Paying off the Mortgage Prior to Retirement

Financial Tip:   Pay off all debt, including the mortgage, prior to retirement.   This requires planning, the use of 15-year mortgages on the last purchased home, and prioritization of debt payments over additional contributions to 401(k) plans.

Discussion:   According to CNBC, experts differ on whether you should retire mortgage debt in retirement.  My view is that the retirement of debt in retirement is too little too late.  Mortgage debt has to be eliminated prior to retirement to reduce taxes and the risk of outliving your resources.

The goal of mortgage elimination prior to retirement is most important for people with most or all of their wealth inside a conventional retirement account because funds disbursed from 401(k) plans are taxed as ordinary income.  People with a mortgage and all funds in a 401(k) plan must disburse funds to cover the mortgage payment and tax on the disbursement.  Moreover, the increase in reported income from the larger 401(k) disbursements will subject a greater portion of Social Security income to tax.  (A portion of Social Security income is subject to federal income tax for single individuals for income starting at $25,000 and for married individuals for income at $34,000.)

The elimination of all mortgage debt prior to retirement requires some financial planning.  The goal could be achieved by the selection of a shorter-term mortgage for the final home purchase, refinancing from a long-term to short term mortgage, or by making additional payments towards the mortgage when nearing the end of your career.   A person over the age of 50 should, at a minimum, prioritize additional mortgage payments over catch-up contributions to 401(k) plans in order to meet this goal.   The worker might even consider further reductions in 401(k) contributions to eliminate the mortgage.

Action must be taken to eliminate the mortgage prior to retirement. A person already in retirement with a substantial mortgage and with most funds inside a 401(k) account does not have many good choices.

Consider, the case where a retired person has all of her wealth in a 401(k) plan.  She took out a 30-year $450,000 mortgage 25 year before retirement and has five more years of mortgage payments before the mortgage is retired.  The interest rate on the loan is 4.0%. Her mortgage payment, principal and interest, add up to $2,148.  (This was obtained from the PMT function in Excel.)   The annual payment on her mortgage is $25,780.   The outstanding balance on her mortgage is $116,654. (This was obtained from the FV function in Excel.)  

She could continue to live in her house and make her monthly mortgage payments.

She would have to withdraw funds from her 401(k) plan to cover her mortgage expense and other living expenses including her federal and state tax bills.  The larger disbursement to cover the mortgage increases her tax bill because the entire distribution from the mortgage is taxed as ordinary income.   She likely has Social Security benefits to cover some of her other living expenses.  However, the higher income from the larger 401(k) distribution to cover the mortgage increases the likelihood a portion of the Social Security benefit is subject to federal income tax.

It makes sense for people to reduce spending and 401(k) disbursements during market downturns to prevent rapid use of 401(k) funds. The person with a mortgage must withdraw funds from her 401(k) plan to meet the mortgage obligation regardless of the performance of the market.  The existence of the mortgage limits the ability of this person to reduce distributions in response to a market downturn.

The person could pay the entire outstanding mortgage balance of $116,654 in one year.  This would put her in a high marginal tax rate and would subject 85 percent of her Social Security benefits to tax in the year the large distribution was made.   

The person could sell her house, pay her entire mortgage and move.  Most elderly want to age in place.  

The viability of the downsizing option depends on the price the person could get on her current house, the amount of equity in her house and the cost of alternative housing, which depends on the price of the new house or the rent.   Hopefully, the new house would be purchased with cash not a new mortgage.

A person with a large amount of liquid assets outside of her retirement account could more easily pay off her mortgage.  The tax from the sale of assets outside a retirement account are substantially lower than taxes on funds distributed from conventional 401(k) plans because only the capital gain portion of the disbursement is taxed and under current law capital gains are taxed at a preferential rate. 

The problems described here could have been avoided by use of a Roth retirement account rather than a conventional retirement account.   A post on the potential advantages of Roth retirement accounts will be available shortly.

Financial Priorities for New Entrants to the Workforce

  • Students entering the workforce tend to have high expenses and relatively modest income.
  • Young adults need to prioritize the establishment of a good credit rating, the creation of an emergency fund, and investments in their job search.  
  • Contributions to 401(k) plans can wait.
  • A strategy of rapid reduction of student debt immediately upon entering the workforce will substantially improve credit scores and borrowing costs and reduce lifetime student loan repayments, by tens of thousands of dollars.   
  • Student borrowers with low-cost federal loans and higher cost private loans should prioritize repayment of the high-cost loan. It may be possible to refinance the federal debt once the private loan is eliminated, further reducing lifetime student loan payments.
  • The rapid repayment of student loan debt can lead to increased contributions to retirement plans once some or all student debt is eliminated.

Many financial planners and firms with solid reputations urge new entrants to the workforce to start their career by aggressively contributing to their 401(k) plan and saving for retirement.  Fidelity, a leading investment firm, recommends young adults have a 401(k) balance equal to their annual salary by the time they are 30.  

My view is that this objective is unrealistic for the vast majority of young adults entering the workforce with limited liquidity and substantial debt.  

My financial advice to young adults entering the workforce can be summarized in three tips – (1) maintain a solid credit rating, (2) create an emergency fund, and (3) rapidly reduce student debt to a manageable level.   The achievement of these goals often requires that student borrowers entering the workforce either entirely forego contributions to their 401(k) plan during their first few years in the workforce or at least substantially reduce contributions for some time.  

The importance of an emergency fund and a solid credit rating:

The first few years after a person completes school and starts a career are often financially challenging.  People leaving school often starts their job search with limited funds in the bank.  Starting salaries are often lower than expected and relatively few students immediately get their dream job. The process of searching for a good job is expensive and time consuming.  The successful job candidate often has some moving expenses.

Student debt repayment obligations generally start 9 months after full-time student status ends.  Moreover, the proportion of students with subsidized federal loans has fallen. The increased use of unsubsidized federal loans and private student loans has increased interest costs on student debt early in the borrower’s career. 

Contributions to a 401(k) plan should be an extremely low priority for a person starting a career with a low starting salary, in full search mode for a better job, without substantial savings and with immediate student debt obligations.

The financial planner will tell the financially strapped person with no funds to take the employer match on 401(k) contributions because it is “free money.”  Employer matches to 401(k) contributions are not free money if the diversion of money from current needs results in late payments and a deterioration of the person’s credit rating

The highest, perhaps only, financial priority of the new entrant into the workforce is to build a financial buffer in order to maintain a solid credit rating.

The failure to maintain a good credit rating will lead to extremely high costs for borrowers.

A search was conducted for likely interest rates for good and poor credit risks for four different types of loans – (1) credit card loans, (2) car loans, (3) a private student loan, and (4) a mortgage.  Assumptions were made on the likely maturity and initial balance of each loan and these assumptions were used to generate estimates of the monthly cost of bad credit.

