California’s Needless Housing Crisis

Richard Epstein*

Richard Epstein

Richard Epstein

Everyone agrees the most attractive areas in California suffer from a housing crisis that calls for drastic action. The difficult question is deciding what should be done. Many of the challenges are embodied in the small California town of Mountain View, population 80,000, which should be basking in sunshine as the home of Google. But instead the town is mired in discord and controversy over a set of well-entrenched anti-growth policies concerning housing. The tight supply of housing has raised the price of the median home to about $1.4 million. Rents, too, have skyrocketed, resulting in the displacement of many long-term tenants—teachers, nurses, and tech employees—who have to endure long daily commutes to work or find jobs elsewhere. Mountain View is now the proud home to numerous mobile home parks, occupied by individuals who crave access to the city—and who reportedly drive Teslas and Mercedeses, no less—but who lack the means to purchase or rent ordinary housing.

The situation in Mountain View has provoked two distinct responses. The first of these was the approval on November 8 of Measure V, a rent control statute that turns Mountain View’s rental market into a regulated public utility, complete with its own five-member board. The ordinance exempts all units built after February 1, 1995. But for the covered units, it rolls back rents to their October 2015 levels, and then limits rent increases going forward to between 2 and 5 percent, with allowances for higher increases if justified by extraordinary costs. The tenant groups that support the statute seek, without explicit acknowledgement, to secure a massive wealth shift in their favor, without discouraging future development. In so doing, they ignore the costs to other potential residents who put a higher value on those units, which will lead to a misallocation of available units whose number is kept artificially low by a wide range of entry constraints. The administrative costs of running this system for their exclusive benefit will, moreover, be borne by everyone inside the city. It is also likely that the threat of a new rent control law will weigh heavily on the market for exempt units, and will retard the ability to build new units as well.

That last possibility is the subject of an intense struggle between Mountain View’s pro- and anti-growth factions. Generally, pro-growth forces have made gains in California leading to a new YIMBY (Yes, in my Back Yard) movement.  And new pro-growth members of the Mountain View City Council have spurred proposals to add about 10,000 new units—roughly 50 percent of the current total housing stock—to provide homes for Google employees. The politics around this proposal are intense, because new housing projects bring new tenants whose children will need to be educated in local schools, funded in part by local property tax dollars, some of which might come from existing tenants. Yet the construction of new office buildings and other facilities, which avoids this educational burden, will only aggravate the mismatch between jobs and homes in the area, further intensifying the housing shortage.

So the questions are: What caused this housing crisis, and what can be done to dig California communities like Mountain View out of their giant housing holes?

On the first question, it should be noted that similar issues occur from time to time outside of California, but usually with far less severity. The explanation for the situation lies in the heavy hand of government regulation on the operation of housing markets through tools like zoning and rent control laws, endless permitting requirements, and a host of other restrictions that go far beyond what is needed to control the health and safety risks associated with real estate development. Of course, real estate markets need some form of external regulation. But the particular form makes all the difference.

On this score, the traditional small-government approach could still work today. The first system of social control is the law of nuisance that prevents landowners from engaging in activities that are offensive to their neighbors, like the emission of filth, noises, and odors. These restrictions are efficient because they imitate standard restrictions always included in all forms of planned-unit developments, whether they be apartment complexes or gated communities. The initial owner of the property knows that his gain from selling or leasing is far greater if all owners are subject to these restrictions than if none are. The owner therefore “internalizes the externalities,” to use a term of art, by picking the optimal set of rules to regulate these risks. There is no conflict between his welfare and that of his buyers. The law of nuisance backstops these rules by protecting outsiders from the combined activities of the new project.

Every standard voluntary development goes far beyond the prevention of nuisances by imposing a set of covenants and restrictions that address such matters as setbacks, height restrictions, aesthetics, common areas, taxation, governance, and many other details. These tend to differ across developments based on the income, tastes, and preferences of the unit owners. But the same logic drives them to efficient outcomes. Any benefit given to one tenant is a restriction on the others. The optimal set of rules continues to maximize the difference between total benefits and total costs, and the entire arrangement “runs with” the land so as to preserve the basic governance structure as individual units are bought and sold.

What is striking about the system of public restraints in California is that they go far beyond the various covenants and conditions that developers devise for their own projects. And they do so in ways that benefit local residents by imposing crushing costs on new arrivals. At this point, the self-balancing mechanism that constrains the behavior of developers is removed, now that local homeowners and voters are given a free hand in how they regulate, because they never have to compensate current landowners or future buyers and tenants for the losses these restrictions impose. Local citizens are prepared to consume a lot of goodies at zero price, which is all that an emaciated takings law now requires of them. At this point, they only cast their ballots for particular restrictions that benefit themselves, no matter what the cost to future members of their community. “Welcome stranger” and “not in my backyard” become the order of the day, so each small community adopts rules that keeps out any new activity that sitting tenants think will lower the value of their own units. Let them build elsewhere is the modern equivalent to Marie Antoinette’s “let them eat cake.”

The correct way to deal with this problem is to impose a serious compensation requirement on the communities that implement these regulations so that the prices they impose on others are now borne by themselves. This elaborate system of takings law should not, of course, require that communities compensate landowners that engage in noxious activities. But by the same token, it requires a strong sense of discipline to make sure that feigned “nuisances” do not justify the full range of large-lot and height restrictions, setbacks, and the like that local communities routinely impose on new arrivals. All too often, the result is an endless back and forth in which developers challenge one set of restrictions, only to find that they have to go back to square one when the plan is rejected by the local planning board. Under current law, the aggrieved landowner cannot oppose these restrictions in court until internal administrative procedures are exhausted, which gives local governments the incentive to string out the process until developers die from financial exhaustion. The endless cycles of application and denial are ample warning to potential developers who become reluctant to buy land, develop plans, and go through endless hearing cycles before obtaining—often from multiple independent bodies—their precious permits. The potential residents that they represent are typically unheard in these proceedings. In similar fashion, the rent control laws generate an enormous wealth transfer to sitting tenants, which, over time, leads to a stagnation in real estate markets, as people hold on to their units knowing they cannot afford the higher prices available to them in the limited unregulated market.

This two-tier system creates massive inequities, which then inspires local governments to try to supply affordable housing to newcomers in ways that are routinely self-destructive. California is a national leader in this institutional folly, because its Supreme Court routinely upholds rules that act as strong barriers to entry. Thus in San Remo v. San Francisco (2002), it upheld a law that required a developer—who wanted to convert prime downtown property into a hotel—to supply substitute housing to sitting tenants, even after their leases had expired, or contribute to an “in lieu” fund that could be used to create new public housing. This senseless tax on conversion prevents the movement of property to higher value uses and thus shrinks the tax base. If a city wants to supply affordable housing programs, it can do so through general appropriations that make taxpayers take the hit for the generosity.

The situation got even worse in California Building Industry Association v. City of San Jose (2015), where a unanimous California Supreme Court held that all builders of new housing had to supply a fraction of affordable housing units at their own expense, even if their proposed plans displace no sitting tenants. The net effect of this convoluted price control system is to retard new development. Again, putting these costs on the taxpayers is the only way to break the logjam. We can be confident that the number of affordable units demanded will shrink because the expenditures will now be on-budget. But, at the same, time the total supply of housing should expand by increasing new entry, which will drive down overall price and rental levels.

At this point, it becomes clear why any Mountain View growth plan will be mired in controversy for years to come. The City Council has full discretion over what kinds of restrictions it can put on new units, and its combined weight will delay the housing relief, increase its costs, and reduce its benefits. What is needed is a systematic way out of the impasse. The first component of this program is to remove any and all permit restrictions on housing that are not related to public health and safety, narrowly defined as under traditional nuisance law. On this model, virtually every development will pass muster, and the key task of the planning commission is to make sure that vehicular access and off-street parking are properly supplied. Otherwise, the regulation stops.

More importantly, Mountain View and other towns have vacant areas and these should be regulated by a simple rule that lets the developer make all decisions inside that area on issues involving density, design, and governance. At this point, the older logic of land use restrictions can go into place. Supply will increase, and prices will go down. Where current citizens want to impose further restrictions, they can do so if they are prepared to pay for them.

The way out is therefore available. But how is that transition to be secured in the face of implacable local opposition? Local governments have no incentive to reform themselves. The California Supreme Court is so convinced of the wisdom of local governments that it will not impose any meaningful restrictions on their operations. The state is thus locked in by bad laws and bad institutions. Ironically, one of the only possible solutions to this blue state problem will come from a potentially remade conservative Supreme Court, which will likely enforce federal constitutional guarantees on takings and due process against California and its local governments.

That process will take time, and it will require the U.S. Supreme Court to recognize that it, too, has to mend its ways. But the populist wave that brought Donald Trump to power may yet protect California from its ingrained regulatory system. The incredible mess in the California housing markets is not a product of bad luck. It is the consequence of horrible laws whose destructive impact is all too evident in the daily hardship and senseless political battles now raging across the state.

*Considered one of the most influential thinkers in legal academia, Richard Epstein is known for his research and writings on a broad range of constitutional, economic, historical, and philosophical subjects.

The Loyal Opposition

Richard Epstein*

Richard Epstein

Richard Epstein

No matter which candidate wins this Tuesday’s election, the nation is likely to continue the downward slide that started with the election of Barack Obama as president in November 2008. In the last eight years, the nation has fractured morally; it has failed to grow economically; and it has been continuously embarrassed in its foreign affairs. As a lame duck president, Obama will likely do nothing to reverse these downward trends. But now consider our alternatives to replace him.

Hillary Clinton, the likely winner, has moved to the left of Barack Obama on many domestic issues: We can expect to see higher taxes, more regulation of the labor markets, futile and misguided efforts to rehabilitate the Affordable Care Act, hostility to free trade, enforcement of repressive environmental regulations, and a stoking of racial tensions. There is not a single major domestic policy issue on which she promises material improvement from her misguided and dogmatic predecessor. She speaks and thinks like a diehard progressive with scant respect for, or sympathy with, market institutions. On foreign affairs, she was once thought to be more hawkish than Obama. But as of late, she has fallen under the spell of the Sanders wing of the Democratic Party. She has also shown little unhappiness with Obama’s ill-conceived Iran nuclear deal.  Thus, she is unlikely to do much, if anything, to reinvigorate a weak American military establishment, and I fear she will continue with a passive policy of disengagement with the Russians, Chinese, and Iranians. Her recent policy pronouncements are a continuation of Obama’s, which means they could lead to a further erosion of American influence abroad, and, ultimately, the escalation of conflict in the Middle East.  

