Hal Varian: The Mortgage Interest Deduction Causes Large Distortions in Housing Markets

Hal Varian of UC Berkeley talks about the housing subsidies built into our tax structure, how it distorts markets, the often overlooked opportunity cost of the distortions, and the political realities limiting the ability to take corrective action:

An Opportunity to Consider if Homeowners Get Too Many Breaks, Economic Scene, by Hal R. Varian: The President's Advisory Panel on Federal Tax Reform struggled long and hard to come up with some economically sensible and politically feasible ways to reform the tax code. ... Some, like simplifying the crazy quilt of tax-deferred savings plans, are relatively noncontroversial. But proposals like eliminating the federal deduction for state and local taxes are much more contentious. ... Certainly the panel's least popular suggestion is to limit the mortgage interest deduction. ... A change of this sort would probably have a significant impact on housing values, particularly at the high end, and therefore would be unpopular with homeowners. Neither party wants to alienate solid middle-class voters, so this suggestion has not been greeted with enthusiasm in Washington.

But many economists would argue ... [i]t would make a lot of sense to eliminate the housing mortgage deduction entirely. ...[H]ousing is highly subsidized in this country and we would probably be better off if the tax treatment of housing were brought more into line with that of other assets. How is housing subsidized? ... First, there is the mortgage interest deduction. Second, the deduction for property taxes. Third, the capital gains exclusion... Fourth, the deduction for points on mortgage loans. Fifth, the deduction ... on home equity loans. And there are many more tax breaks, among them home office deductions. There are also more subtle ways that housing investment is favored by the tax system. The most fundamental subsidy is that homeowners are not taxed on the implicit rent they receive from their housing investment. Think of it this way. Suppose you buy a house outright... If you rent the house out to someone else, you owe tax on the rental payments you receive. If you live in the house, you are effectively renting it to yourself, but no taxes are due on the transaction. ... True, you have to pay a local property tax on your house's value. But property taxes are used to support local services like schools, roads and fire departments, which also enhance the value of a house...

Even if one thinks that homeownership deserves some subsidy, does it really deserve as much as it gets? An excessive subsidy on one asset means that less will be invested in other assets. The money put into building those huge villas on the hillside could have been put into factories, office buildings and schools. Investment in physical capital and human capital makes the economy as a whole more productive, unlike investment in housing.

Given the huge subsidies to housing, it is likely that we as a country have overinvested in this area. Cutting back some of those subsidies would be good economic policy. That being said, I hasten to add that this is unlikely to happen anytime soon. ... The housing tax subsidy has been built into housing prices ... and cutting back could lead to painful capital losses on home values. If you give a lollipop to a baby, it may make him smile, but you will pay dearly for that smile if you try to take the candy away. The best thing to do is to distract the baby with other sweets, while you gradually extricate the lollipop from that sticky hand. That is pretty much what the tax panel has proposed: it offers reduced tax rates on other forms of investment, along with the mortgage interest credit, to make cutting housing subsidies less painful. Carefully tuned policies of this sort may be a politically palatable way to reduce housing subsidies. But I'm not holding my breath.

Comments

[anne]

http://www.nytimes.com/2005/11/17/opinion/17thu2.html

November 17, 2005

American Ingenuity, Irish Residence

The newest expatriates aren't people. They're ideas, and we can't afford to watch them go. The Wall Street Journal reported last week that Microsoft had trimmed more than $500 million from its annual tax bill by putting a small subsidiary in Dublin in charge of $16 billion in assets. The game is simple: a company sends intellectual property to a tax-haven country like Ireland and keeps the tax difference on the money it earns.

The world is used to seeing manufacturing businesses move to countries where labor is cheaper, like Mexico or China. But profits from software created and designed at Microsoft's headquarters, in Redmond, Wash., should be taxed in America, not Ireland. Unfortunately, outsourcing is extending itself to taxes, in large part because the United States Congress has given businesses the loopholes to do it. That means that America's greatest asset - its intellectual property - could be sent offshore to reduce corporate tax burdens.

Microsoft's subsidiary is raking in the dough from licensing fees for copyrighted software, much of it originating in the United States. And what is the subsidiary's legal address? A Dublin law firm that advertises its smarts in turning Ireland into a tax shelter.

Microsoft's response is that it pays all taxes required by law....

[anne]

Think about the lovely shell game. The rights to an invention are shifted from America to Ireland, so revenues for the invention accrue to Ireland and are taxed under Irish law rather than American law. This is conservate tax policy :) Hmmm.