The interest rate assumption was obtained from WalletHub, the car loan assumption was obtained from Nerd Wallet, the private student loan assumption was obtained from Investopedia, and the mortgage rate assumption was obtained from this CNBC article. The differential between interest rates on people with good and bad were 9.8 points for credit card debt, 7.0 points car loans, 10.0 points for private student loans, and 1.6 points for mortgage debt.

The cost of bad credit depended on both the interest rate differential and the likely loan amount.  The analysis presented here assumes a likely loan balance of $10,000 for credit cards, $15,000 for a car loan, $20,000 for a private student loan, and $300,000 for a mortgage.

The analysis assumed the borrower only paid interest on credit card debt.   Assumed maturities were 60 months for car loans, 240 months for private student loans, and 360 months for mortgages.

Based on these assumptions, I found the monthly cost of bad credit was $82 for credit cards, $49 for car loans, $124 for private student loans, and $277 for mortgages.

The figures presented here show bad credit ratings can lead to substantial costs with costs depending on both interest differential and loan amounts.  The interest differential stemming from credit ratings is highest for credit card loans and private student loans.  

The payment differential associated with credit ratings is often highest for mortgage debt because mortgage loans are large. In today’s housing market with soaring home prices and tighter lending standards it is very difficult to purchase a home without good credit.

The cost of bad credit is not limited to one or even a few loans.   Most people take out multiple consumer loans or mortgages in their lifetime.  The lifetime cost of bad credit will be substantial for households that do not improve their credit rating. 

Poor credit ratings have other adverse impacts in addition to higher loan costs.   The Insurance Information Institute points out the insurance companies use credit ratings to set insurance premiums because actuarial studies have shown that credit scores are good predictors of the tendency for people to make insurance claims.  The credit rating agency Experian points out that employers can and sometimes do base hiring decisions on an applicant’s credit history.   Landlords use credit ratings to determine eligibility for an apartment.

The Importance of Rapid Student Debt Reductions Early in a Career:

Students leaving school with substantial federal and private student debt should rapidly repay the private student loan even if the rapid repayment of the private loan causes them to forego contributions to their 401(k) plan.

The rapid reduction after joining the workforce will drastically reduce lifetime student debt borrowing costs.   Rapid debt reduction may make it possible for the student borrower to refinance remaining debt at a lower interest.

Finance companies often attempt to persuade student borrowers to refinance their federal student loans to lower-interest rate private loans.   This article provides recommendations from CNBC on the best companies for refinancing student debt. 

Often student borrowers cannot refinance to a substantially lower interest rate immediately upon graduation because their work and credit history is short, and their initial salary is low.  A student borrower could improve their credit report by foregoing 401(k) contributions for a year or two and then refinance the remaining student loan at a lower interest rate.

There are advantages and disadvantages associated with refinancing federal loans to private loans.  The primary advantage is a lower interest rate, perhaps as low as 3.0%.  You must be careful when refinancing a fixed rate student loan to a variable rate loan because the student loan interest rate can rise substantially if Treasury rates rise.   In addition, the decision to refinance with a private student loan makes the borrower ineligible for forbearances in case of economic hardship and makes the borrower ineligible for income driven loan programs 

The potential financial gains from a strategy of rapidly reducing student debt upon entering the workforce are examined for two student borrowers – one with a large federal undergraduate loan and the other with a mix of federal undergraduate and graduate loans and a private loan.

Student Borrower Number One:   The first student borrow is starting her career with a $50,000 per year job and undergraduate student loans totally $30,000 with an interest rate of 5.05% around the 2019 average student debt level for undergraduates.   

A person in this situation will typically take out a 20-year student loan.   Her payments on the loan will $198.82 per month.  Her total payment over 20 years will be $47,716.   

The person could more rapidly repay her student loan if she foregoes contribution to her 401(k) plan.   Assume she currently pays 10 percent of her income to her 401(k) plan.  If she foregoes this contribution her annual income tax will increase by $600.  However, she could increase payments on her 401(k) plan by $4,400 per year to a total monthly payment of $565.48. 

Under this assumption the student borrower would totally repay her $30,000 student loan on the 61stpayment.   Her total student loan repayment costs would be $33,837, a savings of $13,879.

The strategy of rapidly repaying the student loan causes the student borrower to fall behind on her accumulation of 401(k) wealth.  However, her student loan is totally paid off after 61 months and she could now make larger 401(k) contributions than the person who immediately initiated 401(k) contributions after leaving school.

The student borrower in this example could forego 401(k) contributions and make monthly payments of $565.48 for two years and then attempt to refinance the loan at a lower interest rate for a 10-year period.

The outstanding balance after two years of payments would be $18,932.

The person after reducing the loan balance that quickly might be able to refinance at a 3.0% interest rate.  The total student debt payments from this strategy, rapid repayment for two years followed by a 10-year loan at 3.0%, is $35,509 or $12,207 less than under a 20-year term.

The rapid reduction of student debt will lower the probability the person experiences debt payment problems and will substantially reduce expenditures on student debt.   

The results are even more dramatic for a student borrow that has a combination of federal debt and high-rate private loans.

Student Borrower Number Two:   The second borrower has three student loans, a $35,000 undergraduate loan at 5.05%, a $40,000 graduate loan at 6.66% and a $25,000 private student loan at 10.00%.    Intuitively, it makes sense for this student borrower to prioritize rapid repayment of the higher interest rate private loan.  In most instances, the strategy of rapidly repaying the private student loan necessitates the borrower forgoing contributions to a 401(k) plan early in her career.

The student borrower who chooses to set the standard 20-year maturity on all three student loans has a monthly payment of $775 for 20 years leading to total student loan payments of $200,633 over 20 years.

The student borrower who chooses to set the standard 20-year maturity for the federal undergraduate and the federal graduate loan and set a 5-year term for the private loan will initially have monthly student loan payments of $1,065.   

The monthly payment will fall to $534 after the private student loan is totally repaid, which is lower than the $775 payment that exists if the person kept to a 20-year term on all loans.  This means the person who chose the rapid private student loan repayment strategy could after 5 years make larger 401(k) contributions for the next 15 years than the person who chose a 20-year private loan term.

The total lifetime student loan debt payments for the person who repaid her private student loan in 5 years instead of 20 years is $146,271, which is a total lifetime savings of $54,362. 

This student borrower is in a good position to refinance her federal student debt to a private lower interest rate loan after repaying her private loan.  The cost savings estimates presented here may understate potential benefits from a strategy of rapidly reducing private student debt.

Concluding Thoughts:  The student borrower entering the workforce is often under intense pressure from financial advisors to immediately contribute part of their salary to a retirement account.  This approach can lead to financial disaster.   

The young adult with a modest salary and high student debt payments who prioritizes saving for retirement can fall behind on her bills, which can lead to poor credit ratings.   The deterioration in credit ratings will lead to high borrowing costs and other problems including difficulties renting an apartment, loss of job offers and higher insurance costs.  