Last, but by no means least, is that the stench of scandal will hang over her even if she is elected. The relentless exposure of her various lapses, rigorously dissected by Andrew McCarthy and Kimberly Strassel, among others, will not abate if she is elected president. She will have to fight a doomed three-front war dealing with the shenanigans of the Clinton Foundation, the palpable irregularities of her email server, and the lies and distortions that have come out even as the Department of Justice and FBI have slow-walked their criminal investigations of her conduct. Future waves of embarrassing disclosures could make it impossible for her to govern effectively.

She may well be put over the top by the recent Comey letter that stated that the FBI examination of the Abedin/Wiener server revealed no new information. But anyone who was skeptical of Comey for his suspect July 5 decision not to go further with the Clinton investigation will not be assuaged in the slightest by his most recent statement. Nor is it beyond the realm of possibility that she could be forced from office by some as-yet-unknown political time bomb.  No one can say.

But lest one be too critical of Hillary, there is Donald Trump, whose personal baggage means that his election carries the risk of bringing buffoonery, decadence, and political instability into the Oval Office, as well as possible investigations into sexual assault and fraud for his previous behaviors. On policy matters, he talks as if he is still cutting real estate deals in Atlantic City. His erratic behavior leads many to fear his control over our nuclear arsenal in his position of commander-in-chief and to doubt his respect of constitutional norms on such key matters as the rule of law and the separation of powers. His belligerent insistence on renegotiating international trade deals could lead to a major trade war that would cause incalculable damage to the United States and all of its many trading partners. Trump, it appears, has never heard of the principle of comparative advantage, and thus looks at American trade deals exclusively through the lens of the perceived “losers,” with scant appreciation of the systematic gains from trade. It is no wonder that most corporate executives have shunned his candidacy, given his apparent willingness to freeze out international markets. Likewise, his shrill immigration policy threatens to make it more difficult to run the domestic economy and stabilize his relations with Latin America and Muslim nations.

On most domestic issues, he is an empty vessel who has no political experience or intellectual skills to guide the nation forward. On social issues, he has the rare capacity to inflame racial tensions without cause, and to engage in gratuitous sexual slurs that further outrage public opinion. On foreign affairs, his oft-expressed disdain for treaties could usher in pandemonium on the most central military and economic issues.

It is not a pretty choice. What makes the current situation still more distressing is the polarizing impact that this campaign has had on the American electorate. It takes no sociological wizard to realize the deep antipathy that ardent Trump supporters have for Clinton, whom they think represents the bicoastal liberal elites and their favored minority groups. Clinton supporters return the favor by denouncing everyone who supports Trump as racists, homophobes, and kooks. Harsh talk like this has tended to abate during previous presidential elections. Traditionally, Democratic candidates tacked left while Republican candidates tacked right during the primaries to secure the nomination—only to both inch back to the middle in the general election in order to appeal to the ,median voter, on whom the outcome of elections was thought to hinge.

Unfortunately, this time around that movement to the center does not seem to be taking place. Instead, both parties have assiduously cultivated their respective bases in order to increase their turnout in the national election. To the extent that each tries to win over undecided voters, it is not with appeals to policy, but with denunciations of the character and temperament of the opposing candidate. And so the electorate has become more split, guaranteeing that the supporters of the losing candidate will bitterly resent the new president. There will be no honeymoon period, no reconciliation, only massive distrust. In one likely scenario, a Clinton presidency met by a Republican Congress will lead to renewed exercises of unilateral executive power, along with gridlock on just about every issue, including Supreme Court nominations, given that the president cannot move without the cooperation of Congress on such measures.

Faced with this unappetizing set of prospects, it is interesting to observe the different responses of the intellectual elites on the Democratic and Republican sides. Both are right to castigate the evident weaknesses of the other. But the Democrats are far too likely to whitewash Clinton’s many flaws and to claim that there are strong positive policy reasons to support her candidacy. After all, they don’t have any qualms with her aggressive brand of progressive politics. Interestingly, the response of Republican elites has been much more fragmented. There are many distinguished Republicans who so fear the erratic Trump that they are willing to support the Clinton nomination, warts and all. At the same time, many other Republicans find the prospect of a politically destructive and morally bankrupt Clinton administration too much to bear, so they are supporting Trump’s election and hope to restrain him while in office. And then there are those, like myself, who find the entire situation so unsettling, and both candidates so lacking in merit, that they will not vote for either.

I do not regard this last choice as irresponsible. I am thinking of my vote not just as a way to determine the outcome of an election, but also as an expression of the policies and public officials whom I am prepared to defend. The selection of one candidate over the other is like the purchase of a complex market-basket of goods. The only choice given to anyone in an election is to purchase all the goods in a particular basket or none. In most elections, it is commonly possible to have enough confidence in a candidate and a party platform to make this kind of choice. But in this election, my strong doubts about the character and integrity of both candidates, and my deep reservations regarding the substantive positions of both candidates, lead me to one conclusion. I cannot adopt the theory of vote for the lesser evil when both evils are so unacceptable.

I know that nothing that I could say would influence the decision of a President Clinton or her supporters on domestic issues if they were to control government. Our intellectual and ideological differences are so profound that I doubt that there is any common ground for discussion. One prevailing view is that Clinton has no abiding principles, and thus is always open to moving one way or the other depending on what’s most politically expedient at the moment. Yet my own sense is that she will resist any fundamental shifts in policy, such as reform of the ill-fated individual mandate under the Affordable Care Act. On foreign affairs, she is harder to read, although it is disappointing that she has not distanced herself from the Obama policies on Iraq, Iran, and Israel.

On the Trump side, the situation is more complex. On most policy matters, Trump is a blank slate, ill-prepared for office. Should he be elected, there are two questions to consider: first, will he listen to anyone, and, second, will he listen to the right people? On the former question, the odds are not good, given his willingness to disregard his staff and stumble down his own self-destructive paths. It’s impossible to answer the latter question, but the best thing Trump can do is to include in his inner circle the very conservatives and libertarians who, for compelling reasons, have most fiercely opposed his nomination. They will be reluctant to serve, but, in the end, many of them will overlook their seasickness in an effort to right the ship of state before it runs into the shoals.

Learning how to take advice is no easy art. All too many people assured me in 2008 that Barack Obama would be a fine president because he would get good advisors. What we got in the end was Valerie Jarrett, who drove away other potential advisors notwithstanding her utter want of substantive qualifications. Presidents always have a tendency to draw the wagons close around them when faced with these threats.

Nonetheless, regardless of whether Clinton or Trump is elected president, classical liberals like myself will be shut out of political influence. At this point, the only thing that we can do is to act as the loyal opposition. Economic growth is not necessarily doomed. It can be reinvigorated by sticking to the core principle of defending a limited government that understands its primary economic and social mission is not to purify the hearts and minds of those who disagree with its leaders, but to allow strong institutions, such as private property and the freedom of contract, to flourish, while offsetting the otherwise overweening power of the state. That mission requires strong opposition to the unilateral power of executive action and the unbounded power of administrative agencies. Abroad, it requires that the future president not withdraw from foreign affairs, or take a categorical stance against the use of force against those who attack or threaten our friends and allies in Western Europe, the Middle East, and in Asia.

These principles make sense no matter which party is in office. The job of the political and legal theorist is to keep steady on the course, and to demonstrate, time and again, the necessity for classical liberal positions on the full range of substantive issues. That third voice has to be heard, and heard often, in the impending political struggles that are likely to engulf the nation in the months and years ahead. 

*Considered one of the most influential thinkers in legal academia, Richard Epstein is known for his research and writings on a broad range of constitutional, economic, historical, and philosophical subjects.

Unaffordable Care Act

Richard Epstein*

Richard Epstein

Richard Epstein

The defenders of the Affordable Care Act are running out of excuses for the dismal performance of its health care exchanges. It is now old news that many uninsured individuals are unable, even with sizeable subsidies, to purchase health care coverage from private health care providers. As Yale Professor Jacob Hacker notes in his recent op-ed for the New York Times, the ACA has indeed faced “a rocky six months.” Average anticipated premium increases are running at 25 percent; major insurers like Aetna, UnitedHealth, and Humana have either pulled out of the program entirely or cut back their operations; and one recent tally reports that 16 of the 23 health care co-ops, with over 800,000 enrollees, have shut down, with at least six others on economic life support.

What should be done to respond to this unfortunate situation? The defenders of the ACA want to double-down on the current system by introducing a “public option” that was excluded from the original legislation. President Obama endorsed that position in a communication published recently in the Journal of the American Medical Association. After ignoring the problems with the individual health care exchanges, he suggests “Congress should revisit a public plan to compete alongside private insurers in areas of the country where competition is limited. Adding a public plan in such areas would strengthen the Marketplace approach, giving consumers more affordable options while also creating savings for the federal government.” That same line is echoed by Hacker who dismisses any notion that the public option will lead to a single-payer system, by making the tart observation that the wholesale withdrawal of private insurers from the marketplace has already resulted in a single-payer system in the five states whose exchanges will be serviced by only a single ACA provider next year, with the prospect of still more to come.

Unfortunately, President Obama and Professor Hacker, with their public option rescue plan, misunderstand the source of the current difficulties. The key problem is not monopoly power. It is runaway costs brought on by foolish regulations that no public option can cure. If the system is to survive, which is doubtful, it needs to be fundamentally redesigned.

In principle, there is no doubt that the exit of multiple players from any given market gives the survivors the opportunity to engage in monopoly pricing, which may allow them to increase profits. Yet current companies are leaving the ACA en masse because of developments on the cost side. They cannot make money when they have to play by onerous government rules in supplying health care insurance. Even in a perfectly competitive market, with free entry and exit, no one will sell any product for a price below its anticipated cost, plus an allowance for a risk-adjusted rate of return on invested capital. The firms that left concluded they could not provide a product consumers wanted at a price that would allow them to remain in the market. If there were monopoly profits to be made in this industry, new firms would enter as the old firms left. But the level of private entry into this market has been effectively zero, which is a strong signal there are no profits to be made.

