Tax Policy and the House Price Bubble
The bursting of the recent house price bubble has focused attention on the failures of monetary and regulatory policy. However, tax policy also likely played a role by providing tax subsidies that contribute to a cult of home ownership. This policy is flawed. However, it is politically difficult to change because households see the benefits of tax subsidies and higher house prices but do not recognize the accompanying costs. By showing the downside of high prices, the housing bust provides an opportunity to escape this political trap.
Current tax law exempts capital gains on private homes up to $500,000 and treats mortgage interest as a deduction. Both measures are intended to help middle-class families, yet the reality is they distort the economy, are costly, and likely do little to make working families better off. That speaks for changing housing’s tax treatment.
The mortgage interest deduction is extremely expensive, costing the Treasury approximately eighty billion dollars in 2007. Moreover, it is highly regressive because high-income taxpayers get to deduct their interest payments at top marginal tax rates, whereas others deduct at lower tax rates. That means high-income taxpayers get a higher subsidy rate, and their subsidy is further increased because they also tend to have larger mortgages. Meanwhile, many poor workers get no housing assistance because they rent and rental expenses are non-deductible.
Both the mortgage interest deduction and housing capital gains exemption encourage home ownership. Mortgage interest deductibility encourages switching from renting to owning, while the capital gains exemption encourages owning housing instead of other forms of wealth.
This tax treatment has increased demand for houses, raising prices. However, higher house prices entail larger mortgages so that households end up with larger gross interest payments that offset much of the interest deduction. Additionally, larger mortgages make households more vulnerable to losses if they have to sell under unfavorable conditions – as is now happening.
Since most households lack capital, higher house prices also make it difficult to come up with down-payments. That has encouraged risky non-traditional mortgages such as zero-down products, and these products are a significant factor in the current housing crisis. Furthermore, these mortgages carry higher interest rates that further offset the benefit of mortgage interest deductibility.
At the social level, higher house prices mean both spouses have to work, which undermines family structure. It also puts downward pressure on wages by increasing labor supply. However, the system gives every family an incentive to buy a house to lock-in ownership, even though the system may make them collectively worse off.
Higher home prices are also very unfair from an inter-generational standpoint. Increasingly, younger workers cannot afford houses, and that promises to undermine the market with those buying last losing most.
Finally, excessive home ownership may increase unemployment. This is because workers become tied down to their homes by attached financial obligations, reducing responsiveness to changing job market conditions.
The tax system has helped create a cult of home ownership, and that cult appears to have been an ingredient in the recent house price bubble. Rather than creating wealth, the tax treatment of housing redistributes wealth inter-generationally and makes households financially vulnerable. That means tax policy should change. Here are some suggestions.
First, the capital gains exemption should be abolished for all new home purchases. Instead, the base cost of houses should be indexed to inflation so that homeowners are not taxed on inflation gains. Existing homeowners should be grand-fathered under current law to discourage selling to protect unrealized gains, which would destabilize the housing market.
Second, the ceiling (currently $500,000 per taxpayer) on mortgages qualifying for interest deductibility should be gradually lowered to zero over a ten-year period. Such a gradual phase-out can actually help existing middle-class homeowners because it will make top-end homes relatively less affordable compared to mid-market homes that retain the tax subsidy. That will shift demand toward the mid-market segment, helping maintain mid-market prices and thereby mitigating the housing slump.
Third, since everyone needs housing, the Federal government should phase in a refundable housing cost tax credit available to all, regardless of whether they own or rent. That credit can be financed with revenues generated by phasing out the mortgage interest deduction. During the transition every taxpayer should have the choice between taking either the available mortgage interest deduction or receiving the housing tax credit.
Current tax treatment of housing is intended to benefit working families, but it actually creates bad outcomes. The reality is current tax law distorts the economy, promotes house price speculation, renders households over-indebted and financially vulnerable, and undermines wages and family structure. There is a better way to help working families afford decent housing, and now is a good time for policy to transition in that direction.
Copyright Thomas I. Palley
More on Tax Policy and the House Price Bubble
Several readers have e-mailed about this piece and there has also been some web discussion about it. Here are a few further thoughts on the subject.
(1) My claim is that the tax system was a contributory factor to the bubble, not the sole cause.