Eventually, many people who choose to aggressively save for retirement will raid their 401(k) and maybe even sometimes pay taxes and penalties.  Increasingly, young and middle-aged adults are tapping 401(k) funds prior to retirement to meet current needs.  A CNBC article reveals that nearly 60 percent of young workers have taken funds out of their 401(k) plan   

The wiser course of action for young adults entering the workforce saddled with student debt is to rapidly repay student loans, especially but not exclusively high-cost private loans.  This approach will secure a solid credit rating and will reduce lifetime student loan payments by tens of thousands of dollars.

This post is part of a series comparing the traditional financial plan, stressing 401(k) investments and house purchases with 30-year mortgages to an alternative financial plan, which prioritized debt reduction, use of Roth accounts and use of 15-year mortgages.   The first post provided an overview of the alternative financial plan.  The next post, available in a week or so, will look at some problems with conventional retirement accounts starting with high fees on some plans.

Outline of an Alternative Financial Plan for the New Generation

  • Traditional financial strategies, which prioritize accumulation of wealth in a conventional retirement plan, as soon as people enter the workforce are not working for many households.
  • The alternative financial strategy outlined here involving — aggressive elimination of student debt, greater use of 15-year mortgages, the use of Roth retirement accounts instead of conventional accounts, and additional investments outside of retirement accounts — will reduce financial stress and lead to a more secure retirement than the traditional financial plan.

Many households are struggling with historic levels of debt.

Average student debt for college graduates in 2019 was 26 percent higher in 2019 than 2009.  Around half of bachelor’s degree recipients in 1992-1993 borrowed to finance their education, compared to around 65 percent today.

Increasingly, young and middle-aged adults are tapping 401(k) funds prior to retirement to meet current needs.  A CNBC article reveals that nearly 60 percent of young workers have taken funds out of their 401(k) plan. A study by the Employment Benefit Research Institute (EBRI) reveals that 40 percent of terminated participants elect to prematurely takeout 15 percent of plan assets. A poll of the Boston Research Group found 22 percent of people leaving their job cashed out their 401(k) plan intending to spend the funds. 

Statistics presented in a recent Business Economics article show that people who tap 401(k) plans prior to retirement were more likely to have taken out consumer loans, were more likely to have a poor credit rating and were more likely to be underwater on their mortgage than people who did not tap their 410(k) plans prior to retirement.   

A CNBC portrayal of the financial status of millennials nearing the age of 40 found many members of the age cohort highly leveraged struggling to pay down student debt, using innovative ways to obtain a down payment on a home and barely able to meet monthly mortgage payments.

2019 Congressional Research Service Report found that the percent of elderly with debt rose from 38% in 1989 to 61% in 2021.   The Urban Institute reported that the percent of people 65 and over with a mortgage rose from 21% in 1989 to 41% in 2019.  A 2017 report by the Consumer Finance Protection Board found that the number of seniors with student debt increased from 700,000 to 2.8 million over the decade.

The standard financial plan, proposed by most financial advisors, emphasizing large contributions to traditional 401(k) plans instead of aggressive reduction of consumer and mortgage debt often fails to provide a secure financial outcome.  Future outcomes will be worse, barring a change in strategy in financial strategy, because people are starting their careers with higher debt burdens.

The aggressive pursuit of long-term investments in stocks and bonds instead of rapid reduction in debt is especially problematic in the current market environment where stock valuations are stretched, and interest rates are at historic lows.   The purchase of expensive securities inevitably leads to subpar returns when valuations return to more normal levels.

The alternative financial strategy proposed here differs from the traditional financial strategy in four important respects.   

First, the alternative approach prioritizes the establishment of a solid credit rating, the creation of an emergency fund and the rapid reduction of student debt for individuals leaving school and entering the workforce.  The achievement of these goals usually requires new entrants to the workforce delay or reduce 401(k) contributions for a number of years when starting their careers.

Second, the alternative financial strategy places a high priority on the growth of house equity and the elimination of all mortgage debt prior to retirement. 

Many households with less than stellar credit purchase a home with a subprime mortgage.  Subprime mortgages tend to have high interest rates, adjustable rates with short adjustment periods, a balloon payment, and restrictions on prepayments.  The alternative financial strategy opposes the purchase of a home with an unfavorable interest rate or subprime features.

Most households currently use a 30-year fixed rate mortgage.   The alternative financial strategy recommends the use of 15-year mortgages, either through the original home purchase or through a refinancing, to reduce lifetime mortgage payments and to accelerate growth in house equity.  

Many financial advisors currently recommend additional catch-up payments to 401(k) plans for workers nearing retirement even when the worker will retain a mortgage in retirement.   The alternative financial strategy prioritizes mortgage payoffs over additional 401(k) contributions.

Third, the alternative financial strategy utilizes Roth retirement accounts instead of conventional retirement accounts. 

The decision to use Roth rather than conventional retirement accounts can increase tax burdens in working years; however, there are multiple other ways for working-age households to reduce current tax obligations.  In particular, contributions to health saving accounts linked to high-deductible health plans reduce current-year tax obligations, reduce insurance premiums and like retirement accounts increase income during retirement.

The use of Roth rather than conventional retirement accounts directly reduces tax obligations in retirement, reduces the marginal tax rate for people with other sources of income and indirectly reduces tax on Social Security benefits for some households.

The use of Roth rather than conventional retirement accounts reduces the amount of money a person must park in stocks inside a retirement account because the investor no longer needs to save for taxes on disbursements.  The lower taxes from use of Roth accounts reduces financial exposure to market downturns.   

Retirement account fees will be lower on Roth accounts because the total annual fee is a percent of total invested assets, which is lower because tax on Roth accounts is paid prior to contributions.   

The use of Roth rather than conventional retirement accounts will substantially reduce tax on inherited IRAs.   This savings is larger today because of recent changes in tax rules governing inherited IRAs.

Fourth, the alternative financial strategy makes greater use of investments outside of retirement accounts including investments in stocks and investments in inflation linked bonds. 

Retirement accounts are an effective way to defer taxes until retirement.  However, the existence of assets outside a retirement account reduces tax obligations during retirement years.  

Disbursements from conventional retirement accounts are taxed as ordinary income while taxes on capital gains and dividends are currently taxed at preferential rates.   (The tax preferences for capital gains and dividends may be reduced by the Biden tax plan.) 

The availability of funds outside a retirement account are especially important when retirement accounts have high annual fees and interest rates are low.  The effective interest on some bonds held in retirement accounts is negative when the retirement account has a high annual fee. 

There are no fees associated with the purchase bonds directly from the U.S. Treasury.  These bonds have relatively low market risk.  The purchase of Treasury bonds with specific maturity dates is an effective way to hedge against market down turns impacting consumption during retirement.