Indeed, the situation is even more dire than this account suggests, because the individual health care market is not viable, even with the enormous public subsidies that are available to a large fraction of the insured population. According to figures from earlier this year, about 9.4 million enrollees (out of 11.1 million) on the ACA exchanges receive a government subsidy that averages $291 per month on policies that cost an average of $386 per month. That means that close to 85 percent of the enrollees receive an average subsidy of $4,632 per year, or close to 75 percent of the total price, for a grand total of about $43.5 billion in annual subsidies for their combined coverage. The situation looks even worse when you recall that the private plans of about six million people were canceled because they did not comply with the minimum standards set under the ACA. Those plans made money and contributed tax revenues to the government. So at a minimum, the $43.5 billion in subsidy dollars only increased the total exchange enrollment by about 3.5 million recipients. The rest of the reduction in the number of the uninsured comes not from the operation of the exchanges, but from the expansion of Medicaid by about 15 million enrollees, placing even more strain on an already overworked system.

The obvious inquiry here is why the President, or anyone else, should think the public option will be able to cure the underlying ACA cost problem and help the government save money. Private health insurers work in many complex markets, where they manage to turn a profit. Is there any reason to think that a new and untested government provider will be able to succeed where the companies have failed? That rosy and improbable scenario would only be possible if the government received a complex set of privileges and advantages denied to their private competitors. These subsidies could take the form of receiving free or below-cost services from other government agencies—or being exempted from the various regulatory reviews and requirements imposed on their private competitors. In other words, the few surviving private firms will be competing on an uneven playing field against coddled government entities. The rise of the public option would mean virtually all private insurers exit the field. Hacker is unduly optimistic when he thinks that the outcome will be a stable equilibrium with public and private carriers. A single-payer system, with its massive inefficiencies, is the more likely result.

It is therefore necessary to rethink the problem from the ground up. The only way to do that is to examine the devastating constraints the ACA places on the overall health-care marketplace. The first point to note is that parties in competitive markets are not told the dimensions on which they are allowed to compete. They can offer whatever mix of goods and services they choose for whatever price they charge. They can target the entire market or only a single portion of it. They can enter and exit at will. They receive no direct subsidies from the government for the services they supply.

As I have long argued, the ACA flouts these basic principles. The first point is that each of the ACA’s bloated four-tier plans—Bronze, Silver, Gold, and Platinum—have to offer 10 key essential services. As reported by Healthinsurance.org, these include “outpatient care, emergency services, hospitalization, maternity and newborn care, mental health and substance abuse disorder services, behavioral health treatment, prescription drugs, rehabilitative services, laboratory services, preventative care and pediatric services, including oral and vision care for children.” Some of these services are not found in any voluntary market, yet all of them must be made available at a high level that is determined by government regulation, and which is not sustainable in voluntary markets.

In addition, everyone must be accepted into every plan, regardless of whether they have a preexisting condition. Most potential insureds know about their anticipated risk profiles and thus enroll in plans when they expect to face heavy expenses that the insurers cannot take into account. Beyond that, all insurance carriers are required to ignore both age and sex, even though these are powerful predictors of future health care costs. An adverse selection problem arises because both old and young are most likely to enroll when the costs of their plan are smaller than their benefits.

Faced with these constraints, private insurers have to make choices their customers won’t like. They can restrict the choice of physicians, and they can increase the level of deductibles, both of which make the plans less attractive and speed the rate of exit. Recall that enrollments are done on an annual basis, so people who have lost coverage the first time will not enroll a second time, especially if the terms of the new plan are less attractive than those of the previous one. By the same token, various patient groups for assorted ailments will steer their members to their preferred plans because the cost of a sick person’s care is far lower on the exchange. Any public option that operates under ACA rules will be vulnerable to the identical pressures that have driven the individual exchanges to the brink.

The planners of the ACA had enough foresight to realize that its open enrollment system could lead to winners and losers. They therefore designed a “risk corridor” program, which is intended to require side payments from those insurers that have drawn a good group of insureds to those insurers that have drawn a more expensive group. The implicit assumption behind this strategy is that system-wide receipts will exceed system-wide costs. But, of course, that need not be the case. Some plans will indeed do better than others, but the overall costs of running the exchanges could nonetheless still be negative, which in practice means that as the overall losses get greater, it becomes more and more difficult to fund transfer payments solely from revenue sources within the exchanges. In order to stem the shortfall, the Obama administration sought to make payments to insurers that were not authorized by Congress, only to be slapped down in court.

If the public option will accomplish nothing, then what should be done? As I have long argued, the only solutions worth considering are those that reverse the major structural failings of the current system. In the short run, the list of required benefits has to be pruned; greater price freedom has to be restored; new enrollees must be required to stay for minimum periods to counteract the adverse selection problem; insurers have to be able to more accurately price in ways that reduce the cross-subsidies currently built into the system; and transfer payments among insurers have to be scrapped.

It is an open question whether these and similar reforms can remove the rot that has worked its way into the system. Yet by the same token, it will be difficult to push for a wholesale repeal of the ACA, given that it is no longer an option for people who have been forced out of the private market to return to the plans the ACA shut down years ago. After all, any new statutory reform could be so short-lived that new entrants might be hit hard by  unanticipated restrictions before they can recoup their investments.

There is a sober lesson to learn from this sorry situation. None of the ACA’s shortfalls should have been a surprise to people who understand how insurance markets operate. The basic proposition remains that market liberalization always beats increased regulation. The former reduces administrative costs and creates desirable incentives. The latter leads to heavy cross-subsidies, endless compliance rules, and systematic deficits. It is also hard to reverse course when the strongest proponents of the given program ignore its manifest structural deficits, which is exactly what the incorrigible President Obama and Professor Hacker have done in calling for a public option that will only make a bad situation worse.

*Considered one of the most influential thinkers in legal academia, Richard Epstein is known for his research and writings on a broad range of constitutional, economic, historical, and philosophical subjects.

Yale, Beyond the Pale

Richard Epstein*

Richard Epstein

Richard Epstein

In his recent op-ed in the Wall Street Journal, Yale President Peter Salovey tried to explain how colleges can make room for both freedom of speech and a culture of inclusion and diversity. Salovey wants to have his cake and eat it, too. The supposed tension between free speech and inclusion is false, he argues, because it is possible to pursue both ends simultaneously. Several days later, Yale was again in the news for its sexual harassment tribunals. As Jennifer Braceras explains in her op-ed for the Wall Street Journal, “College Sex Meets the Star Chamber,” Yale’s current policy on sexual harassment has led to a massive expansion of Yale’s control over the life of its faculty, students, and staff. At first, look, Salovey’s defense of free speech and inclusion seems unrelated to Braceras’s argument about the reach of Yale’s sexual harassment directive. But they are part of the same problem.

Yale defines sexual harassment very broadly: “Sexual harassment consists of nonconsensual sexual advances, requests for sexual favors, or other verbal or physical conduct of a sexual nature on or off campus, which includes (3) such conduct [that] has the purpose or effect of unreasonably interfering with an individual’s work or academic performance or creating an intimidating or hostile academic or work environment.” To be sure, no one wishes to defend assaultive or abusive sexual misconduct. But the Yale definition is capable of a broader reading. Combine the italicized words in the basic definition with clause (3) and the threat that this definition poses to free speech becomes clear. The phrase “purpose or effect” reaches actions that some reasonable person thinks might have an adverse effect, even if no harm was intended by it. Nor is there any effort to limit what is meant by a “hostile academic or work environment,” or activities on and off campus. It is all too likely that eager Yale bureaucrats will read these provisions broadly in order to expand the scope of their own authority.

The situation is still more dangerous because of the highly dubious procedures that are used in these cases. The tribunals use the lower “preponderance” of the evidence standard for guilt, rather than the stricter “clear and convincing” standard, which means the accuser has to bring less evidence against the accused. On top of that, the accused is denied the central right of cross-examination, even though he will face dire sanctions if convicted. It is impossible to know from the articulation of these standards exactly how any particular case will play out, or whether the Yale system will guarantee some modicum of consistency across separate cases. But what is perfectly clear is that the diehards who are likely to implement this policy are the same folks who have taken the lead in implementing Yale’s policy on inclusion and free speech, in ways that necessarily sacrifice the latter to the former.

The point here is not one of idle speculation. As Braceras notes, the administrative process against the accused does not need to be launched by an actual complaint by an individual victim; instead, independent parties, including Yale’s Title IX coordinators, are entitled to initiate and prosecute these cases. Given their own strong precommitments, this mixing of functions necessarily builds in an institutional bias against any claim that given speech acts should be protected. As a general matter, a broad definition of relevance is used in cases of this sort, so that it is possible for self-appointed inquisitors to roam far and wide to build up a case against unpopular professors or administrators, especially since the Yale procedures include no statute of limitations. The combination of loose definitions and dubious procedures is poisonous to the protection of free speech. Yet the tension goes unresolved.

It is equally instructive to realize that one does not have to introduce formal procedures in order to pose a grave threat to free speech on campus. Salovey takes great pride in noting “the Yale administration did not criticize, discipline, or dismiss a single member of its faculty, staff, or student body for expressing an opinion.” That sentence may be technically true, but it does not explain why Salovey did not mention the unfortunate fate of Nicholas and Erika Christakis, both of whom resigned from Yale under massive pressure after student protestors demanded that Nicholas be removed from his position as master of Silliman College. Why? Because Erika had written an email that took issue with a letter from Yale’s Intercultural Affairs Committee that warned students against various insensitive forms of behaviors, like wearing offensive Halloween costumes. The letter noted, like Salovey’s op-ed, that Yale values “free expression as well as inclusivity.” But the massive level of abuse directed at Nicholas and Erika Christakis reveals how strongly Yale weighs one imperative over the other.

The errors here are not just unfortunate glitches, but systematic blunders. One of the most critical matters in dealing with the right to free speech is the correlative duty that all individuals have to avoid actions that harm another person. But the harm principle contains much built-in ambiguity. It can only be clarified within a complete theory of freedom of speech, which itself must rest upon a comprehensive theory of freedom of human action. At the very least, any speech that involves the threat of force or the use of fraud should be subject to sanction under this principle, given the risk to the autonomy of others. That is why both assault and defamation have long been actionable harms. But by the same token, the harm principle can never be extended to cover cases where one person takes offense at the speech or conduct of other individuals—which is why flag-burning, however distasteful to most people, nonetheless receives constitutional protection. That extension of the harm principle, if applied uniformly to all speech acts, means that anyone who takes offense gets the right to sanction, if not veto, the speech of others, at which point no one can speak at all.

To forestall this risk, the great principle of toleration requires suspending the use of formal sanctions against disagreeable speech. Failure to follow this principle introduces the most dangerous set of incentives, by allowing any person to magnify his own indignation and outrage as a means to assert greater control over the speech of others. The danger of this position is apparent. The broader definition that equates harm with offense can only work if it is selectively applied. Thus protected groups get to complain loudly about the microaggressions against them, but they, in turn, are entitled to venomously attack those with whom they disagree.  A culture of free speech and open inquiry cannot long survive using this broad and selective definition of harm.