[anne]

The simplicity of such a tax shift for software producer is stunning.

[calmo]

Thank you for explaining Ireland's rise as an IT center Anne. This had me baffled for quite a while. Is the Carib just too crowded of maybe there is some specific Irish charm (the winters can be pretty clammy, no?) for the Mircosoft gang?
Appreciate that lucid account from Varian. I wonder how many of these tax concessions were drafted by the same accountants that allowed the IT industry to flourish.

[anne]

Ah, but Ireland has had a highly educated young work force, as well as an openness to educated Asian immigration, and Ireland has entry to the European Union and indeed has been subsidized by the EU allowing for an especially attractive business tax structure.

[Bruce Wilder]

"An excessive subsidy on one asset means that less will be invested in other assets. The money put into building those huge villas on the hillside could have been put into factories, office buildings and schools."

Does it? Really? This is an awfully uncritical way to express an idea. "Tradeoffs" are a core notion in economics, but one, which leads to a remarkable degree of uncritical "thinking" in chiches.

A "tradeoff" makes sense, on a static possibilities frontier, where limited resources can be allocated to the production of various goods.

The possibilities frontier, in this case, however, is imposed by the availability of opportunities for productive investment. Does subsidizing one investment possibility make another (for argument's sake, let's imagine an investment possibility unrelated, say, to home building) less profitable? How?

If there is a budget constraint on all investment, it might. But, why assume a budget constraint on overall investment? Why not assume that economic actors take all available investments, with a positive net present value? (If they don't, is it because of inadequate global savings? or, inadequate insurance against risk? or problems of trustworthy and efficient intermediation?)

A subsidy increases the net present value of a particular category of investment. If you subsidize an investment, it might draw spending away from consumption, but why would it reduce the net present value of any other investment? (Global income "constrains" global spending because they are identical.)

Say, your choice is, buy a home or take a computer class or buy a steak dinner. The net present value of the home is inflated by subsidy; the budget constraint is on all spending, though, so it affects the steak dinner and the computer class in the same way. If the subsidy draws away from other spending, the effect is diffused through all consumption.

The classic "New Deal" argument for subsidizing home ownership was an insurance argument. They were not worried that we would overbuild housing to an extent, which would be bad. And, maybe they should have been. But, the model in that original argument included a life cycle. People would be induced to invest in home OWNDERSHIP, when they were young, and as they grew older, the equity in the home would contribute to the financial stability of the family. A family, which owned a home, later in the lifecycle, would be better able to weather unemployment and illness, better able to send kids to college, better able to save for retirement.

A while back, I put a rant in comments about the Mark's "bathtub" metaphor for aggregate savings. My problem was that the bathtub can overflow. Direct a lot of savings into the stock market, and the value of stocks will rise -- there might even be a speculative bubble -- but, no matter how much savings is available for buying corporate equity, it will not add to available investment possibilities, it will NOT create future streams of corporate profit, whose net present value IS the (long-run) value of the stocks. The extra savings will just overflow the bathtub -- disappearing from the economy. Directing savings into home ownership might result in too much housing -- too big a house, for example -- but the house will not disappear in a stock market crash.

It is a fundamental misconception to equate savings with investment (outside the trivial and misleading double-entry bookkeeping of the national income acounts). It is also a fundamental misconception to confuse dynamic choices with a model of static tradeoffs. Savings has to do with acquiring ownership of future income streams, i.e. rents. And, ownership of rents has an insurance effect, reducing the risk aversity of decision-makers, who have "insurance". Home owners, later in a family life cycle, may be less risk-averse, and therefore, better able to take up investments with significant risk -- sending the kids to college, for example, or investing in equities as a retirement funds vehicle, for that matter.

It is not clear to me, in principle, that subsidizing home ownership will reduce other investment in a simple-minded tradeoff, in the long-run. By distributing the "insurance" of home ownership, it might increase overall investment, by reducing the risk aversity of broad classes of investors, particularly with regard to investments (like investments in a child's education), which are highly risky and not easily marketable. I could even argue that home ownership is likely to increase stock market investment by home owners, over a life cycle, because the "insurance" of home ownership reduces the risk aversity of most home owners, as equity increases.