The traditional approach to retirement often centers on the question – How much money should be placed in a 401(k) plan in order for you to retire?   There are even calculators that create estimates of the amount people need to place in a 401(k) to retire with adequate income.

The actual amount of wealth you need to place in your retirement account is indeterminate.  The amount you need to save depends on several factors including whether the retirement account is Roth or conventional, retirement account fees, amount of debt, whether you plan to downsize, the quality of your health insurance and the tax status of assets outside your retirement account.

The alternative financial strategy outlined in this introductory memo recognizes that financial security cannot be summarized by the dollar value of a 401(k) plan.  A person with large net worth dominated by large equity holdings in a conventional 401(k) plan is faced with large future tax obligations and is perpetually exposed to a market downturn, especially if she has a monthly mortgage bill to meet.  The person could be better off with a lower 401(k) balance if she had paid off her mortgage, put money in a Roth rather than a conventional retirement account, and purchased some inflation-indexed bonds.  

Several features of the alternative plan presented here will reduce the amount that you must contribute to a retirement plan and the amount you pay over your lifetime in retirement plan fees.  Fees charge by retirement accounts are not a trivial matter.  This report by the Center for American Progress reveals a median-wage worker might pay $138,000 in retirement fees over her lifetime.

The traditional goal of financial planners is the construction of a portfolio that will allow retirees to initially distribute 4 percent of the 401(k) balance and maintain that distribution level though out retirement.   The 4 percent rule often fails to provide a sustainable level of consumption in retirement with the largest failures occurring when portfolios are closely tied to the market and the market takes a downturn early in retirement. 

Some financial advisors advocate a more flexible distribution rule that mandates reductions in distributions during market downturns.  It seems as though a strategy calling for sharp reductions in distributions during retirement is an admission that the financial strategy planning for retirement was a failure.  An alternative financial strategy which includes alternative investment including, I-Bonds, E-Bonds and perhaps annuities, will lead to more stable consumption patterns in retirement.  The alternative financial strategy would include a more stable and sustainable rule determining monthly distributions of funds.

The upcoming blog posts presented here and a larger formal paper will describe the potential benefits of the alternative financial strategy in greater detail.  A detailed discussion on how to best rapidly reduce student debt and the potential advantages of the debt elimination strategy will be available at this blog soon.

Roth vs Conventional Retirement Accounts: Impact of the Biden Tax Plan

The CNBC article makes the case the Biden tax plan will make Roth accounts more desirable than conventional accounts.  The article understates the benefits from choosing Roth over conventional accounts, which pre-date the Biden administration.

The article states that Roth accounts are generally more desirable than conventional accounts if you expect your marginal tax rate to be lower in retirement than during working years.

Actually, the decision between Roth and conventional accounts largely determines your tax bracket in retirement.   Roth distributions are not part of your taxable income.   People with other income, an annuity, interest, dividend or capital gain income, and wage income for a part-time job or from a spouse can keep their income and tax bracket down if they have funds in a Roth account rather than a conventional account.   The advantage of Roth over conventional accounts during retirement is not just that distributions from the Roth are untaxed but also that distributions from Roth reduce the taxpayers marginal and average tax rates.

The article points out that distributions from Roth rather than conventional accounts will reduce the amount of Social Security that is taxable income for taxpayers with income above a particular threshold.   This is also huge because the exclusion of both the Roth distribution and the Social Security benefit from taxable income both reduces tax and taxable income and moves the taxpayer into a lower tax bracket, thereby, reducing marginal and average tax rates.

The exclusion of contributions to conventional accounts from current-year taxable income is a key benefit of conventional retirement accounts.   However, there are many other ways to reduce taxable income and tax during working years, including, contributions to health savings accounts, newly enacted child tax credits, and deductions on mortgage interest and other housing deductions.

Many people with scarce funds and medical expenses should choose contributing to a health savings account over contributing to a 401(k) if they have a high-deductible health plan.  Health savings accounts and conventional retirement accounts are highly substitutable because both reduce current year taxable income and excess funds in health savings accounts can be used for non-health purposes in retirement.   People who lower their marginal tax rate by contributing to health savings accounts or through other means should place whatever funds they have remaining in a Roth rather than a conventional retirement account, especially if their tax reduction strategy was successful.

A lot of working-age people pay no or very little income tax.  But for some reason, financial advisors really like to push the tax advantages in working years associated with contributions to conventional retirement accounts.   This decision can be extremely costly in retirement years.  Household with a disproportionate amount of wealth in a retirement account, who also have mortgage debt, must distribute funds to pay the debt and funds to pay tax on the distribution to pay the debt.

The article mentions the new tax provision discussed here that requires many people with inherited IRAs to make distributions within 10 years.   This tax change was enacted in 2019 prior to the Biden presidency.  Heirs of a conventional account will pay tax, at the ordinary income tax rate, on these distributions.   This could be quite painful if distributions are forced during peak-income years.  Heirs of Roth accounts will not pay tax on these distributions.   Do your heir a favor and convert your traditional accounts to Roth account before you die.

The CNBC article states that lower estate tax thresholds proposed by Biden will cause Roth conversion.   Perhaps.  But there are already a lot of reasons to convert and even if the Biden administration succeeds in getting a sizeable expansion in the base subject to the estate tax most wealth in households impacted by the estate tax will not be associated with retirement accounts.

Roth accounts are for most people the better choice.  Not a close call.  This has been the case for quite some time.   The horse is out of the barn.

Complicated rules for inherited retirement accounts

The 2019 Secure Act changed rules governing distributions from inherited IRAs and 401(k) plans.  The new rules prevent some beneficiaries from stretching withdrawals across their lifetime.    This CNBC article does a good job explaining the rules.

The new rules require many people who inherit a 401(k) plan to take disbursements within a 10-year period. However, there are some exceptions for minors and spouses.   

The clock for disbursements over a 10-year period starts at 18 for minors inheriting a Roth IRA.  However, prior to becoming 18 the minor must make a required minimum distribution RMD based on life expectancy.  The RMD for minors should be really small because minors have a large future expected life.  This rule might make sense if the IRA or 401(k) is huge but is it rational for people who inherited a small account?

The distributions from Roth accounts are tax free while the distributions from conventional accounts are taxed as ordinary income.   I guess the Treasury will gain some tax revenue from accelerated Roth distributions if the funds are invested in assets with taxable interest, dividends or capital gains.

The distributions over the 10-year window can occur in any year.  Since Roth accounts are not taxed it may make sense to distribute the funds in year 10.  Conventional accounts are taxed; hence, taxpayers may want to spread distributions across years.

Funds not distributed by year 10 are subject to a 50% tax.  Ouch!

Spouses who inherit an IRA do not have to take distributions until age 72.

The time frame for distributions for people who inherit an account through probate is 5 years not 10.  Hence, it is important to name a beneficiary on your 401(k) or IRA.