(2) The idea of looking for correlations between tax changes and the bubble is simplistic – though it is interesting that the easing of the capital gains rules occurred close to the beginning of the bubble.
(3) The important point is that the tax rules contributed to a culture/climate in which people believed they were stupid if they did not own. That created the perfect environment for a bubble to take place once other factors (easy money and regulatory failure) were in place.
(4) And of course, once the bubble was underway the tax rules were like accelerant.
(5) Lastly, bubbles are not all identical. The tax angle is peculiar to America’s bubble. Spain’s bubble was triggered by Spain’s joining the euro, which dramatically lowered Spanish interest rates. The UK bubble was partially triggered by foreign purchases of real estate, especially in central London. However, once bubbles get going they all share a common dynamic in which people believe prices will keep rising and one is dumb not to get on board.
May 6th, 2008 at 6:39 am
Not only will getting rid of the interest deduction be more fair, it will get rid of this insane ideology of not paying down debt as quickly as possible. It gives advantage to remaining in debt and that is dumb.
I can see tax policy to help with home ownership for first time buyers, but how about something that encourages home equity? Say a homeowner’s savings plan allowing up to $5k tax deduction per year for $25k? And then up to $5k per year principal reduction for the first 5 years of home ownership. Then people are encouraged to “own” their home in that they actually have equity and increase their equity.
It has a benefit that if people then find they have financial problems they are better able to navigate them.
May 6th, 2008 at 4:50 pm
There are reasonable points made, but I must contend with the use of the term “home ownership” here. Someone who purchases a $300k house and creates $270k in debt and a future outflow of cash (through property taxes) that has an NPV of $30k is not a home owner, but an investor in real estate. When you see this as an investment decision you come to learn the worst part of the “home ownership” cult. The fact that the middle class has been duped to create an investment portfolio in which more than half of it is in 1 piece or real estate, as most middle class families pay more for a house than the entirety of their retirement savings.
May 7th, 2008 at 1:30 am
[...] Noticias cada dÃa: el diario que se mueve contigo.: Portada wrote an interesting post today on Thomas Palley " Blog Archive " Tax Policy and the House Price BubbleHere’s a quick excerpt bookmark this on del.icio.us - posted by kckeane to economics finance housing tax and saved by people… [...]
May 7th, 2008 at 5:33 am
[...] Thomas Palley » Blog Archive » Tax Policy and the House Price Bubble However, tax policy also likely played a role by providing tax subsidies that contribute to a cult of home ownership. This policy is flawed. However, it is politically difficult to change because households see the benefits of tax subsidies and higher hou (tags: taxation housing finance usa publicpolicy) [...]
May 7th, 2008 at 7:15 am
This past housing bubble was created by low interest rates and sustained with unferafiable mortgage products.
The interest deduction and capital gains provides homeowners additional cas flow intering the housing market and leaving it.
You need reality check..make your propsed changes and nothing will change in housing.
Remember when credit card interest was deductable which was replaced by the “Banks” (ie also Fed)equity” dedction program.
Which one screwed Americans more???
May 7th, 2008 at 7:37 am
Horrible article and horrible first response. “Cult of Home Ownership?” Are you kidding? Sounds like the statement of a renter that is probabaly single and or has no children. Houses are the basis for a Home, neighborhood and community that continue to be the basis for a strong family life and good envronment for rearing children.
California, Florida and a few other states have some big problems due to irresponsible borrowers, irresponsible lenders and irresponsible law makers that allowed this to happen. We don’t all live there.
I have a 5.25% mortgage and a 35% tax bracket. With the interest deduction that makes my net cost of funds 3.6% Rather than paying off the mortgage I pile tax deferred mony in to retirement accounts that have been yeilding greater that 10% for years and years. Compounding over the years will make me enough to write a check to payoff my mortgage when I can draw on the accounts.
Maybe we should do away with tax deferred retirement accounts as well. Get real.
May 7th, 2008 at 8:12 am
[...] Tax Policy and Housing Bubble: Thomas Palley writes on his blog about the connection between tax policy and the housing bubble. “Current tax treatment of housing is intended to benefit working families, but it actually creates bad outcomes. The reality is current tax law distorts the economy, promotes house price speculation, renders households over-indebted and financially vulnerable, and undermines wages and family structure. There is a better way to help working families afford decent housing, and now is a good time for policy to transition in that direction.” [...]