Yale, of course, is a private university that is not bound by the First Amendment, and hence could adopt whatever warped political and intellectual environment that it wants. But what Salovey cannot do is claim that Yale respects the principle of free speech, especially after the resignation of the Christakises following the relentless personal attacks on them as a result of Erika’s thoughtful email. What Salovey should have done was spoken forcefully and publicly in their defense, and entreated them to stay. Nor should he have stopped there. It was incumbent on him to endorse explicitly and publicly the commitment to free speech that President Robert Zimmer announced for the University of Chicago not too long ago. Zimmer made it crystal clear that he expects Chicago students to develop a certain toughness of mind in academic settings that transcends today’s vogue of “trigger warnings” and “safe spaces.” In order to learn and grow, students must encounter views averse to their own.

Yet Yale does not take that evenhanded and content-neutral position to preserve free speech on campus. Instead, it acts as an institutional arbiter that offers some groups special protection and leaves others to fend for themselves. It is quite chilling to read the Yale website, which heralds the university’s new commitment to the principles of diversity and inclusion across all aspects of Yale life: recruitment, mentoring, communications, and the like. One component of that program is a commitment to spend $50 million to make diversity hires on the faculty. Other initiatives are intended to create new centers and programs to study diversity throughout the university.

The Yale website proudly proclaims: “A diverse workforce and inclusive environment increases productivity, creates new ideas, performs on a higher level, and enhances Yale’s ability to continue to excel in an increasingly complex, competitive and diverse world.” Apparently, the principles of diminishing marginal returns do not apply to diversity. At no point does Yale even hint at the opportunity costs that are incurred by this uncritical adoption of its diversity agenda. Which programs were cut to make room for these new initiatives? And why?

Another obvious problem is that Yale does not celebrate political and intellectual forms of diversity, even though the overall leftward movement of university faculties has intensified in recent years. If Yale truly cared about diversity, it would look to increase the number of conservative-minded and pro-market academics in its hires of new faculty, while backing off hiring faculty members who have strong sympathies with groups like Black Lives Matter or the anti-Israel BDS (boycott, divest and sanctions), which represents the very antithesis of inclusion. But there is no indication that right-of-center thinkers are welcome under Yale’s tent.

Yale’s new inclusion and diversity policies will have grave consequences for the future of freedom of speech on campus. They will further reduce the likelihood that the institution will either announce or enforce content-neutral policies. The direct effect will be Yale’s continued discrimination against, or exclusion of, people whose views are found to not fit within its faux-inclusive community. Yale’s diversity-focused policies of recruitment, promotion, and retention will continue to drive the university further to the left now that no one in the administration is prepared to defend the traditional values of academic excellence and freedom of speech against the demands of diversity and inclusion. As a Yale Law School alumnus, I fear Peter Salovey’s misguided agenda will cause Yale to descend into moral dogmatism and intellectual mediocrity.

*Considered one of the most influential thinkers in legal academia, Richard Epstein is known for his research and writings on a broad range of constitutional, economic, historical, and philosophical subjects.

An Open Letter to Trump

Richard Epstein*

Dear Mr. Trump:  

Richard Epstein

Richard Epstein

It is hard—perhaps impossible—to calculate the damage that you have done to the United States and its people, and the people of the world. The situation that the United States faces today is one of great uncertainty at home and great peril abroad. You are running at the end of Barack Obama’s failed presidency, against Hillary Clinton, one of the least trusted and most unfit candidates ever to run for high office. There is little question that any other Republican candidate, including your vice presidential nominee, Mike Pence, would be far ahead of her in the polls, because any other candidate would concentrate on her dubious ethics and weak policy proposals.

But not you. Instead of tackling substantive issues on the campaign trail, you have doubled down on your shameless efforts at self-promotion and self-justification. You have engaged in endless tweets that reveal a thin skin and an unstable psyche. You hired the lawyer Marc Kasowitz to write one of the dumbest demand letters in the history of defamation law to the New York Times, asking it to retract its story about your past sexual misconduct because, he bizarrely claimed, old stories cannot be true, even if they are. Though I’m no New York Times cheerleader, I found myself, along with millions of other Americans, cheering as the paper’s General Counsel, David McGraw, gave your lawyer the written drubbing that your bullying deserved.

As you make yourself the central campaign issue, you also reveal that you are unfit to hold office. In your praise of Vladimir Putin, you show a flagrant disregard of the constitutional limitations associated with the office of the Presidency, so much so that I joined with other Constitutional originalists to oppose your nomination because of your extravagant views of unilateral presidential power. In addition, you stoked fears that you are anti-Semitic when you ranted: “Hillary Clinton meets in secret with international banks to plot the destruction of U.S. sovereignty in order to enrich these global financial powers, her special interest friends and her donors.” These wild charges ignore the more serious case against Clinton. With each passing day, more powerful evidence emerges that key government officials, including President Obama and Attorney General Loretta Lynch, may have improperly taken part in blocking criminal prosecutions against Clinton by using kid-glove procedures. These behaviors stand in striking contrast to the FBI’s overzealousness in the failed prosecution of Virginia Governor Bob McDonnell for far less serious offenses of supposed corruption—charges that were unanimously rejected this past June by the United States Supreme Court.

I have recently asked some of my colleagues about the scope of Article II, Section 4 of the Constitution, which provides that the President “shall be removed from Office on Impeachment for, and conviction of, Treason, Bribery, or other high Crimes and Misdemeanors.” Does that provision apply to actions that were committed by Clinton prior to her anticipated election as President, when she was Secretary of State? It is a serious interpretive question that we should hope never arises. Yet unless fresh revelations cease simply because she is elected President, this question could occupy public attention long after your juvenile antics have become old news. But the impeachment threat does not hang over her alone. Just this past Saturday, David Gelernter, a professor of computer science at Yale, publicly supported your candidacy as the best protection against Hillary Clinton, noting that impeachment by hostile Democrats and Republicans alike is, in this “abnormal year,” a vital safeguard against your potential abuse of power.

Right now, it seems that you will not do anything constructive to save your rapidly declining campaign. But there is still time for you to put the nation ahead of your insatiable ego. There are a number of reasons why you should abandon your pointless and petulant vendettas.

First, even as your presidential chances fade, the balance of power in Congress is still very much in play. Right now, it appears that you are quite happy to take down the rest of the Republican Party with you. But today, a divided government in which the Republicans control either—or preferably both—houses of Congress is more critical than ever. If the Republicans lose control of the Senate, all of Clinton’s judicial nominees will sail through. Spared the need to compromise, she will pick judges from the left-wing of her own party, which means the courts will rubber stamp the untenable political positions the Democrats have urged in recent years. There will be further unnecessary racial strife, as Clinton repeats her false charge of institutional racism against state and local police, which denigrates the work of tens of thousands of public officials and police officers. There will also be increased persecution of small religious groups that do not have the wherewithal to stand up to the Office of Civil Rights in the Department of Education, or the Equal Opportunity Employment Commission.

Then there’s the economy, which will implode under her so-called tax reforms. Her proposed higher taxes on ordinary income, capital gains, and large estates will deprive the private sector of the capital needed for innovation and jobs. Every emboldened alphabet government agency will be in the hands of the Democrats, which means that more senseless regulations and government programs will be created. A perfect example is Clinton’s madcap plan to subsidize the construction of half a billion solar panels, based on her idea that Hurricane Matthew offers striking evidence that global warming poses a grave threat to the overall economy. This is not the way to make America great again.

The only safeguard against the runaway progressivism of a Clinton presidency is a Republican Congress. But you compromise the chances that responsible conservative politicians will be elected when you call out House Speaker Paul Ryan for distancing himself from you. Each time you charge that elections are rigged against you, you further delegitimize our political system in ways that will make it harder for decent people of both parties to run for public office.

You have also failed to articulate a coherent vision of limited government and strong property rights on which the success of this nation depends. The Democrats are united at this point in their progressive vision that centralized government power will somehow lead to greater income equality on the one hand and improved growth on the other. This proposition ignores the simple truth that it is far easier to level downward than upward, which is what will happen if incentives for wealth creation are suffocated by high taxes and extensive regulations, making the pie smaller and the public mood more divisive than it already is.

So you have to clarify that your policies do not replicate that result. And the first point here is to back off the delusion that the way to make America great again is to tear up all trade agreements and build a wall to keep people from coming across the border from Mexico. On the first point, it is easy to claim that jobs lost in the rust belt have landed in Mexico or China—easy but flawed. The missing step is simple enough. There is nothing that says that the lost jobs can’t stay here if they don’t go to Mexico. The state-level differences in lost jobs are quite enormous, as states like Illinois will continue to lose jobs because of their own business climate. If the jobs do not go to Mexico, they will go to Tennessee, or perhaps just disappear.

One of the key benefits of free trade is that it forces nations and states to reform their own practices so that they can become more competitive. Knock down the exit threat and the massive internal impediments to growth gain a new lease on life. Allow for the trade, and you open up markets in other countries like Mexico, which increases the economic opportunities for their citizens, making them less likely to want to sneak across the border into the United States. Your opposition to the Trans-Pacific Partnership only doubles down on your systematic ignorance of how complex economic systems work, making it all the harder for you to differentiate your positions from those of the Democrats you oppose.

On other points, you do have comparative advantages that you should stress. You favor lower taxes and decreased regulation without embracing the protectionist creed that undoes much of the benefits that domestic reform could achieve. It is important to attack the populist urge to soak the rich. It is imperative to oppose any increase in union power, and to forcibly oppose union efforts to block the expansion of charter schools, a particularly foolish move supported by the NAACP.

On foreign affairs, it is critical for you to hone in on the failures of the Obama administration in virtually all corners of the world. The growing instability in the Middle East stems from the President’s unwillingness to use force, which has given Putin, Assad, and ISIS free run over the area. The humanitarian consequences of America’s Middle East policy are also deplorable, and have bred chaos in other parts of the world. The refugee crisis has created major dislocations inside Europe, and has helped contribute to the breakdown of trust across the continent. Surely, you could say more about your proposals to increase the number of combat-ready troops and to repair the frayed relationship between the head of the military and the President of the United States.

