The LIHTC was created by the Tax Reform Act of 1986 (TRA; P.L. 99-514 ) to provide an incentive for the acquisition and development or rehabilitation of affordable rental housing. In the two decades since its enactment, the LIHTC has become the leading source of financing for affordable rental housing. As the 110 th Congress begins, and legislative conversations turn toward affordable housing, the LIHTC may receive attention. Proponents of the LIHTC view the credit as highly efficient and effective. As evidence of effectiveness, advocates state that the LIHTC is responsible for producing 50% of all multifamily housing starts annually, and virtually all affordable rental housing in the United States since the credit was introduced. Proponents also suggest that the very high price of tax credits in equity markets is a sign of the credit's popularity. Opponents claim that the LIHTC has crowded out other forms of rental housing finance, and that result, not the credit's value, is the leading source of financing for rental housing. Additionally, the credit is perceived as more costly and less efficient than demand-side subsidies like the Section 8 Housing Voucher Program. Opponents also claim that the price of tax credit dollars is high, not because of its efficiency, but because the credit offers a deep subsidy to investors as well as other tax benefits. As policymakers begin to address affordable housing issues, modifications to the LIHTC will likely be considered. This report discusses some fundamental public-policy questions that have not received much attention. Is the lack of affordable housing a result of a housing-market failure? Does the LIHTC address the affordable housing problem? And is the LIHTC efficient, or can it be improved? Despite the significance of the tax credit in housing finance markets, these questions are not definitively answered in economics literature. This report, where possible, attempts to answer these questions. Where it is not possible to answer the policy questions, this report draws attention to the information, actions, or both, necessary to obtain the answers. The principal conclusions of this report are as follows: The perceived lack of affordable housing, while of concern to policymakers, the press, and to some degree, the general public, is not necessarily caused by a housing-market failure. There is insufficient empirical evidence to determine what is causing the affordable housing "crisis." The evidence is unclear that the LIHTC actually helps to solve the affordable housing problem, and there is some evidence that it may actually crowd out (replace) other affordable housing development rather than increase the number of housing units. The LIHTC has a complicated system of delivery that may increase costs relative to the benefits it provides. Moreover, it may be less efficient than other affordable housing programs. After discussing how affordable housing is defined, this report examines whether a housing-market failure exists, whether the LIHTC program is efficient, and whether the LIHTC is cost effective relative to other programs; and concludes with a discussion of several policy options. There is a growing consensus among policymakers and the general public that the nation faces a shortage of affordable housing, particularly rental housing. The 2002 bipartisan, congressionally mandated Millennial Housing Commission's final report confirmed and defined the shortage as a "crisis." The Harvard Joint Center for Housing Studies' 2006 State of the Nation's Housing Report identified housing affordability as one of the key challenges facing the nation. But is the "affordability crisis" the result of a housing market failure, warranting government intervention in housing markets? To answer that question, we start by defining the concept of affordable housing. The term "affordable housing" is widely used and generally refers to housing of standard, decent quality, and that a family can afford without compromising their ability to meet other needs. While higher-income families generally have a range of housing that, under this definition, is available to them, families with lower incomes have fewer options. Housing affordability for middle- and lower-income groups is generally measured in terms of cost burden. Generally, cost burden measures the actual percentage of household income spent on housing by renters. Households are considered cost-burdened if more than 30% of annual income is spent on housing. When families are considered housing-cost burdened, they may have difficulty affording necessities such as food, clothing, transportation, and medical care. In 2004, 7.6 million renter households were considered cost burdened, with an additional 8.4 million renter households considered severely cost burdened—paying more than 50% of their income toward housing. While some moderate-income renters experience severe rent burdens, low-income renters face the greatest burdens; more than 86% of severely cost-burdened renters were in the bottom quintile of the income distribution. Economists report that the problem of severe rent burdens may be growing while the supply of low-cost rental units may be declining, creating an affordable housing shortage. It is estimated that the inventory of affordable units—with