Many people who inherit IRAs or 401(k) plans have modest income.  This bill requires distributions even when the person might be better off saving for retirement.    Many people inheriting a small IRA or 401(k) are not wealthy.

The bill was passed during the Trump Administration.     Trump Administration and Republican tax policy was in general very generous to high-income people but not averse to using complicated rules to get a bit more tax from some people who may be middle income.

Modifying 401(k) Plans


According to the Bureau of Labor Statistics around 29 percent of people with access to a 401(k) plan choose to not contribute to their plan.  In addition, The Employee Benefits Research Institute (EBRI) reports that in 2015 around $92 billion was removed from 401(k) plans prior to retirement.   The combination of people refusing to contribute to their 401(k) plans and people taking premature contributions will result in many people with inadequate retirement income. The rules governing 401(k) plans need to be changed so that fewer people choose to forego making contributions and distributions prior to retirement are limited to a certain extent.

Current rules governing contributions to 401(k) plans provide significant financial advantages to workers who contribute.   The contributions are not subject to federal or state income tax in the year they are made.  Returns on investments are not taxed until retirement.   Many firms match or partially match employee contributions.   Many financial advisors believe that workers who fail to contribute, especially those at firms that provide an employee match, are irrational.  

There are several rational reasons why some workers forego contributions to 401(k) plans. Recently reported statistics indicate that around 40 percent of households do not have enough savings to cover a $400 bill.  A person without a basic emergency fund could be late on her mortgage or rent, unable to pay for a doctor or emergency room or fix a car.  A decision to place funds in a 401(k) plan that leads to late payments on bills will lead to late fees, a bad credit rating, higher borrowing costs and other adverse financial outcomes.   

A decision to make substantial 401(k) contributions might result in a person selecting a 20-year student loan over a 10-year student loan.  Consider a married couple with $60,000 of combined student debt at a 5 percent interest rate.   Lifetime student debt payments are $19,000 lower if student debt is repaid in 10 years rather than 20 years.   Many student borrowers could only afford the shorter-term student loan by reducing 401(k) contributions.

A decision to make substantial 401(k) contributions might force a person to take out a 30-year mortgage over a 15-year mortgage.   A person taking out a $400,000 30-year mortgage at 3.9 percent would have an outstanding balance of $257.000 after 15 years.   The 15-year mortgage would have been totally repaid, and in addition the borrower would have obtained a lower interest rate.  Again, many student borrowers can only afford the shorter-term mortgage by reducing 401(k) contributions.

In some states a person with assets in a 401(k) plan are not eligible for food stamps or Medicaid for nursing home expenses.   Go here for a paper on how retirement savings impact eligibility for food stamps.   Go here for a paper on how retirement savings impact eligibility for Medicaid nursing home expenses.   The underlying assumption behind such laws is the worker who comes upon bad times must deplete her retirement account prior to receiving any financial assistance from the government.

Many people retire early often because of the loss of a job or for health reasons.   People who retire early and have all of their funds in a 401(k) plan will be worse off than people who have saved both inside and outside their retirement plans both because early distributions from a 401(k) plan are subject to a 10 percent penalty and because distributions from conventional 401(k) plans are fully taxed.

Many older workers must choose between paying off their mortgage prior to retirement or increasing the amount of funds they place in their 401(k) plan.   Financial planners tend to favor additional accumulation in 401(k) plans over more rapid paydown of mortgage debt.  This choice often fails to work out well because people with a mortgage in retirement must, all else equal, make a larger distribution than people without mortgage obligations and the entire distribution from the conventional 401(k) plan is fully taxed.   The higher 401(k) distributions due to the need to make mortgage payments is especially difficult for retirees when a market downturn occurs at the beginning of retirement.

A household that is 401(k) rich and cash poor faces substantial financial risks.  Some households with 401(k) wealth but other financial needs raid their 401(k) plan and pay a 10 percent penalty in addition to tax on their early distribution leading to inadequate funds in retirement.  These problems could be reduced by changing the rules governing distributions from a 401(k) plan.  

Three rules should be modified.  First, workers should be allowed to withdraw 30 percent of funds contributed to a 401(k) plan without financial penalty.   Second, the worker should be prohibited from withdrawing any other funds from the 401(k) plan (the other 70 percent of contributions and all returns if any) until after age 59 ½.   Third, loans from 401(k) plans would be prohibited.

This combination of rule changes incentivizes workers to make additional contributions to their 401(k) plan while assuring that they do not raid their account prior to retirement.  

The provision for penalty-free withdrawal creates an emergency fund inside a 401(k) plan.  The provision for penalty-free withdrawal will allow a worker with student debt or mortgage debt to pursue a more aggressive repayment strategy while simultaneously saving for retirement.

Under current law, workers are allowed to distribute their entire 401(k) account prior to retirement.  This outcome could be forced upon a worker who loses his job in order to obtain Medicaid or food-stamp benefits.   The new rule by prohibiting most distributions prior to retirement will leave all workers with most funds in their 401(k) funds at retirement.

A final advantage of the rule change is that it allows more workers to reduce their tax obligations in retirement.   Under current tax rules, contributions to 401(k) plans result in tax savings in working years and higher tax obligations in retirement.   Some taxpayers use Roth accounts to minimize future tax obligations.  The new rules create a simpler way for workers to minimize their tax obligation in retirement. They can simply transfer 30 percent of their funds outside of their 401(k) account and purchase either stock, which is taxed at long term capital gains rates or an inflation linked Treasury bond, which is taxed at preferential rates.

The current 401(k) rules are not working for a lot of people, especially people with limited liquidity and large debts in relation to their income.   The proposals presented here provides incentives for people who can’t contribute to start savings and also benefits current savers reduce their tax obligations in retirement.  

David Bernstein is an economist living in Colorado.   He is the author of a policy primer on student debt, health care, and retirement income titled “Defying Magnets:  Centrist Policies in a Polarized World.”

Policy Question on Payroll Tax Holiday

This post will be updated sporadically with a policy question that troubles me. People who want to follow these thoughts need to either check this blog or my groups Policy & Politics and Finance Memos on Facebook.

The payroll tax holiday in the 2.0 trillion pandemic stimulus bill includes a requirement that businesses repay payroll tax relief in the future. A previous payroll tax holiday created in 2010 had the Treasury reimburse the Trust fund with general tax revenue.

Many defenders of Social Security thought the 2010 approach was bad policy because historically only payroll taxes and not general tax revenue was used to fund the trust fund. They though this approach might, by increasing deficits, reduce support for Social Security.

My view is that no one cares about the deficit anymore. Trump increased the deficit during a prosperous economy and the new stimulus bill is 50 percent of the budget without meaningful offsets.

My concern is that small companies will be unable to simultaneously pay back payroll taxes and new tax on ongoing payrolls. The double payments after the payroll tax ends will bankrupt some companies and slow the economy.