It is not clear whether you have the good sense to rise above personal slights and indignities; but if you do not, one of two things will happen. Either you will lose the election and be condemned as one of the most destructive forces in American history for your inflammatory behaviors, or you will win the election and be an ineffective leader as your endless preoccupation with the personal and the petty will make you a divisive threat to the country that you hope to lead.

So here is my piece of not-so-friendly advice: Either shape up, or, even at this late date, step aside and let Mike Pence take your place at the head of the ticket.

Sincerely yours,

Richard A. Epstein

*Considered one of the most influential thinkers in legal academia, Richard Epstein is known for his research and writings on a broad range of constitutional, economic, historical, and philosophical subjects.

Intellectual Myopia On Insider Trading

Richard Epstein*

Richard Epstein

Richard Epstein

This past week, the United States Supreme Court heard oral argument in Salman v. United States, an important case concerning federal securities law. At issue are the limitations placed on insiders who trade in the shares of companies on the basis of material, nonpublic information. The parties covered are not only those who obtain the information themselves, but the persons to whom they (as “tippers”) pass on that information, commonly called tippees.

The prohibition on insider trading is said to derive from Section 10(b) of the Securities Exchange Act of 1934, which makes it unlawful for any person to “employ any device, scheme, or artifice, to defraud,” as implemented under SEC Rule 10b-5.  The purpose of this prohibition on insider trading is to restore overall investor confidence in the exchange markets, by denying to certain insiders the ability to reap undue benefit because of the informational advantage from undisclosed information that they gain against their actual or potential trading partners.

The extension of Rule 10b-5 to insider trading only took place in 1962 in the critical SEC decision In Re Cady, Roberts, & Co., and it has been long surrounded by controversy. Salman concerns whether, under Rule 10b-5, the tipper of the inside information had to receive some tangible benefit from the tippee, or whether some more diffuse social benefit sufficed to trigger criminal liability. 

The simple fact that the SEC sought to expand the scope of the insider trading prohibition has generated serious uneasiness. In writing about this case in Defining Ideas, Professor Jonathan Macey, a noted securities law expert at the Yale Law School, reaches the grim conclusion that Salman could easily provide the government with an opportunity to unduly expand the reach of the securities law by allowing it to use its own ill-defined notions of “fairness” to attack just about anyone it wants. In the abstract, that point resonates with small-government groups, such as the Cato Institute, whose amicus brief for Salman stresses an argument Salman’s lawyer, Alexandra Shapiro, made in court—that what qualifies as criminal should be narrowly construed in order to avoid dangerous government overreach.

In general, I am no defender of increasing the breadth of government enforcement. But in Salman these fears are wildly overblown. In this instance, liability should be expanded to cover all individuals who make unauthorized use of insider information whether or not the tipper has received any benefit from the tippee.  To see whether this rule makes sense, let’s start with the facts of the case. Maher Kara, who worked in Citigroup’s healthcare investment banking group, passed along inside information to his older brother, Michael Kara, who knew that the information was stolen but nonetheless used it to make some advantageous trades. Michael then shared the information with his future brother-in-law, Bassam Salman, who then followed Michael’s trades.  Salman, like Michael, knew that he was trading on stolen information. At this point, it is instructive to analogize the situation to one in which Maher took some tangible property from Citigroup, which he then gave to Michael, who then transferred some portion of his booty to Salman, who then used or disposed of it for his own personal benefit. In these cases, the standard common law rule is that Citibank could recover any profits Salman got from the use or sale of the stolen property.

As I explained in a recent article in the Yale Law Journal, the applicable principle for dealing with stolen tangible property—and by extension stolen information—is that the only person with any valid claim to the property is the bona fide purchaser for value. Raising that defense bars two types of individuals from keeping the property. The first are those who bought the property with knowledge that it was stolen. The second are those who received it as a gift from the thief. When the theft is established, the law imposes a constructive trust on the donee, which in turn requires him to return the stolen property, or the proceeds of its sale, to the owner. The word “constructive” means that the recipient is treated as if he had received the property as a trustee, even though he did not.

The same basic framework carries over to the theft of information, such that Salman flunks both ways. He received the stolen information as a gift, and he knew that it was stolen. He is the lowest of the low, a bad faith donee. So why then does his pathetic case end up in the Supreme Court? Because the Justices have for years asked the wrong question, assuming that Maher and Michael had to receive in return some “personal benefit” from Salman for his use of the stolen information. More precisely, the question presented was:

Whether the personal benefit to the insider [Maher] that is necessary to establish insider trading under Dirks v. SEC requires proof of “an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature,” as the Second Circuit held in United States v. Newman, or whether it is enough that the insider and the tippee shared a close family relationship, as the Ninth Circuit held in this case.

The question presents a false choice, when the right answer is that no return benefit should be required at all, once Salman knew that he was trading on stolen information. Instead, the constructive trust should be imposed to capture his knowingly illegal conduct. The only interesting question is how the Supreme Court persuaded itself that some return benefit was required in insider trading cases. At this point, we need to unpack the two cases mentioned in the question presented.

First, take Dirks. Raymond Dirks was an officer of a broker-dealer of a corporation who received from Ronald Secrist, a former officer of Equity Funding, reliable information that Equity had deliberately inflated its share values. Dirks freely shared this information with clients and investors, who sold their stock to avert future losses, when he could not persuade either the SEC or the Wall Street Journal to investigate based on his tips. The legal question was whether Dirks, who surely operated from mixed motives, was guilty of aiding and abetting insider trading—and no more, since he did not trade himself. The answer given by the ever-prudent Lewis Powell was that he was not. He was not an insider and hence he could only be held responsible “when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee [here Salman, once removed] and the tippee knows or should know that there has been a breach.” Justice Powell then introduced the personal benefit test into the equation by noting that the question of whether the insider was in breach of his fiduciary duty depends “in large part on the personal benefit that the insider receives as a result of the disclosure.”

At this junction, the dispute under the personal benefit test is whether tangible benefits are required, as suggested in Newman, or whether a set of close family interconnections, such as those found in Salman, suffices.

This entire learned debate is an irrelevant diversion. The simple point here was that Dirks knew that this was inside information, and so the key question is what should he do with that information in order to expose a scandal. The simple answer is that he should make that information public before sharing it with his various clients, but his failure to do so makes him guilty of abetting the insider trading, which is what the lower court found. And that is surely the case in the ordinary situation where the tippee receives information about inside share value that he shares with his customers when there is no whiff of scandal at all. In neither case is there any room for an actual fiduciary duty of the sort that corporate officers and directors owe to a firm. It is enough to impose the constructive trust by analogy to the physical transfer.

This view of the transaction helps explain the correct resolution of the situation presented in Newman, on wholly different facts. In that case, officers of two corporations released information to a selected group of analysts at the behest of the company in order to stimulate interest in the firm’s shares in ways that would increase their value. Unfortunately, the SEC promulgated Regulation FD. (i.e. fair disclosure) in 2000, making it unlawful to release company information selectively to some analysts unless, in the name of “full and fair” disclosure, it released the information to all. As usual, the SEC missed the mark. So long as the world is on notice that these selective disclosures are made, all traders can take that into account in making their own decisions for those firms (which need not be all firms) that engage in the practice. There is accordingly no fraud.

As it happens, Regulation FD imposes sufficient dislocation on firms that management tends to authorize,sub rosa, just these selective disclosures on the theory announced above—that inside information can be used by all recipients for their purposes, so the taint on all transferees is removed. Sadly, that line of argument was not open to the Court in Newman, so it then decided the case on two related grounds. First, the remote tippees (three and four links away) received this information as part of a deluge of information from multiple sources that made it impossible for them to know whether they had inside information or not—a problem completely absent in Salman. Second, the Second Circuit held that the diffuse set of personal benefits linking the various parties together—all of which were weaker than the close family ties in Salman—flunked the personal benefit test as announced in Dirks, setting up the conflict between the circuits when the Ninth Circuit in Salman held that the family connections sufficed.

During the oral argument before the Supreme Court, the Justices and the lawyers inconclusively bandied about endless hypotheticals as to what counts as a personal benefit. But as is so often the case, no one bothered to rethink the relevance of that issue at all. The correct resolution involves knocking out Regulation FD, and asking whether the release of the information was authorized expressly or implicitly by the firm—and if not, whether the tippee knew of its illegal release. In this scenario, the personal benefit test becomes irrelevant and Salman gets the hard punishment he deserves.

It is sometimes said, as by Professor Macey, that this view of liability opens the floodgates on insider information, but it does nothing of the sort. In United States v. O’Hagan, a 1997 Supreme Court decision fleetingly mentioned by the Court in the oral argument for Salman but extensively discussed by Macey, the defendant was the lawyer for a large firm, MetLife, who took confidential information that he received from MetLife, which he then used to buy shares on his own account, thus running up the price that MetLife had to pay to complete the operation. This situation is an open-and-shut breach of the standard agreements always imposed by law firms and investment banks on their members—never to trade against the interests of a client. Clearly, that decision retains its full force no matter which way Salman comes out because of the enormity of the self-dealing. But should the case have come out differently if James O’Hagan had given key information to a casual friend who did the same thing? The danger to the client interest is the same whether the insider uses the information alone or shares it with a friend.

If you think of the securities law as trying to reinforce the restrictions that private parties impose on their employees and independent contractors, then Salman has to be decided for the SEC to prevent wholesale breaches of insider’s fiduciary and contractual duties—but only if the Supreme Court shakes off its intellectual myopia and rethinks the question as a matter of first principle.

*Considered one of the most influential thinkers in legal academia, Richard Epstein is known for his research and writings on a broad range of constitutional, economic, historical, and philosophical subjects.

The Government’s Civil Rights Bullies

Richard Epstein*

Richard Epstein

Richard Epstein

Earlier this month, the U.S. Commission on Civil Rights issued its report Peaceful Coexistence: Reconciling Nondiscrimination Principles with Civil Liberties. The report, which was occasioned in part by the same-sex marriage debate, tries to determine the correct relationship between antidiscrimination laws and the First Amendment’s protection of the free exercise of religion. Currently, persons of religious faith have been legally charged with discrimination under state antidiscrimination laws for refusing to provide their individualized services to same-sex couples because they sincerely believe that marriage is a relationship existing only between one man and one woman. The question is: should they be granted a religious exemption?

The report’s title, Peaceful Coexistence, conveys, perhaps unintentionally, a grim social reality in the United States. Historically, of course, it described the uneasy relationship between the United States and the Soviet Union at the height of the Cold War. In that context, the phrase described how two nations, organized under radically different principles, could avoid the dangers of mutual annihilation through nuclear warfare.

