution of selling and general administrative expenses to markups rather than variable costs, and this omission has increased over time. —P.V.D.

Employer Credit Checks

“The Unintended Consequences of Employer Credit Check Bans on Labor and Credit Markets,” by Kristle Cortes, Andrew Glover, and Murat Tasci. January 2018. SSRN #3103294.

Regulations are often enacted with the best of intentions, but they sometimes produce counterintuitive results.

In my Fall 2016 Working Papers column, I described laws that “ban the box,” prohibiting employers from asking about criminal history on initial job applications. The intent of such policies is to increase employment among black males, who have disproportionately more criminal convictions than other applicant groups. Most black men, however, do not have criminal convictions. Under ban-the-box policies, they are not allowed to signal that fact to employers. As a result, they lose work opportunities because employers, deprived of the criminal history information, become less likely to hire black men.

Something similar appears to be happening with credit history information. In the aftermath of the Great Recession, many people lost their jobs and fell behind on their debts. When these people subsequently applied for jobs, some were denied employment when prospective employers became aware of the applicants’ low credit scores. Legislators responded by describing this situation as a “poverty trap” because the applicants need employment in order to repair their credit scores, but they need better credit scores in order to gain employment. In response, 11 states banned employer credit checks as of January 2018.

This paper compares employment vacancy creation in states that enacted bans relative to states that did not and relative to exempt occupations in which credit score checks were still allowed (e.g., jobs involving handling cash or access to payroll and Social Security information). When a state bans employer credit checks, the average county experiences a 12% reduction in vacancy creation relative to trend. This decline in job creation is likely caused by the bans because vacancies are unaffected in occupations in which credit checks are still allowed. —P.V.D.

Disability Insurance

“Intergenerational Spillovers in Disability Insurance,” by Gordon B. Dahl and Anne C. Gielen. February 2018. NBER #24296.

University of California, San Diego economist Gordon Dahl has devoted much of his career to examining the efficiency and distributional effects of social welfare policies. In my Summer 2014 Working Papers column, I summarized his analysis of expansion of maternal leave benefits in Norway. Dahl and his co-authors concluded that the program had no effect on a wide variety of desired outcomes and instead redistributed income to the affluent.

This paper evaluates the long-term effects of reductions in disability benefits in the Netherlands between 1993 and 1996. The reductions applied to younger cohorts, while older cohorts were exempted from the new rules. Younger workers who were pushed out of disability insurance or had their benefits reduced are now, a generation later, 11% less likely to receive disability benefits than their parents’ generation (with no increased use of other government safety net programs). Further, they earn 2% more in the labor market as adults.

The combination of reduced government transfers and increased tax revenue from lower use of disability benefits resulted in a fiscal gain of €5,900 per treated parent from child spillovers by 2014. Moreover, children of treated parents complete an extra 0.12 years of schooling on average, an investment consistent with an anticipated future with less reliance on disability insurance. Ignoring the beneficial parent-to-child spillovers understates the long-run benefits of the Dutch reform by 21%–40% in present discounted value terms. —P.V.D.