inflation-adjusted rents of $400 or less, including utilities—declined by 1.2 million from 1993 to 2003. With losses of units due to repair, abandonment, or demolition, the shortage of affordable rentals available to low-income households is estimated at 5.4 million. According to standard economic theory, an economy best satisfies the wants and needs of its participants if markets operate free from distortions such as taxes. Government intervention in housing markets, as in any market, may be justified on economic grounds if market failures exist. Market failures can occur when a market, left on its own, fails to allocate resources efficiently. If a market failure exists and a subsidy remedies that failure, then there is economic justification for the subsidy based on efficiency. If a market failure does not exist, then there is no economic justification for the subsidy based on efficiency. There may, however, be justifications for government intervention based on other public-policy goals, such as ensuring a minimum level of housing consumption for all households or equalizing opportunities for housing consumption. Certain socially undesirable phenomena may be valid targets of public policy, such as pay inequality, poverty, lack of affordable housing, and inflation, but there is no consensus as to whether these problems meet the definition of economic inefficiency. Some economists argue that the lack of affordable housing is not a market failure to be corrected, but rather a result of increased demand being met with a slow supply response, which causes prices to rise. If the lack of affordable housing is a supply-response problem, state and local land-use regulations may be contributing factors. Land-use restrictions and zoning laws are examples of government regulatory areas that can hinder the timeliness of supply responses to changes in demand. Another key factor potentially contributing to a lack of affordable housing, but one not categorized as a market failure, is the unwillingness of lenders to make loans to investors because of class or race bias, a form of discrimination often referred to as redlining. Where discrimination in lending occurs, capital subsidies for affordable housing might improve the allocation of capital. If a market failure exists, the presence of externalities may be the culprit. An externality, itself a type of market failure, exists when the activity of an individual directly affects, positively or negatively, the welfare of another, and that result, or consequence, is not incorporated in market prices. Economic theory suggests that there are externalities in housing-services markets because there are both private costs and benefits for individuals as well as social costs and benefits for the public at large. High prices for housing in certain areas can increase housing prices in adjacent areas. Also, to the extent that housing structures, perhaps older ones, induce blight, there is an imposition of external costs on society. These externalities of housing sometime serve as grounds for government intervention in such areas as neighborhood redevelopment and housing production. Yet, the few studies that have examined the LIHTC's contribution to neighborhood quality have found only small effects, both negative and positive. In some cases, the new construction of LIHTC projects positively influenced the price of single-family homes in the immediate surrounding area. In other cases, the LIHTC projects negatively influenced the price of single-family homes. The lack of affordable housing raises a host of important economic issues. For example, to the extent that households spend disproportionate amounts of income on housing, other basic necessities might be neglected. One recent report found that households devoting more than 50% of their income to housing paid an average of $175 for food and $35 for healthcare per month in 2003. In comparison, households spending less than 30% of their income on housing paid an average of $248 for food and $109 for healthcare monthly. If health care spending, for instance, is insufficient for households, it could lead to poor health and well-being. This outcome could create both private costs for the household and social costs for the community (negative externalities), either through increased public subsidies for health care or increased disease and poor health for others. Yet, it can be argued that the negative externality experienced by households in the example above is not confined solely to the housing market. In that case, the externality might be more appropriately viewed as a matter for the health care marketplace. Correcting market failures may not be the only reason for government intervention. Other reasons could include the desire to increase equality of outcomes (to provide a minimum level of housing consumption by all members of society) or to create equity of opportunity (ensuring viable participation in housing markets by providing some minimum endowment of assets). If housing subsidies, like the LIHTC, contribute toward these outcomes, then the subsidies may be justified. Most economists, however, would argue that a demand-side subsidy, like housing vouchers, would be more appropriate than the LIHTC (a supply-side subsidy) in satisfying this type of policy objective.