May 7th, 2008 at 8:23 am
A better solution for housing and the economy as a whole is to replace the current code with the FairTax. The FairTax would lower the price of new housing, lower interests rates, and allow people to save faster for their downpayment. It is progressive, because it eliminates the regressive payroll taxes, regressive deductions like home mortgages, and provides for a rebate of the taxes paid for necessities. Plus, the FairTax applies to everybody, unlike the income tax, where only 27 itemize in order to take advantage of the mortgage interest deduction and other deductions utilized by the wealthy. The Founders knew the taxation of income was evil. The FairTax returns us to the Founders principles on taxation.
May 7th, 2008 at 9:14 am
Well written and well thought article. I wouldn’t quibble with anything here. I like this so much I’m going to put a link on my blog this afternoon to get people to read this.
Thanks.
May 7th, 2008 at 9:39 am
Tom,
You sound like Henry George! See how far he got with land? The real estate lobby will squash this kind of talk like squishing cockroaches. If you’re going to monkey with tax expenditures, you need to do it at the margins: eg. renter equality or adding in tax deductions for reducing the fuel or water consumption will make it more politically feasible. I would think increasing mortgage margin requirements would, eg. eliminating private mortgage insurance, would the outcome proposed more easily.
May 7th, 2008 at 12:58 pm
Thomas Palley is really wrong on this one. Caveman and women almost certainly looked for a single-family cave they could call their own. The desire for a home has nothing to do with tax deductions or capital gains treatment.
Houses should be exempt from capital gains taxes for the simple reason that most people consider a house a place to live rather than capital. Realtors and bankers have done everything they can to convince people otherwise but most people still consider a house a home.
Selling houses on the basis of market price is largely a scam perpetrated by realtors and bankers. Most people do not buy a house to put it on “the market.†So houses shouldn’t be treated as capital assets after the purchase. Houses should depreciate in value as they age, like cars. Down payments would be easier with depreciating values.
If houses sold on the basis of natural price and depreciated in value there wouldn’t be a mortgage crisis, and many more people could afford homes. Local governments might have to find an additional source of revenue but that is a small price to pay for broader home ownership.
The mortgage interest deduction is indeed regressive. Home loans are usually inflationary, doubly so when the homeowner gets a home equity loan a few years after taking out a mortgage. No one should get two home loans from a funny money system until every one gets one home loan. But the Congress can’t bring itself to guarantee such equal treatment. The inflation created by home loans is negligible compared to the shenanigans of investors.The giant sucking sound you hear is the sound of investment bankers anurse at the federal breast.
Houses have increased in size as family size has decreased. Like auto makers that make more profit on large cars, house developers make more on large houses.
Palley, like many economists, confuses the market power of realtors, developers, and bankers for the market. That is to confuse the bank robber for the bank, as someone so sagely observed.
May 7th, 2008 at 8:01 pm
[...] which was referred to on March 18. The call has been taken up (in part) by Thomas Palley, “an economist living in Washington DC” (hat tip: Naked Capitalism): First, the capital [...]
May 9th, 2008 at 10:17 am
I agree with the FairTax proposal mentioned above. Capital gains taxes need to be eliminated, along with all forms of income taxation. That solves the whole mortgage deduction dilemma.
June 18th, 2008 at 3:03 pm
I am not a homeowner, and I am being punished by these tax policies. Prior to the §121 exclusion of $500,000 in gains however, the system deferred gains that were rolled over into houses that were equally or higher priced, which really put an upward pull on housing prices. Under the prior law, you had to buy a more expensive home than the one you sold, or you got taxed on the difference.
What the country really needs to do is eliminate all distinctions between ordinary income and capital gains. Counting social security taxes plus my income taxes, my tax rate is three times as high as Bill Gates’ is, since he is only paying 15% on his shares of MSFT. So I have to drag my but out of bed every day and go to work, while Bill can spend all his time on his boat, and he gets a 1/3 discount on his taxes. Not good for the economy, and absolutely destructive to the middle class.