Should the Treasury reimburse the Trust funds for revenue lost from the payroll tax or should the government require companies make extra payments in the future to make up for this lost revenue?

My vote is that the Treasury should use general tax revenue to shore up the Social Security system both now in this emergency and in an ongoing basis. Hard for Republican budget hawks to argue for cuts to Social Security when every single one of them voted for Trump’s corporate tax cuts in relatively prosperous times.

Put your vote in the comment section of Policy & Politics.

The Politics of Student Debt

The Politics of Student Debt

There are two distinct lanes in the Democratic party. The progressive lane gravitates towards big ideas, which if implemented would transform society and the economy. The centrist land proposes modest changes to existing programs, which often would not substantially change the status quo. Most of the focus of the political discussion centers on the big proposals offered by participants in the progressive lane often leading to their rejection. Proposals offered in the centrist lane receive much less scrutiny. Problems and limitations of centrist proposals are often ignored.

The debate among candidates on student debt closely follows this pattern. The progressive lane advocates for free college and for immediate and substantial debt forgiveness for all or almost all people currently with student debt. The centrist lane advocates additional assistance for community college, and expansion of existing programs including Pell grants, Income Driven Loans, and Public Service Loans. The discussion centers on the economic and political feasibility of proposals offered by the progressive lane and does not consider the adequacy or potential problems with solutions offered by centrists.

An objective analysis of the progressive agenda suggests that its enactment requires a complete transformation of the U.S. economic, political, education, and tax systems. The consensus from this discussion is that a solution that works in a high-tax high-regulation European economy cannot be easily or quickly transferred to the United States. Moreover, many people argue that large subsidies for student borrowers are unfair to workers and taxpayers who do not attend school and are unfair to previous cohorts of student borrowers who paid off their student debt.

Centrist plans for making college more affordable and alleviating student debt burdens get far less scrutiny than progressive plans. In recent decades, there has been a substantial increase in the number of student borrowers, average student debt and the number of people entering retirement years with outstanding student loans. Centrist proposals, while more generous than policies espoused by the Trump Administration, are unlikely to reverse these trends.

A major education policy goal for many politicians in the centrist lane is on assuring an adequate supply of workers in hard to fill positions. Klobuchar in her New York Times interview on education spoke about the lack of shortage for MBAs or CEOs and the need to fill positions for home health care workers. The financial incentives in her proposals and the proposals offered by other centrists would steer many students away from academic four-year colleges towards two-year schools emphasizing practical career choices. The argument that people with substantial talent need to gravitate towards practical career choices early in their life because of economic reality is not highly inspirational or consistent with the view that education can lead to upward mobility.

The emphasis on education for practical positions leads centrists to support substantial increases in funds for community colleges. A policy that decreases the relative price of community college to four-year college could lead to fewer students from low-income households at four-year colleges. This approach could create a two-track academic structure where students from low-income households are slotted towards community college and students from households with more financial resources are slotted towards more prestigious four-year institutions. The student from the low-income and mid-income household may have enough talent to become a CEO or an MBA or a doctor. It is not clear whether the increased emphasis on community colleges will keep these doors open.

The centrist plan also includes increases in the budget for Pell grants. Pell grants target relatively low-income households and would have a relatively small impact on student debt for the typical student borrower. It would be extremely difficult and expensive to expand the Pell grant program to reduce debt burdens on students from middle-income households. Funds for Pell grants are part of the annual budget and subject to the whims of Congress.

Two additional ways to assist students from low-income households deserve consideration.

The first method involves free tuition or substantially reduced costs for the first year of four-year colleges. A free first year of college would decrease student debt for all student borrowers. Benefits would be especially large for students who fail to ever complete their degrees or students who take a long period of time to graduate, two populations that often experience repayment problems.

A free first year of college would allow for private grant funds to be allocated across a smaller population. (First year students would theoretically not need private grants if the first year was free.) An increase in grant funds per student after the first year of college would further reduce student debt burdens.

The second method involves the creation of additional two-year degrees at major four-year institutions. This approach allows more students access to major universities. The availability of more two-year degrees at four-year colleges could reduce the number of people who leave school without a degree. There may also be some students ready for graduate school after two years of undergraduate work.

The debate over debt relief options also centers on extremely ambitious proposals offered by candidates in the progressive lane. Less attention is focused on options favored by candidates in the centrist lane including the expansion of income driven loan programs and the Public Service Loan Forgiveness program.

A proposal offered by Senator Warren would discharge $50,000 of student debt for people with income less than $100,000 and a reduced amount of debt relief for borrowers with income above that threshold. Senator Sanders has offered universal discharge of student debt for student borrowers.

These broad debt relief programs are not economically efficient because they divert scarce resources away from more pressing problems. Many of the student borrowers who would receive assistance under these proposals are able to repay their loans without government assistance. The proposals are also unfair to workers who don’t benefit from higher education and to previous students who repaid their loans.

The candidates in the centrist lane favor expanding Income Driven Loan programs and the Public Service Loan Forgiveness programs. There are major problems with loan programs that link student loan payments to income and programs that offer debt relief for public service. However, problems with these programs and potential improvements are barely addressed because all of the attention is focused on the more ambitious progressive proposals.

Income Driven Loan programs link loan payments to annual income and allow for the possibility of loan discharges after a number of years. There are many problems with this approach. Student borrowers must choose to enter an Income Driven Loan program or remain in a conventional loans program when leaving school. Whether a student borrower is better off under an Income Driven Loan program or a conventional loan program depends on income and marital status over the lifetime of the loan and is often impossible to predict when students make their loan selection.

Moreover, student borrowers must reenroll annually in income driven loan programs. Errors by loan services could result in the denial of loan discharge applications for some student borrowers. The loan discharge is contingent on student borrowers making 240 on-time loan payments. Income driven loan programs may fail to provide debt relief to student borrowers who fail to make payments because of financial hardship. This is the group most in need of assistance.

The Public Service Loan Forgiveness program does not have a great track record. The program makes loan discharges contingent on an applicant staying in a public service position for 10 years. Some applicants lose debt relief when they switch careers. Over 99 percent of people in the first cohort of applicants to apply for a loan discharge under the Public Service Loan Forgiveness program had their discharge applications denied, even though the applicant had made loan payments for 10 years. There are several reasons for the large rejection rate on loan discharge applications. Some applicants were informed that they were employed at firms in positions, which were not eligible for the public service loan program. Some applicants were informed after 10 years or payments they had chosen a payment plan that was not consistent with the public service loan forgiveness program. Problems involved with administering the public service loan program are documented in this report written by the Consumer Finance Protection Board.

There are superior alternatives to Income Driven Loan programs and Public Service Loan Forgiveness programs that are not even currently being considered.