One would hope that the stakes would be lower in this domestic debate, but judging from some of the rhetoric surrounding the issue, they are not. The Chairman of the USCCR, Martin Castro, recently commented publicly that “The phrases ‘religious liberty’ and ‘religious freedom’ . . . remain code words for discrimination, intolerance, racism, sexism, homophobia, Islamophobia, Christian supremacy, or any form of intolerance.” And there are powerful echoes of that position in a statement by five of the commissioners—Castro, joined by Roberta Achtenberg, David Kladney, Karen Narasaki, and Michael Yaki—who write: “These laws”—which seek exceptions to the antidiscrimination laws—“represent an orchestrated, nationwide effort by extremists to promote bigotry, cloaked in the mantle of ‘religious freedom.’”

These claims are dangerously hyperbolic in the same-sex marriage context. In making my argument, I will put aside all constitutional questions and examine the issue solely as a matter of first principles. The central point is that there is a heavy and real burden, frequently ignored, on those who wish to make claims of bigotry and phobia.

Let’s define our terms. “The English noun bigot,” Wikipedia tells us, “is a term of abuse aimed at a prejudiced or closed-minded person, especially one who is intolerant or hostile towards different social groups (especially, and originally, other religious groups), and especially one whose own beliefs are perceived as unreasonable or excessively narrow-minded, superstitious, or hypocritical. The abstract noun is bigotry.” Phobia, meanwhile, is defined as a “persistent, abnormal, and irrational fear of a specific situation that compels one to avoid it, despite the awareness and reassurance that it is not dangerous.” The issue is whether these terms are more applicable to the people of faith attacked by the commissioners, or to the aggressive commissioners themselves.

One way to answer this question is to examine a case before the Washington Supreme Court, Arlene’s Flowers, Inc. v. Ingersoll, which tests the scope of Washington’s law against discrimination that protects “the right to be free from discrimination because of race, creed, color, national origin, sex, . . . [or] sexual orientation.” The law further gives a person “deeming himself or herself injured by any act” done in violation of the statute the ability to sue for “the actual damages sustained… together with the cost of suit including reasonable attorneys' fees or any other appropriate remedy authorized by this chapter.” The provision contains no religious exemption for those who refuse to provide services on grounds of conscience.

The sole owner of Arlene’s Flowers is Barronelle Stutzman. The plaintiffs Robert Ingersoll and Curt Freed are a same-sex male couple planning a marriage. Ingersoll was a long-time customer of Stutzman who requested that she prepare the floral arrangements for his impending same-sex marriage to Freed. Stutzman refused, and gave as her reason her Christian belief that marriage takes place only between a man and a woman. She politely referred him to several other florists who were prepared to take his business, and she was even prepared to sell him the flowers he might use to create the appropriate arrangement. But she did not want to prepare the arrangements herself. In light of this, the actual damages in this case were the $7.91 it cost Ingersoll to drive to another florist. Notwithstanding, Ingersoll and Freed, represented by the American Civil Liberties Union, prevailed at trial in a lower court.

The first question is: why apply antidiscrimination law to ordinary business transactions? There are literally tens of millions of people in the United States who follow these Christian beliefs, but there is no evidence of any resistance to doing business with anyone who walks in the door. Wholly apart from the law, it is bad business to turn away customers, especially if those arbitrary sentiments drive other potential clients away. So long as an omnipotent state does not put a decisive thumb on the scale, as it did under Jim Crow, the forces of competition will quickly fill the gap in the provision of services. So why provoke a battle royale over $7.91?

One reason offered by the liberal members of the USCCR is that the case is not really about these actual damages at all, but about the larger issue of emotional distress. Thus, a statement by five of the commissioners quotes Chai Feldblum of the Equal Employment Opportunity Commission as follows:

If I am denied a job, an apartment, a room at a hotel, a table at a restaurant, or a procedure by a doctor because I am a lesbian, that is a deep, intense, and tangible hurt. That hurt is not alleviated because I might be able to go down the street and get a job, an apartment, a hotel room, a restaurant table, or a medical procedure from someone else. The assault to my dignity and my sense of safety in the world occurs when the initial denial happens. That assault is not mitigated by the fact that others might not treat me in the same way.

The term “assault” is used in a very broad sense here; it bears no relationship whatsoever to the common law definitions that mention the use or threat of force against another person, which cannot be found when a person who refuses to do business offers helpful suggestions as to where a disappointed customer may go. The law does recognize a tort of intentional infliction of emotional distress, but limits it to cases of extreme and outrageous conduct, far removed from the Feldblum scenario.

Worse still, it is dangerous to describe these injuries as “deep, intense and tangible,” when people can readily find cordial services elsewhere in a competitive industry. Nor is this supposed injury greater than that which people might feel when turned down for many other reasons, such as when a baker refuses to bake a cakethat says “Blue Lives Matter” on it. But these emotional losses just don’t count. Finally, treating these self-generated harms as actionable gives people the perverse incentive to magnify their sense of loss, when the correct social objective is to minimize it to promote general civility.

Feldblum’s account looks at only one side of the equation. It never asks about the emotional and psychological harms that people like Stutzman the florist might suffer. Indeed, she should bear the heartache if Ingersoll stalks out of her shop never to return, and should have no redress if others follow suit. But in this instance, her emotional harms arise not from customer dissatisfaction, but from concerted legal action by those bullies who want to force her out of business, unless she buckles under state power by engaging in specific acts that violate her deepest beliefs.

But not to worry. The die-hard defenders of the antidiscrimination law tell us how to make her problem go away. The same five commissioners insist:

Providing commercial goods and services does not require that one “blesses” an event. Taking pictures is not “testifying” to one’s spiritual endorsement of a legally recognized ceremony. Frosting a cake is not “helping to celebrate something ... believe[d] to be a transgression of divine law.” Selling flowers is not “contribut[ing] to” a marriage celebration. Those are secular, commercial, quid pro quo transactions; straightforward exchanges of products and services for money.

Really? The expert expositors of Stutzman’s religious beliefs are the same civil rights commissioners who are prepared to trash the lives and reputations of every businessman and businesswoman who acts contrary to their commands. What gives them the moral authority to decide the religious rights and obligations of other people? More to the point, note how well their dismissive attitudes fit the definitions of bigotry and phobia.

Stutzman has thought long and hard about her position. She draws subtle distinctions key to her faith. She works hard to respect the beliefs of those who disagree with her. She understands that she risks the loss of their business and that of others by living according to her beliefs. But she draws a line on principle. Her conduct bears no relationship to a “prejudiced or closed-minded person, especially one who is intolerant or hostile towards different social groups.” Her actions are not borne of some irrational fear.

But the words “bigotry” and “phobia” clearly do apply to the five commissioners who happily denounce people like Stutzman. They show no tolerance, let alone respect, for people with whom they disagree. They exhibit an irrational fear of those people’s influence. They show deep prejudice and hostility to all people of faith. They indulge in vicious overgeneralizations that make it harder to live in peace in a country with people of fundamentally different views. And they seem to take pleasure in bullying little people who can’t fight back.

This issue is bigger than whether religious people should be granted exemptions from certain laws. It’s about the role of state power in our lives. Our nation has to seriously rethink the question of whether it wants the state to force people to do business with others. The only cases where that makes sense are with common carriers and public utilities that have some clear level of monopoly power, where the refusal to deal means having many people going without essential services altogether. But competitive markets have powerful corrective powers. Government monopolists do not. Unfortunately, that lesson is lost on the commissioners of the USCCR, who, in their willingness to beat up on little people, fail to understand that they are the problem, not the solution. 

*Considered one of the most influential thinkers in legal academia, Richard Epstein is known for his research and writings on a broad range of constitutional, economic, historical, and philosophical subjects.

Clinton’s Tax Conceit

Richard Epstein*

Richard Epstein

Richard Epstein

Hillary Clinton has revealed further details of her plan for the fiscal future of the United States. Her vision addresses both sides of the equation: how and from whom taxes should be raised; and how and for whom they should be spent. Her plan is squarely within the progressive tradition. She insists that “The middle class needs a raise,” and that the federal government will pay for the raise by increasing taxes on the top one percent, who once again must be made to pay their “fair share.”

The notion of diminishing returns from higher taxes at no point informs the key features of the Clinton plan: a four percent income tax surcharge on those earning over $5,000,000 per year; the imposition of the “Buffett rule” that requires an alternative minimum tax of at least 30 percent on those earning more than a million dollars per year; an increased capital gains rate for investments held for less than six years; a hefty increase in the estate tax, by reducing its base to $3.5 million per person from the present $5.45 million per person; an increase in the top rate from 40 percent to 45 percent; and capping the charitable deduction at 28 percent, even for people in a higher individual tax bracket.

Clinton plans to funnel many of these tax dollars into an aggressive form of industrial policy that gives public officials under her guidance the power to decide which businesses in which locations—chiefly inner-cities and depressed neighborhoods—will move to the head of the queue. In addition, she wants to spend more on infrastructure, but has said very little about how to insulate essential improvements and repairs from political intrigue. Clinton’s fatal conceit is that she will be able to manipulate the political levers to give targeted benefits to her preferred constituents, without reducing overall levels of growth.

But her plan will crater. The selective government interventions that she proposes will perversely distort key private decisions on consumption and investment. In a hypothetical tax-free world, investment and consumption decisions are made by individuals seeking out the highest rate of return for their various efforts. At the same time, there is always the impulse for charitable behavior among those individuals—whether to help the poor or to provide educational, artistic, or medical benefits to the community. In general, a legal system that enforces contracts, curtails aggression, and restrains monopolies and cartels will have resources flow to their best use. Secure property rights and voluntary exchange are the foundations for any sound social policy. Within this framework, private actors can establish through repeated interactions the correct relative prices for the goods and services needed for both production and consumption.

Obviously, this ideal system of private property and voluntary exchange does not run on vapors. Someone has to enforce the rights and duties it creates, which requires the collection of tax revenues in order to discharge these key government functions. Ideally, that system of taxation should have two constraints, one distributional and the other aggregate. First, a sound system of taxation should not change the relative prices attached to various alternatives from what they were in a tax-free world. If A prefers X to Y in that hypothetical tax-free world, A should prefer X to Y in a world with taxation. Otherwise, the collective intervention will subsidize inefficient choices. Second, the aggregate levels of expenditure should be set to produce outcomes that give back to each citizen a package of goods and services worth more than the taxes he or she pays to create them. Over-taxation chokes off productive private labor.

