Economic downturn: UC experts weigh in

Despite the sluggish condition of the national and state economy, most University of California economists see hope on the horizon. But conquering job loss, inflation fears and the continuing fallout from the subprime mortgage meltdown will require dramatic public policy changes. Here are a few suggestions for stimulating growth, fixing the mortgage industry and boosting state revenue.

'Biopolar' housing sector needs new medicine

Edward Leamer, UCLA professor of economics and statistics; Chauncey J. Medberry Chair in Management; director, UCLA Anderson Forecast

When analysts at the UCLA Anderson Forecast issued their first-quarter report in March, they had bad news and not so bad news. Their forecast proclaimed a sluggish economy close to recession - but not there yet.

Forecast Director Edward Leamer used the term "nervously intact" to describe the forecasters' no-recession outlook. 

He is still holding onto that guarded optimism although the housing sector meltdown continues to be a drag on both the national and California economy.

"The housing sector has its ups and downs," he says. "It's bipolar. There is manic buying followed by depressed periods. In order to keep that bipolarism in check, you need to take the right medicine at the right time."

Leamer has some ideas about what that medicine should be and it's neither a bailout for current homeowners nor an income tax rebate check. A reported 130 million U.S. households are expected to receive tax rebate checks, ranging from $300 to $600 for singles and $600 to $1,200 for joint filers, with an additional $300 for each dependent child. By the time the last rebate checks are distributed in July, the economic stimulus measure is expected to cost $110 billion. However, according to news reports, people who have gotten their rebates say they are using the windfall to pay off bills or cover the higher costs of food and gas – not to buy new consumer goods.

In Leamer's view, the problem with the economy is not a lack of consumer spending, but what consumers are spending on.

To really stimulate the economy, he says, Americans need to get back into the home-buying mood.

"Basically, when you buy a new home, you spend a lot of money," Leamer says. "It's highly stimulative. If you buy another toaster oven at Wal-Mart, you're just helping Chinese manufacturers."

Attracting buyers when real estate values are dropping will require government intervention, he says, because when housing prices slide, buyers lose a sense of urgency to make a purchase. There is an expectation that prices will go even lower, so buyers tend to stay on the sidelines waiting for a better deal to come along.

Leamer suggests a temporary tax rebate of 5 percent, up to $25,000, of a home purchase price. The rebate should be available only to first-time home buyers. That would benefit middle-income and younger buyers who haven't been able to afford home ownership rather than real estate speculators. Offering the rebate for a 12-month period would create a sense of urgency, as people thinking of buying a home would act sooner rather than later to take advantage of the rebate. Such a rebate program would work on the state level as well, he says, and would generate enough spending to produce future higher state or federal revenue.

Again, the timing of the rebate medicine is important, and based on Leamer's analysis, the second half of 2008 would be the best time to offer the rebate. Once the housing market starts moving out of its depressed stage, he says, the Federal Reserve needs to start raising interest rates to avoid the manic buying frenzy that typically follows a period of depressed sales.

More relief for homeowners needed

Kenneth Rosen, California Professor of Real Estate in the Haas School of Business, chair of the Fisher Center for Real Estate and Urban Economics at UC Berkeley.

Kenneth Rosen rates the potential damage from the mortgage crisis right up there with the stock market crash of 1929. Fortunately, he says, the federal government intervened with the March bailout of investment firm Bear Stearns.

"They've stepped up to provide liquidity to the banking industry," Rosen says. "They've taken a lot of the steps to alleviate the crisis."

But there is still much work to do on the consumer side. As more homeowners face foreclosures, Rosen supports a sweeping loan modification program to reduce further impacts from the subprime mortgage fiasco.

Many of the reforms under consideration in Congress and the state Legislature include some version of the measures Rosen believes will prove the most effective. Those include a moratorium on all owner-occupied foreclosures and mortgage payment increases as adjustable interest rates adjust upward. In cases where home values have fallen below the loan balance on owner-occupied residences, he'd like to see the loan balance adjusted to the current value with the investor who owns the mortgage absorbing the loss.

Mortgage payment increases should be capped at 7.5 percent a year and subprime mortgage rates adjusted to no more than 1 percent above the current prime mortgage rate.

The goal of all reform measures, Rosen says, should be to keep honest buyers in their homes. He believes a large number of the people in foreclosures lied about their income and intention to live in the house to qualify for a loan. Those speculators don't deserve a bailout, he says.

California must embrace the T-word

Steven Sheffrin, dean, UC Davis Division of Social Sciences; director, Center for State and Local Taxation; professor of economics

As painful as it sounds, the time may have come for Californians to resign themselves to higher taxes.

"The gap between the state's spending and revenue taken in is large enough that it can't be closed by spending cuts alone," says Steven Sheffrin, UC Davis social studies dean and an authority on taxation.

Yet he's not enamored with the idea of raising the sales tax rate. Instead he favors expanding the sales tax to include services. The practice of taxing only tangible goods dates to the 1930s before a service economy evolved. Consumer spending habits have been changing over the last several decades to include more services. According to the California Legislative Analysts Office, in 1981, 48 percent of consumption was subject to sales tax. In 2005, 38 percent was taxed.

"My view is rather than impose a higher rate, it would be better to expand the sales tax," says Sheffrin, echoing an idea that has been circulating through state budget crisis discussions.

If California began taxing services such as personal grooming and household services, billions of dollars in revenue could be raised, says Sheffrin, a former financial economist with the Office of Tax Analysis and the U.S. Department of the Treasury.

A co-author of the 1995 book Property Taxes and Tax Revolts: The Legacy of Proposition 13, Sheffrin thinks a revamping of the landmark property tax initiative is overdue.

June 6 marks the 30th anniversary of the voter approval of Proposition 13. Given the current budget deficit, Sheffrin believes there are two changes to Proposition 13 that could help deliver the state from its recurring budget shortfalls.

The first would be to limit the tax-increase protections to residential owners and begin to tax commercial properties at a percentage of the market rate. In 2003, the UC Davis Center for State and Local Taxation, which Sheffrin directs, studied the implications of taxing commercial property at 1 percent of real market value. Sheffrin, who co-authored the study, estimated the state would have gained $3.3 billion more in tax dollars.

"Eventually California will move to take away Prop. 13 protections for commercial and industrial properties," he says. "I don't know when that will be."

An alternative might be to boost the 2 percent annual cap on property tax increases to 4 percent.

UC San Diego Economics Roundtable Lecture Series: Prospects for the U.S. Economy and Monetary Policy Implications

Janet Yellen, president, Federal Reserve Bank of San Francisco, professor emerita UC Berkeley
Monday, July 7
7:30 to 9 a.m. (Continental Breakfast)
UCSD Faculty Club
Fee to register. For more information: (858) 822-0510 or emunk@ucsd.edu