A provision in a loan contract eliminating interest charges near the end of the loan term would be simpler to administer and fairer to both borrowers and the taxpayer than a program offering loan discharges after 20 year of payments. A loan discharge provision creates an incentive for some students to increase the amount they borrow and discourage quick repayment of student debt. Students with a loan that allows interest rate reductions near the end of the loan term will always repay more if they borrow more and are not discouraged from entering a short- term payment plan.

The elimination of interest near the end of the loan term also offers some debt relief to student borrowers who miss payments and are ineligible for a loan discharge.

The Trump Administration and Congress propose to eliminate the Public Service Loan Forgiveness program because of its cost to taxpayers. In order to obtain debt relief from a public service loan program, applicants must stay in a public service career for 10 years. Some applicants may choose to eschew more productive positions to obtain a debt discharge.

A narrower Public Service Loan Forgiveness program that provided less debt relief for a short period of time when student borrower begin repayment could increase loan repayments when people are starting their careers and salaries are relatively low. This program would be easier to administer and less expensive than the current Public Service Loan Forgiveness program. More importantly, the revised shorter-term benefit would not create job lock.

The discussion and the energy in the Democratic party revolves around support for or opposition to big ideas. The potential and problems associated with modest proposals are not fully evaluated. Not surprisingly, this debate is not leading to the formation of practical policies that would actually reduce student debt burdens. We need a third lane offering pragmatic progressive policies, which could lead to real change.

Observations on the 2020 Economic Crisis — March 18, 2019

I have several comments about the severity of the current situation and prospects for bailouts.

  • Many financial analysts believe the stock market is oversold and will rebound quite quickly once the pandemic ends.  However, many companies with debt are likely headed towards bankruptcy.  The economic fallout could result in an economic downturn that leads to a long recession and a sustained downturn in stock prices.
  • Many politicians in the “center” are going to want to bailout Boeing, airlines, hotels and other industries.  A distinction has to be made between bailing out companies and bailing out shareholders.   Hard for me to justify unconditional bailouts of companies that issued a lot of debt and used cash to buy back stock to reward shareholders and CEOs with large bonuses.  Taxpayers should receive an equity stake in businesses receiving financial assistance as they did for bailing out companies like GM and AIG in 2009.   There should be restrictions on management salaries and dividends at companies accepting federal funds.  Some bailouts will occur through a chapter 11 bankruptcy process and reorganization that impacts creditors and shareholders.  I suspect Congress will eventually bail out some firms but there must be conditions and the process towards a bailout may not be a smooth one.
  • One way to structure a bailout so that the American people obtain some financial benefit is to give each household shares of companies receiving financial assistance.  Another way for American taxpayers to benefit from a bailout is to give the Social Security Administration ownership of share in companies purchased with general Treasury funds.
  • The tax code needs to be modified to reduce incentives for companies to issue debt and purchase company shares. 
  • Bank stocks are cratering even though bank analysts argue that banks are in good financial shape.   The banking sector is likely to realize large losses from loans to oil sector on top of losses related to the pandemic.  
  • The 10-year U.S. government bond interest rate is rising rapidly going from 0.65 on Monday 3/16 to 1.26 on Wednesday 3/18.  Rate was even lower last week.  The Fed does not have much control over long rates and may be out of ammo.  Typically, investors count on increased bond prices to coincide with and offset downturns in stock prices.   This result is unlikely this time because interest rates are starting at such a low level and people are selling all assets, including bonds, to get cash.  

Should Big Tech be Broken Up?

This post evaluates Senator Warren’s plan to break up big tech firms.  The analysis presented here supports the view that some of her proposals would assist large established firms and would reduce choices for consumers.  Google and Facebook have monopoly power in search and social media, but other large tech firms are capable of contesting these markets, the two firms compete with each other for ad revenue and face substantial competition in many markets from Apple, Amazon, Walmart and other firms. 

Introduction:

Senator Warren proposes major changes to anti-trust law and increased enforcement against big tech firms in her article  “It’s Time to Breakup Amazon, Google and Facebook.” 

Warren’s approach includes the following

She wants large companies with major Internet marketplaces to either sell only third-party goods or its own goods.   Marketplaces serving third-party sellers would be set up as a regulated platform utility.   The rule would require Amazon to separate Amazon Basics from Amazon marketplace, could prevent Amazon Prime and Netflix from selling the movies it produces and would require changes to the Apple Istore.  

She wants the newly created platform utilities to follow a standard of fair, reasonable, and nondiscriminatory dealing with users.  She also wants to restrict data transfer to third parties by platform utilities.

Separately, she would require Google to separate Google Ad sense from Google Search.

She would reverse some previous Tech mergers and make future tech mergers more difficult.  Previous mergers to be reversed include – Amazon’s purchase of Whole Foods and Zappos, Facebook’s purchase of WhatsApp and Instagram, and Google’s purchase of Waze, Nest and DoubleClick.

Warren has a really clear and simple vision of the world.  Google, Apple, Amazon, and Facebook all have monopoly power.   All four companies use their monopoly power to obtain large profits from consumers. The solution to this problem is to break up existing firms, reverse previous mergers, prevent future mergers and increased regulation.  

My view of the world is less black and white than Warren’s view.   Some of the major tech firms have high market shares potentially creating substantial monopoly power.  Some of the previous mergers were anti-competitive and need to be reversed but in some cases the advantages of the previous merger outweighed costs.  Moreover, some future mergers and acquisitions by competitors of Google and Facebook could increase competition and expand choices for consumers. 

In some cases, on-line regulation of Internet marketplaces is desirable but in other cases the regulation would leave the Internet firm at a significant disadvantage compared to traditional retailers. 

Analysis:

The theoretical case for applying antitrust procedures to Internet firms differs greatly from the theoretical case associated with applying antitrust to traditional industries like steel or oil.  Traditional firms attempt to get monopoly power in order to increase price and get large profits.  Many Internet firms like Google and Facebook do not charge anything for their services.  These firms get profit from ad revenue and from the use of their data on consumers.   They are willing to spend money to attract customers because an increase in the size of their network increases the scope and value of their network.  

Google and Facebook are not like swimming pools where at some point (typically pretty quickly on a hot day) additional swimmers make the pool less attractive.   There is no real cost of additional users to Google and Facebook.   Also, since the basic purpose of these networks is to allow people to interact and work together an increase in the size of the networks increases their value.  Why are Google Docs and Microsoft Office so popular?   People share documents.  An increase in the number of people sharing stuff or interacting can increase the value of the software or network.   

Google and Facebook have overwhelming market share and monopoly power in search and social media respectively.  Both firms have higher profitability levels than they would if the industry was competitive.  Google’s dominance in search allows it to manipulate results and favor certain sellers or merchants over other sellers and merchants.   The unchecked and unregulated power of Facebook has led to privacy violations, misuse of data and political manipulation of Democratic elections by bad actors.  The manipulation of consumers by Facebook may have resulted in Donald Trump being elected president and may similarly impact the 2020 presidential race.