There is no perfect way to reach these dual objectives. But in our imperfect world, classical liberal theory offers a good way forward. It favors flat taxes on a broad base of income, or more preferably consumption, to achieve these two ends. The flat tax reduces political discretion in determining who should be taxed, and since no one is exempt from its reach, it gives each person an incentive to search for a uniform tax rate that maximizes the net benefits from funding all public goods. That tax reduces the factional gains from forming political blocs, and it cuts down on the uncertainty that private parties face when making long-term investment decisions.

On the expenditure side, a similar degree of stabilization is achieved by funding public, i.e. nonexclusive, goods that are shared by all alike. This is why the original Constitution limited the objects of taxation to paying the public debt, providing for the common defense, and securing the general welfare of the United States—which excluded all transfer payments between private parties. By securing a stable framework, this system gives the poorest members of society greater opportunities to find gainful employment and other opportunities—at least if not blocked by entry restrictions, including minimum wage laws and strong unions. The challenge of redistribution, intended to redress inequalities in wealth, is not fully addressed by these devices. But charitable deductions create an implicit public subsidy in which a diverse set of private donors, not government officials, make the key policy and management decisions.

The Clinton program rests on an exaggerated sense of the good that government can do. But her plan will backfire in a number of ways. First, by raising the capital gains rate she reduces capital mobility and thus locks people into inferior investments. The higher rates will depress the collection of the capital gains tax, by encouraging people to delay unloading bad investments. Second, by imposing the higher taxation rates on the richest individuals, her program further tamps down on investments made by people whose investment and management skills can best create new jobs for ordinary people. She wrongly thinks that governments can expand opportunities, when its level of entrepreneurial expertise is negligible at best. Unfortunately, we can expect her program to fail just as other government programs have in everything from solar energy to neighborhood cooperatives. Government officials work best when they have focused goals of the type that define a system of limited government. Going further by managing private businesses exponentially increases the risk of cronyism and other forms of misbehavior.

Precisely that will happen, moreover, with her misguided proposal to eliminate capital gains taxation for money invested into depressed areas, which is likely to reproduce the colossal waste that came from overspending in places like Baltimore, where massive federal investment has done nothing to stop crime or the population exodus. The right strategy is the exact opposite: encourage people to move to safer and more prosperous communities, which might jolt the political and civic leaders of places like Baltimore to get off life support. Programs that reward failure only create more failure. No private party would spend its money on such a fruitless mission—and the federal government should not create a useless bureaucracy to decide which supplicants should receive what forms of aid. Nor should it give tax breaks that favor unproductive investments over sensible ones.

Today, ordinary workers are leaving their home states in search of jobs and a better standard of living. They are moving to places like Texas where taxes are lower and labor markets are freer. But these business-friendly environments—and the people living and working there—will suffer if Clinton’s plan to strengthen unions and raise minimum wages is implemented on a national scale.

Similarly, her proposal to cap charitable deductions at 28 percent operates as a tax not only on donors, but also on the individuals who receive these benefits in relatively efficient form. The net effect is to reduce the flow of private support for charitable activities, which will increase the scope of badly run public programs. It would be a national tragedy to reduce the amount of private sharing of wealth. It is not the case that only the rich get hurt by the limitation on charitable deductions. After all, if the wealthy stop making gifts, that improves their own financial position. The real harm, then, is to the recipients of charity, who will receive less. Virtually every charitable entity in the United States should be up in arms at this crude effort to tax them out of existence.

It is equally unwise to impose an alternative minimum tax. That program is only necessary in order to backstop our progressive system of taxation, which is riddled with loopholes. But rather than add complexity, we should simplify and rationalize our basic tax system in ways that make a back-up tax unnecessary. In this regard, taxing capital gains is often a mistake. Even if we do not move to a consumption tax, it makes sense to exempt from immediate taxation receipts that are reinvested in other capital assets.

By this standard, the estate tax is the worst of all possible taxes, because it is a lump sum tax on wealth that distorts decisions on investments and consumption. There is no equity in imposing this tax on those people who die at 60, while deferring the same tax for 30 years for those who die at 90, especially when they may have consumed or given away their wealth tax-free in the interim. The standard argument in favor of the consumption tax is that it reduces the excess tax on savings, in ways that improve intertemporal wealth management. Raising the tax and reducing the exemption will have negative effects on resource management that will reduce taxes that could otherwise be received on dividends and salaries. Yet nothing in the Clinton plan addresses the interplay between tax systems.

There is little doubt that the middle class has suffered from a regime of slow growth. But Clinton’s crude efforts to use new targeted tax revenues to fund industrial policy will only complicate the tax code while frustrating private activities that could grow the economy. A far better approach toward growth is to reduce the barriers to entry in industry after industry. The combination of lower administrative costs, higher legal certainty, and greater private initiative will work far better than any set of progressive gimmicks with their perverse incentives and heightened political intrigue.

*Considered one of the most influential thinkers in legal academia, Richard Epstein is known for his research and writings on a broad range of constitutional, economic, historical, and philosophical subjects.

Europe Gets Apple Right

Richard Epstein*

Richard Epstein

Richard Epstein

On August 30, the European Commission issued a blockbuster ruling that required Ireland to recoup, with interest, the €13 billion in tax benefits that it has granted Apple since 1991. The tax breaks, the commission held, violated the European Union’s “state aid rules” that no company should be given preferential treatment under the law.

The decision elicited a strong reaction from Apple CEO Tim Cook who denounced it as “total political crap.” He was not alone in this belief. Holman Jenkins, Jr., writing in The Wall Street Journal, for example, said the decision was motivated by the European Commission’s desire to impose “tax harmonization” on all EU members as a way of “defending Europe’s stagnant social model,” which could not generate any Amazons, Googles, or Facebooks on its own. The United States Treasury echoed the same theme in a white paper that anticipated the EC’s ruling. And now Ireland, backed by Apple and Treasury, has decided to appeal the EC decision to the European Courts. Who is right, and why?

My initial judgment—always subject to revision on the strength of additional information—is that the EC was correct in its decision. In making this assessment, I admit that I harbor a deep suspicion of the EC in its multiple roles. In general, there is much to the charge that the EC’s policies are prejudiced against American companies that do business in the EU. But it is one thing to start with a strong presumption, and another to put the pieces together in a prudent fashion.

The first query is whether an antitrust outfit like the EC should be making judgments about tax policy in the first place. In this instance, the answer comes from Article 107 of the Treaty on the Functioning of the European Union, which provides, with multiple exceptions not relevant here, that “any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between Member States, be incompatible with the internal market.”

The internal market refers to the free flow of goods across national boundaries among EU members. In this connection at least, the EU operates more like an open trading union and less like the top-down Brussels establishment whose regulatory abuses strengthened the case for Brexit. Harmonization in the EU is always harmonization-up rather than harmonization-down. In contrast, Article 107 is directed toward the issuance of selective benefits to individual firms, and, as such, does not prevent any member state from setting its general tax rates as high or low as it wants, so long as it does so on a nondiscriminatory basis.

The EU’s general nondiscrimination policy allows for members to compete for new business by offering an attractive tax environment. Indeed, the EC only demanded that Ireland impose its generally low 12.5 percent corporate tax rate on the revenues that escaped taxation elsewhere in the EU or, indeed, even in the United States. There was no effort to require Ireland to raise its overall tax rates so as to reduce its competitive advantage.

At this point, the EC’s application of Article 107 is not some form of retroactive taxation that hits Ireland from behind. Instead, what the EC protested was the peculiar two-step process by which Ireland determined Apple’s total tax burdens. First, income from various sales around the EU were allocated to activities in Ireland, which may have short-changed taxing authorities in other EU states where Apple does business, by booking all sales elsewhere in the EU to Apple Sales International (ASI), an Irish subsidiary of Apple. Thereafter, Apple allocated huge portions of the income from ASI and Apple Operations Europe to a shadowy “head office” that was not located in any tax jurisdiction at all. The EC did not challenge the somewhat dicey first step. But it did take after the second. “In fact, this selective treatment allowed Apple to pay an effective corporate tax rate of 1 percent on its European profits in 2003 down to 0.005 per cent in 2014" (EC italics).

Of ASI’s €16 billion profit, only €50 million was subject to Irish tax. Unless these numbers are grievously in error, the EC’s conclusion seems pretty straightforward: “This selective tax treatment of Apple in Ireland is illegal under EU state aid rules, because it gives Apple a significant advantage over other businesses that are subject to the same national taxation rules.” Indeed, the “decision does not call into question Ireland's general tax system or its corporate tax rate,” which includes its 12.5 percent corporate tax rate. Nor does it require that taxes be paid in Ireland on gains that are reallocated to the country of sale or are repatriated to the United States. Critics like the Journal’s Jenkins would do well to read the ruling before they mischaracterize its results.

Nor can the ruling be challenged on the ground that the larger concern with tax parity is deeply misplaced. Take the parallel practice in the United States. Individual states set their business income taxes, and it is important to encourage tax competition between jurisdictions to place downward pressure on taxation, without allowing for individual states to game the system for short-term advantage. Thus in Moorman Manufacturing Co. v. Bair (1978), the U.S. Supreme Court held that it did not offend the Due Process Clause of the Fourteenth Amendment for Iowa to use a single factor—sales within the state—instead of the standard formula that weighted property, payroll, and sales within the states equally. The Court held that each state was free to deviate from the norm in making its own decisions.

Unfortunately, Moorman suffers from two serious drawbacks that relate to the Apple-in-Ireland controversy. First, the multiplicity of formulas obscures the direct comparison of rates across state lines, which imposes an informational barrier against tax reduction. Standardization of rates here serves the same function as the standardization of the annual percentage rate of interest in loan transactions. It makes shopping easier. Second, the flexibility is open to gaming in that states can target, as in Moorman, an out-of-state corporation by picking a formula that maximizes domestic revenue—in this instance, sales within states. In my view, the standardization of the well-nigh universal tripartite formula should be done through the Due Process Clause. But if not, then it is surely allowed by treaty as in the EU case.

Nonetheless, figures on the left seem every bit as confused about the implications of the Apple decision as those on the right. Consider Massachusetts Senator Elizabeth Warren’s recent New York Times op-ed. Warren draws exactly the wrong inference from the EC ruling when she claims that the best way for the United States to fix its broken tax system is to increase the tax revenues collected from big corporations, so that they end up paying some “fair share,” which, inevitably, is some amount more than what they pay now. The point contradicts the EC’s observation that nothing in its Apple-in-Ireland decision requires individual nations to adopt either high or low rates. Following Warren’s ruinous proposal will make large American corporations less competitive in global markets, which, in the long run, will reduce the amount of wealth that they can create in the United States, much of which can be taxed as higher wages and dividends. High taxes will also reduce the likelihood that start-ups will take root in the United States.