I don't really know enough about the details of the way the home mortgage interest deduction works to comment on reform proposals. I readily credit the idea than Fannie Mae and Freddie Mac have gotten out of control, and increasing the liquidity of home equity in certain ways might be a really bad idea. But, I do think that the sophistication of the economic analysis, which seeps into the public discourse on the subject, could be a little higher. I have Varian's classic textbook, a leftover from an intermediate micro course taken long ago, so I know how brilliant he can be. But, I am diappointed that he does not do a better job of informing the public discourse on this subject.

[JS]

"Given the huge subsidies to housing, it is likely that we as a country have overinvested in this area. Cutting back some of those subsidies would be good economic policy."

I completely agree with this. But, as Varian points out, it is not politically palatable. I suppose we'll wait until it is a terrible problem, as Volcker suggested we would probably do, and then it will be too late.

[calmo]

See, here's a guy who thinks the public (readers of the business section of the NYT atleast) could handle more sophistication than the intermediate micro level that Varian stoops to. (And just after I savaged the public for being more than a few years behind Galileo.) [Varian, constrained to a single page, is going to have to sharpen his pencil should he discover the sophistication of his audience.]

Bruce, I can't tell you how much I admire your critical capacity. Those pointed questions --truly you are a pain in the ass. I am ashamed to admit that I recognize this interogative habit (and am at pains even now to restrain myself). Where were you in our lively (ok it could have been, had you participated) discussion of cointegration?

[anne]

Bruce Wilder:

'The classic "New Deal" argument for subsidizing home ownership was an insurance argument. They were not worried that we would overbuild housing to an extent, which would be bad. And, maybe they should have been. But, the model in that original argument included a life cycle. People would be induced to invest in home ownership, when they were young, and as they grew older, the equity in the home would contribute to the financial stability of the family. A family, which owned a home, later in the lifecycle, would be better able to weather unemployment and illness, better able to send kids to college, better able to save for retirement.'

Nice, nice :)

[anne]

Ah ha! Suppose I record my lectures and send them for Irish safekeeping and credit my salary to Ireland. Hmmm. Oh dear, I am a walking talking tax shelter. And I like the Irish anyway :) Even more so now.

[Lord]

Only a tax collector would consider anything that goes untaxed a subsidy as all income obviously belongs to them and we are entitled to only what they deem necessary. As far as income goes, interest paid is someone elses income, and taxing it is double taxation. Then there is this assumption other areas are starved for investment since their rate of return can't compete with mortgage rates so the way to remedy this is to lower the rate of return on housing. If these areas can't deliver the returns, they can't really be all that productive, can they? All this is is a call for more intervention to skew markets in ways the author deems desireable, no different from the current system.

[Mark Thoma]

Yes - I want to think about whether there is a market failure that prevents the insurance value from being fully capitalized into the price of a house - if so, then an intervention to subsidize may be justified economically.

Hmmm.

I like it when you all give me good things to think about (as happens daily).

[anne]

Bruce, that was an especially clever comment. I like Varian, but was bothered by the column. Robert Reich was also complaining about the mortgage and property tax deduction, but you were clever and went back to the rationale for the deducations. Again, the refrain, middle class households have been especially ill treated by the insurance industry and also ill treated by investment companies, save Vanguard. Housing has been a respite. Now, you have otherwise sound analysts who would threaten an essential middle class investment. Darn, I may be the only analyst who openly appreciates the housing boom.

[anne]

The guess is that the housing boom is over, but over in a gentle way, and I am quite happy about the effects I perceive in the boom. Middle class assets were significantly bolstered, though I wish there had been more saving and less consumption of the financing made available from equity increases and mortgage savings.

[donna]

The problem is, I get a tax break on my mortgage, but get taxed on my savings interest. Far easier to pull out an equity loan, have even more money to spend, and consume, consume, consume.

Where the heck are the incentives to save anything in this society? It's just friggin' broken, all over.

[anne]

A failure to tax interest at the same 15% preferred level of dividends and capital gains, I argue, seriously limits an incentive to save.

[spencer]

What was the wide spread comment years ago?

The Japanese have beautiful factories and poor homes while the Americans have beautiful homes and poor factories.

[Alan]

Varian writes: "The most fundamental subsidy is that homeowners are not taxed on the implicit rent they receive from their housing investment. Think of it this way. Suppose you buy a house outright... If you rent the house out to someone else, you owe tax on the rental payments you receive. If you live in the house, you are effectively renting it to yourself, but no taxes are due on the transaction."