High market share is an important indicator of potential monopoly power and is of great concern to industrial organization economists.   However, high market share does not automatically lead to monopoly power when markets are contestable.   The theory of contestable markets created by William Baumol asserts that high concentration may not lead to problems associated with monopoly if there are low barriers to entry and exit.  The implication of this theory for Big Tech is that the way to deal with the potential search and social media monopolies is to facilitate the entry of additional competitors.

One of the reasons why Google has a monopoly position in search is that both Google Android and Apple phones default to the Google search engine.   Google pays Apple a whole lot of money to make google search the default on its phone.  This side payment is basically an incentive to not compete and is in my view illegal collusion under existing antitrust law.  Warren did not flag this problem in her article.  Anti-trust authorities should end this arrangement.  This change would make the market for search not only contestable but actively contested.

The problem of Google’s monopoly power in search cannot be resolved by separating Google search from Google ads.  Google makes no money from search.   Virtually all of Google’s entire revenue is from its ad division.   A separate Google search division with no ad revenue would probably not be financially viable.

Believers in the theory of contestable markets assert that the key to taking on the Google and Facebook monopolies is to encourage entry and greater competition from existing tech firms. Microsoft with its unsuccessful Bing search engine and with its LinkedIn social network is already in competition with both Google and Facebook.     Ironically, Microsoft could more actively compete with both Google and Facebook by purchasing firms an activity that would be restricted by the adoption of Warren’s approach.  

For example, Microsoft could more easily compete with Google by purchasing Yelp and integrating Yelp with its search engine Bing.  Yelp may be receptive to a partnership with Microsoft because it has accused Google of anticompetitive behavior.   Microsoft would also have to purchase or develop a mapping company to compete with Google Maps, Waze and Apple Maps. 

A useful search engine must be complemented by mapping software for cases where the customer needs to move towards the item or business being searched.  The primary purpose of Google’s purchase of Waze was to prevent another firm from integrating Waze with their search algorithm.  Waze is now experiencing a slow death.  I agree with Warren that Google’s purchase of Waze was anti-competitive and should be reversed.  This type of antitrust action might prompt Apple or Microsoft to start competing with Google on search.  

Microsoft’s ability to compete with Facebook would similarly be enhanced if it purchased the blog platform Medium and integrated it with is social network LinkedIn.   This move would increase the number of LinkedIn members and would also increase activity by current users.

The case for reversing previous acquisitions made by Facebook is weak.   Prior to their purchase, Instagram and WhatsApp had fairly low revenue and income.   These firms may not have been viable on their own and other social media companies including Twitter and Snap did not have the money to make these acquisitions.  

These acquisitions did expand Facebook’s monopoly in social media, but the acquisitions also increased the ability of Facebook to compete with Amazon and Google for ad revenue.   I am unsure how the courts would weigh the benefits and harm of these mergers.  I am pretty sure that prohibiting these mergers would have reduced growth in Silicon Valley, stifled innovation and reduced tax revenues and charitable giving.

The case for breaking up Amazon is also weak at best.  Amazon is huge and has disrupted many industries and firms but large size without abnormal profits is not a reason for antitrust enforcement.    Amazon, aside from the cloud computing division the company, has low profits margins.   Amazon is in stiff competition with many brick and mortgage retail firms including Walmart, Target, CVS and other drug companies. Many of these competitors have higher profit margins than Amazon.  

Sometimes it appears as though the established firm uses anticompetitive methods to prevent competition from an on-line competitor owned by Amazon.  CVS and Target are refusing to honor their customer’s valid requests to transfer prescription to PillPack and Express Scripts has removed PilPack from its network.

The acquisition of Whole Foods by Amazon resulted in a huge shakeup in the grocery industry decreasing stock prices of several firms.  However, Whole Foods only had slightly more than 1 percent of the U.S. grocery market at the time it was acquired by Amazon, hardly a reason for concern.

Warren’s plan potentially treats a large retail firm like Walmart or Kroger differently than Amazon.   Inside a Walmart and Kroger one can find name-brand products and products produced by the store side by side.  Presumably, the same arrangement would be available on the store web page.  Under Warren’s rule, Amazon would not be allowed to put its own brands up next to a competitor’s brands.   Why should it permissible for Walmart to list name and Walmart options on the same shelf or web page and impermissible for Amazon to do the same?

The growth of Amazon by increasing competition has reduced prices to consumers and has kept inflation low.  The growth of Amazon has hurt some retailers but has helped the economy in many other ways.  An antitrust action against Amazon would do more to strengthen many of Amazon’s large competitors and would not clearly benefit consumers who benefit from the low prices offered by Amazon. 

One of the most interesting and innovative aspect of Warren’s anti-trust approach involves regulation of platform utilities, companies that arrange sales from third parties to customers.    Warren, when explaining the platform utility regulation, says companies should not be allowed to umpire and play in the same game.   

The largest adverse impact of the regulation of platform utilities involves competition in the entertainment industry.  The proposal to regulate Internet marketplaces as platform utilities favors the cable industry, Disney, and network TV over Amazon Prime, Apple, itunes, and Hulu and potentially Netflix.  Many of the best current movies and television shows are now produced by Netflix, Amazon and Apple.   These streaming services have increased choices for consumers and have allowed some people to cut the cord with local cable company monopolies.  

Streaming companies are constantly looking for high quality material from independent producers.  These company gets a fixed monthly fee from consumers who buy a subscription.  They don’t appear to guide people away from independently produced shows and movies towards content they finance. I am not sure what could be gained from preventing companies from distributing their own films.

Another area where Warren’s proposal could have a large impact is in competition for Internet related devises inside a home.  Google purchased Nest but there are still several other makers of smart thermostats.   Amazon own Ring but there are still  several other makers of smart doorbells.     There seems to be plenty of competition in this area and little need for an intervention by antitrust authorities.

Concluding Thoughts:

The growth of companies on the Internet has created a lot of competition for older established companies in the brick and mortar economy.   Consumers have often benefited through lower prices and the introduction of new products.     

Two companies, Google and Facebook, have a significant monopoly position in their respective fields.  Both companies have used their monopoly power to obtain abnormal profits, have not properly safeguarded consumer information and have at times used their power to impede competitors.  

Warren’s stringent antitrust approach would curb the power of large Internet firms but would also favor large traditional established companies.  In some cases, it is the large established firm that engages in anticompetitive behavior. Some restrictions on large Internet companies could result in higher prices and fewer choices for consumers.

 A more effective strategy for expanding competition in the Internet industry involves creating incentives for existing large tech firms to compete with Google on search and incentives for existing large tech firms to compete with Facebook on Social Media.

David Bernstein is an economist living in Colorado and the author of a policy primer addressing issues pertaining to student debt, health insurance and retirement income called “Defying Magnets:   Centrist Policies in a Polarized World.”