Besides, U.S. corporations already pay high taxes. As the Tax Foundation reports, “The United States has the third highest general top marginal corporate income tax rate in the world at 39.1 percent, exceeded only by Chad and the United Arab Emirates.” The United States also has the highest corporate income tax rate among the 34 industrialized nations of the Organization for Economic Cooperation and Development (OECD). It is time to reduce taxes in the United States so that major corporations can invest at home and become competitive globally.

Warren also insists that our tax code “should favor jobs and businesses at home—period.” This destructive form of protectionism could easily trigger an international trade war, while blocking American businesses from buying inputs from overseas in order to make themselves fitter for international competition. Killing off international trade hurts both the United States and its trading partners. Warren’s rationale is the exact opposite of that behind the EC decision, which seeks to create a level playing field inside the EU.

Additionally, Warren wants to create special enclaves for small businesses, which cannot take advantage of many of the tax tricks that are available to large corporations. But this suggestion is only half right. A sensible regime of taxation, like that embodied in the Apple decision, removes the tricks that create hidden subsidies. Her proposals for special goodies to small businesses will be an open invitation to create a second set of subsidies that can only distort business decisions in the United States, as it has done in energy markets.

The level of new business formation in the United States has been in rapid decline over the past eight years. But that rate of decline will continue apace whether or not small businesses get tax breaks. The real culprit is the ever-greater strangulation of local businesses as a result of misguided reforms in labor and capital markets that Warren routinely champions. An old Milton Friedman quip exposes the central flaw in Warren’s approach: An oarsman finds that there is a hole in the front of his boat, and his solution is to bash a hole in the back of the boat to even things out. It is just that perverse logic that fuels the Warrens of this world.

At its root, the Apple decision rests on premises far removed from Warren’s progressivism. It makes a classical liberal argument in favor of free trade across national boundaries. Though the EC often acts as a statist institution, it has made a sound economic decision by taking on an American icon that deserves to have its wings clipped.

*Considered one of the most influential thinkers in legal academia, Richard Epstein is known for his research and writings on a broad range of constitutional, economic, historical, and philosophical subjects.

New York’s Self-Inflicted Housing Crunch

Richard Epstein*

Richard Epstein

Richard Epstein

People who live in New York City know that its frenetic pace can induce anxiety. In part, that angst stems from living in a highly congested city brimming with energy. But there’s also the anxiety from New York’s crazy-quilt pattern of land use regulation, which a New York Times editorial recently labeled “High-Rise Anxiety.” The unease stems from the many overlapping restrictions both on new construction and the utilization of existing facilities. These regulations have created a two-tier system in which some prosper handsomely while others scramble to make ends meet.

The current housing crunch in New York, and in other cities like San Francisco, is attributable to the complex set of prohibitions and subsidies that shape these markets. Under the modern administrative law system, private property rights are of little consequence when a developer is trying to build. What matters ultimately is that all of the relevant “stakeholders” have a right to participate in an endless negotiation process before anything gets done. The de facto presumption is against changes in both new and existing housing markets. The building permit is the unit of political currency, and each requires enormous inside connections, patience, and luck to obtain. It can take developers many years to obtain their precious permits, if they get them at all.

This permit impasse stems largely from the progressive view of administrative law. Its initial proposition is that markets fail for two reasons: first, they allow for exploitation of vulnerable tenants. Second, they ignore external effects on third parties.

As to the first, the alleged villains are unscrupulous landlords, whose drive for higher rents must be countered by a rent stabilization program to protect sitting tenants. The New York program was first put into place in 1969, where it was sold as “emergency legislation,” originally for three-year terms, routinely renewed. (The latest renewal was for four years.) The trigger to end rent stabilization is a vacancy rate of 5 percent or more, which will never happen for units that are priced below market rates. Hence rents are allowed to rise, if at all, only in accordance with an administrative rate formula tied to costs rather than to greater demand. The law thus leaves the landlord with all the downside in a weak rental market, while allowing tenants to not only pay in perpetuity only a fraction of market value for their units, but to be also protected from eviction at the end of the lease. At root, rent stabilization is a form of price controls on steroids.

By tying the price caps to the protection of sitting tenants, the law generates its own powerful local base of political support. If you could tweak the law so that the landlord that complies with the rent cap could select whatever tenant he wants at the expiration of an existing lease, then the entire system would collapse like a house of cards. Local tenants will not vote to ensure low rents for new arrivals. It is the territorial basis of this regulatory system that allows it to endure long after other price control systems, such as those for gasoline at the pump, bit the dust.

The second justification for regulation stems from the impact of new development on nearby communities. Everyone has a deep interest in whom their neighbors are and will be, and this is particularly true in New York, where population density puts people in close contact with one another. The city law puts current residents in a position of dominance, relative to their landlords, through the creation of an elaborate system of community development boards, officially described as follows:

Community boards are local representative bodies. There are 59 community boards throughout the City, and each one consists of up to 50 unsalaried members, half of whom are nominated by their district's City Council members. Board members are selected and appointed by the Borough Presidents from among active, involved people of each community and must reside, work, or have some other significant interest in the community.

These intensely local boards make sure that outsiders have to face an uphill battle to secure the needed permissions to build new projects, because these will always have some real, if often exaggerated, impact on nearby residents. It takes little imagination to see that the members of these boards will often have their own axes to grind, which explains why so many well-positioned people are keen to serve on these boards without compensation.

These boards are especially active in responding to gentrification, which does not benefit sitting tenants, even if it improves the overall position of the city. In responding to this issue, the New York Times supports Mayor Bill de Blasio’s “big idea” to rezone neighborhoods to require developers to include a certain number of affordable housing units in a new project, while strengthening the rent stabilization law. This two-prong approach is risky. Such affordable housing provisions have mushroomed all throughout New York, having received a constitutional blessing in state courts.

One way to fund an affordable housing program is through direct public subsidies, given to eligible tenants who qualify for assistance. The relative advantage of this system, as the late Justice Scalia recognized in Pennell v. San Jose (1988), is that it puts the public subsidy on-budget, where democratic processes can determine both its size and the preferred beneficiaries. But voters resist these subsidies for just this reason: powerful political forces will vie to direct the largest share of the subsidies to themselves.

Indeed, it was just these political forces that recently undid New York’s long standing 421-a program that allowed for the construction of affordable housing, subsidized by a complex system of tax-exemptions, but applicable only in poorer neighborhoods. That program was not renewed in January 2016 because Governor Andrew Cuomo refused to back it unless it required developers to pay construction workers, yet another stakeholder, union-level wages that would have raised, by one estimate, construction costs by 13 percent—or roughly $45,000 per unit.

The tragedy of this debate is that both Mayor de Blasio and Governor Cuomo are so imbued with the progressive spirit that they do not realize that the true villains here are their own restrictive land use programs that have long hobbled New York’s housing markets. Their common position is misguided even by progressive standards. Rent stabilization laws necessarily distort prices in local housing markets by giving sitting tenants perverse incentives to stay in their current housing units. It is just too costly to give up a current subsidy on a large unit to pay higher market rates on an unregulated smaller unit elsewhere in town. So the rigidity in ownership leads to a systematic underutilization of existing housing that chews up valuable public resources while simultaneously reducing the city’s tax base. Any responsible social welfare calculation has to take into account the countless numbers of individuals, in and out of New York, whose own opportunities are systematically constrained by the current rules.

A similar critique is properly directed at the extensive veto rights given to neighbors. The common law, from its earliest days, long recognized that special rules were needed to deal with harmful interactions with neighbors. The judge-made nuisance law protected people against pollution, noise, vibration, and other similar hazards. All of these restrictions add to the overall value of land by stopping antisocial forms of behavior. The easy verification of this proposition comes from a close look at the various planned developments that include voluntary covenants that protect against these asocial behaviors. No one, regardless of wealth or political persuasion, advocates a relaxation of these guidelines, or protests the efforts of local governments to block activities that threaten the health and safety of a neighborhood. Nor does anyone think that a local government goes beyond its proper function by making sure that current and future infrastructure, on such matters as public utilities and street access, can support construction or expansion.

Most strikingly, none of the current land use disputes are about these issues. Instead, the argument here is that the class of recognized externalities that call for government regulation goes far beyond these limited cases, to include rules that allow one set of neighbors to decide the wealth and ethnicity of their potential neighbors. The difference in the two approaches is astounding. Nuisance disputes are rarities in today’s cities for the simple reason that no one wants to rent or buy in a pig sty. But when the composition of the community—by age, race, income, disability, or family status—becomes grist for the public mills, externalities are always everywhere, even for new construction projects built on vacant land.

The situation gets more convoluted when new developments have to manage issues like views and light, landmark status, and neighborhood character, which are always fair game for public deliberation. The current legal worldview starts from the premise that renting or owning in a given community gives an expanded entitlement to block or limit the activities of other people, without having to pay these latecomers any compensation for the loss or curtailment of their own property rights. The correct solution is this: the government can condemn these development rights for their fair market value. But don’t hold your breath.

In shifting away from the common law approach, the law does not solve the problem of externalities. It magnifies it. The older common law rules wisely recognized that the “harm principle” is hopelessly broad as stated. That principle, as announced by John Stuart Mill in On Liberty, holds: “That the only purpose for which power can be rightfully exercised over any member of a civilized community, against his ill, is to prevent harm to others.” Virtually every human action produces some effects that will leave someone worse off, especially in dense urban settings. Hence, the only way to make this plausible-sounding principle work is by limiting its application, as is done in the law of nuisance. The public deliberations of large classes of harms, including the blocking of views, must be treated as nonactionable, that is, outside the scope of legal protection on the simple ground that the overall social welfare is better advanced if these ubiquitous losses are systematically ignored.

The willingness to use the narrower definition of harm—one that deals with force, fraud, and monopoly—was never universally observed prior to the rise of the modern system of land use regulation. But legislatures, courts, and the public gave it far more respect than it receives today. Hence this grim warning: so long as every externality counts in administrative proceedings, all sides in the current land use disputes will contribute to high levels of anxiety that are a necessary consequence of the modern progressive state.

*Considered one of the most influential thinkers in legal academia, Richard Epstein is known for his research and writings on a broad range of constitutional, economic, historical, and philosophical subjects.