Good systems don't require saints but bring out the best in sinners ("Truth in affordable housing" by Edward L. Glaeser)

This is an article from back in 2007.

"THROUGHOUT MASSACHUSETTS, politicians, activists, and the press have been shocked -- absolutely shocked -- by Inspector General Gregory Sullivan's assertion that builders of some affordable housing developments overstated their costs to hide profits. Some have called for more regulation and greater oversight. A better response would be to change the system to make it less tempting to lie.

The projects in question were built under Chapter 40B, a law that is something of a "get out of jail free" card for developers facing tough land use controls in areas with little affordable housing. Developers can use Chapter 40B to escape from the ever-thickening web of local rules, if at least 20 percent of their units are affordable. By law, their profits are capped at 20 percent; any profits beyond that are to be turned over to the town where a development is located. Ivory-tower types can find much in this law to debate, but there is no debating that Chapter 40B has been an important creator of affordable housing in the state.

Massachusetts should take the opportunity to make it better. If the profit cap were replaced with a flat charge for each non affordable unit built using Chapter 40B, then the incentives to misstate costs would disappear.

Right now, Chapter 40B's limit on profits creates a strong incentive for developers to lie -- to overstate costs to make profits seem smaller. They sure have responded to those incentives, if the inspector general's audit is correct. One technique seems to have been using two related firms: a land buyer and a builder. The land buyer purchases the land and then sells it to the builder at a huge markup. The builder then earns no profits because he has spent so much for the land. This technique works equally well with a related lender, who overcharges for interest, or a related subcontractor, who overcharges for services.

Is the overstating of costs so unusual that we should attribute these findings to a few bad apples? An old Hollywood saw tells actors to base their contracts on a film's gross revenues rather than its net profits, because studios will overstate overhead costs so that they can report no net profits. Skillful manipulation has made it seem that even the most successful pictures lost money. The book "Freakonomics" by Steven D. Levitt and Stephen J. Dubner offers similar examples of people, from Chicago teachers to sumo wrestlers, who respond to incentives in a slightly unethical manner.

Good systems don't require saints but bring out the best in sinners. Chapter 40B essentially taxes builders based on self-reported costs, which expects builders to be saints -- and seems to produce sinners. Replacing the profit cap with a flat fee would put avarice to better use.

A flat fee for each non affordable unit would give builders incentives to make their units more attractive, so that they rent or sell easier. A profit cap hampers builders' ability to earn more by improvements. A flat fee means that builders have strong incentives to keep down costs. A cap that limits profits to a percentage of costs actually provides incentives for builders to boost costs, since their profits are limited to 20 percent of those costs.

Some people fear a flat fee because developers with an incentive to cut costs may decide to cut quality. I doubt it. We have a first-class building inspection system to insure safety. Moreover, since most of their units are sold or rented at market rates, builders have a strong incentive to make sure the development as a whole is high-quality.

Others fear a flat fee because some developers may earn real profits from a program intended to provide affordable housing. But as long as builders provide that housing, it seems churlish to begrudge them some earnings. If we are really upset about the amount of profits, we can raise the fee over time.

My own view is that the fee should be modest -- $25,000 per unit or less -- and decline in projects with more affordable housing. For the Bay State to grow and house its middle-income residents, it needs new housing, and particularly more affordable housing. Profits push developers to build more homes. By moving from a profit cap to a per-unit charge for 40B projects, Massachusetts will help ensure that builders' desire for wealth produces more and better homes instead of doctored balance sheets."