I suppose this comes of being a non-economist, but I don't understand why this "implicit rent" for a house is different from any other possession or service. If I rented my car, or drove people around for pay like a taxi, I'd also have to pay tax on the money I'd receive. So by driving myself I am getting that implicit income. If I mowed other people's lawns, or cleaned their houses, or sold them the bread I bake, I'd get taxable income. Does that mean that, when I do these tasks for myself, I'm being subsidized? I don't see the difference in principle from owning a home.

[hari]

Limiting housing subsidies is a good idea (and I'm in California!)

In an ideal world, no one would have to pay taxes. But given the need for taxes, and to do it in the fairest and the most economically efficient manner possible, the proposal to limit mortgage deductions is a very good and timely one.

The current housing subsidies:

1) Encourage and reward those taking on the largest possible amounts of mortgage and home-equity debt, as early as possible.

2) Discourage saving in general, and saving for a home purchase in particular because the savings are at a heavy tax disadvantage. The savings also lose purchasing power rapidly because the home prices are inflated by cheap and tax-advantaged credit.

3) Contrary to popular belief, make housing less affordable by inflating home prices excessively.
The proper way to make housing affordable is not by pumping cheap credit into the system while endlessly inflating prices, but by keeping house prices low and increasing supply. This will also reward those that save more while making it easier for everyone to pay off the principal (what an alien concept!?) instead of encouraging overconsumption and outsized debts.

4) Distort the economy by channeling capital away from more productive investments.

These effects are very clearly seen today in abysmal personal savings rates, and a housing bubble that is pushing people into taking larger and riskier loans.

Over the long run, limiting these housing subsidies will have a very positive effect because saving and investment will be increased, housing will be cheaper, and the economy will become more efficient and productive.

In the short run of course, there will be huge resistance to these proposals from those who stand to lose the most. Home owners have seen huge un-earned increases in their wealth in the recent past. These increases are largely a transfer of wealth from current and future homebuyers, and other taxpayers. The prospect of these unexpected wealth gains slowing down or reversing is not a compelling reason to avoid implementing a better and more equitable tax code.

Also, most opinions in the media seem to assume that rising home prices are a "good thing" to be cheered, while advocating reduced home prices is somehow completely unacceptable and almost sacrilegious. The past several years have seen enormous inflation in home prices with little income or job growth, primarily fueled by explosion of credit, tax subsidies and speculation. After 100% or more increase in home prices, if the prices are scaled back 20 or 30%, is it not something that should be welcomed? Are unlimited wealth gains for every homeowner and real-estate speculator part of a social contract that needs to be underwritten by future homebuyers, savers and other taxpayers?

Transitions can be tricky and specific measures might be looked into to ease the pain, but there is nothing more important for long run US economic health than to encourage saving and investment. These changes to the tax code are a step in the right direction.

[anne]

Interesting ideas :) Notice by the way that California suddenly appears to be in better budget shape than had been portrayed a short while ago. I expect the increase in property values is the reason. There is much to consider about the real estate boom of these last years.

[dilbert dogbert]

Where I live we don't need anymore office buildings. The Whiskeygulch complex won't fill for quite a while and there are a lot more see thru building nearby in the Golden Triangle. The Excite At Home building is starting to have tennents, but---. Also I wonder if any business would build a new factory in the US when they have all those opportunities in China. If we throttle housing I am not sure where the investiment money would go.

[anne]

Notice the Vanguard REIT index is up 10.4% for the year. I am entirely hopeful the slowing in housing will be a gentle slowing, and commercial real estate will reflect no more than a gentle slowing. This has been the pattern in Britain, the Netherlands, and Australia. Spain and France appear to be moderately slowing as well. Hong Kong bounces about, but recovers readily from the declines, though Hong Kong may teach us little about our prospective experience.

[anne]

http://flagship2.vanguard.com/VGApp/hnw/FundsByName

I still suggest we pay close attention to the REIT index for a sense of whether the slowing in housing will be more pronounced than gentle or more long lasting than seasons.

[Lord]

Certainly it encourages debt, but it also encourages savings as someone needs to save the money that is borrowed. Interest rates would fall, depressing the incentive to save, if debt was discouraged. Fortunately we have outsourced saving to China.

Certainly it inflates housing prices, but it does not alter affordability. They would be just as unaffordable if debt was not deductable. Affordability is simply the market clearing price.

These more productive investments are such bad ones that they are unable to compete with mortgage rates. I guess we will just have to make them charities.