Thomas Palley: Tax Policy and the House Price Bubble

Thomas Palley says this piece "should be controversial":

Tax Policy and the House Price Bubble, by Thomas I. Palley: 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.

Comments

[ken melvin]

I like this. Now if someone would address the effect of the ownership society.

[Jay]

He makes reasonable points but there is a major flaw that ken quickly used in his non-sequitor.

If someone purchases a house for $300k by paying the seller $30k in cash, and creating a $270k liability is this "home-ownership"? I think not. Ff you include the NPV of the future taxes associated with owning the property I am guessing you are closed to zero equity (the accounting definition for ownership).

The author also doesn't mention quite possibly the greatest harm the house "ownership" cult has had on middle class Americans. That $300k home from my prior example shows up on the asset side on the balance sheet (that is highly levered). The portfolio of the middle class tends to be undiversified that is overly invested in real estate (usually one location) and treasury bills (via S.S.).

[blackswan]

"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."

That statement is absurd. Did the tax system cause the real estate bubbles in Great Britain, Spain or Canada? Nope. The financially engineered bubbles were cause by speculation, lax lending regs, CDOs and low interest rates.

Most of the US house flippers were paying short term capital gains taxes (ordinary income taxes). Under Obama, even the buy and hold non-owner occupant buyers, will pay long term capital gains taxes of 28%. Most people, who bought their houses after 6/2005, will not have to worry about paying taxes at all. No one has had to pay taxes on home appreciation in Japan for the last 18 years. Appreciation no longer exists there. The capital gains tax component in this article is probably irrelevant for at least the next five years, since the US has 18.6 vacant homes and much tighter lending regs again.

I think a good time to stop giving tax breaks on loan interest is when they stop taxing interest on savings. What might that encourage?

[Jay]

Blackswan:

By "low interest rates" do you mean low risk premium spreads?

[Jay]

Also Blackswan be careful, you used the transitive property where Paulley did not invoke it.

You say, "That statement is absurd. Did the tax system cause the real estate bubbles in Great Britain, Spain or Canada?"

But when you look carefully he says...

"The tax system has helped create a cult of home ownership"
"that cult appears to have been an ingredient in the recent house price bubble"

You can't go from his statements to your conclusion without making several assumptions that are as absurd as assuming God exists.

[lark]

One problem is that we treat renters poorly in this country, so there is a scramble to get into one's own home.

In the 80's I was evicted twice, by greedy landlords. One was a convicted rapist who had no problem doing things like turning off the electricity and actually removing the front door, leaving our apt exposed. There was very little in the way of legal protection and rents kept soaring.

It's all very well to talk about those who shouldn't aspire to home ownership, but the fact is, if you don't own, you're trash. And just like so many other areas in our society, if you don't make the grade in terms of membership in an elite group, you have a very difficult time making a decent life for yourself and your family. This is particularly an issue if you are living where the jobs are. Rents are high in those places.

My experience with evictions was a strong push to buy, which we did for the first time about 20 years ago. Nowadays we wouldn't be able to afford it.

Our country is so slanted towards the elites, and so loaded with contempt (and hassle) for everyone else, that change will be difficult.

[Jay]

"In the 80's I was evicted twice, by greedy landlords. One was a convicted rapist who had no problem doing things like turning off the electricity and actually removing the front door, leaving our apt exposed."

What is important, what is truly important is to exude as much meanness as possible. Not to mention your argument is based on a biased sample with size N=2.

"It's all very well to talk about those who shouldn't aspire to home ownership, but the fact is, if you don't own, you're trash."

Patently absurd drivel. In fact I would argue that if during 2003 to present if you are a renter I would call you intelligent, investment savy, etc. Just look at the mortgage payment to rental cost ratio over as much history as you get.

"This is particularly an issue if you are living where the jobs are. Rents are high in those places."

Going back to the my last statement, I can agree with "Rents are high in those places compared to Kalamazoo Michigan". But when you compare it to a house for sale next door, again patently wrong.

[Ken Houghton]

The "cult of home ownership" is a Bush Administration creation, not one of the 1986 or 1996 tax changes cited.

Palley does, however, work from several erroneous assumptions, the first of which is that the mortgage interest deduction inflates prices enough to make the capital gains tax a major issue.

In short, he forgets the AMT, which reduces the value of the MI deduction as income escalates—to exactly those "high income" people who benefit most in the Palley model. Also, house prices depend on that income (mortgages need to be approved) to clear; you can't make the median U.S. household income and meet the income requirements to buy a $200,000 home, let alone a $500,000 one, unless you're selling your own.

Also, is the ceiling really $500K per person? My accountant says it's $250K pp, $500 per couple. (He may be correct, but since he's already shading the MI deduction and CG exemption as aplying only to the "high income," it doesn't seem the way to bet.)

Palley also may be correct on the "cult" having contributed to the bubble—but I'm a simple man, and I basically assume that the principle-agent problems were created in response to existing demand (Say's Law abides), combined with a lax regulatory environment.

Short wisecrack: Anyone who can't do the math on whether it is better to owe (er, own) or to buy shouldn't be buying.

Longer version: Ask Dean Baker about renting vs. owning. Claiming that renters "don't benefit" when the spread is 5:8 in their favor is absurd. (We bought when the all-in cost pre-tax was less than we were paying; any tax gains from the MI deduction went back into Home Repairs and Improvements.)

He's clearly correct on home ownership leading to unemployment, but that's not a matter of "excessive." (More likely the opposite; areas with excessive home ownership tend also to have the type of infrastructure that attracts people. It's the towns in the middle of nowhere that lost their industry where people are stuck—and, as s_t_r never ceases to note [nor should s/he], those aren't the areas where house price appreciation has been a Headline Happening.)

So there are a few fallacious assumptions, some broad tarring, a bit of missing detail, all tangled together into a solution that solves nothing, least of all the issue it pretends to discuss, and doesn't address the issues he pretends it does.

says...

Hey Jay,

I have a couple of investment properties, I will be more than glad to let you move in and pay my mortgages payment and my property taxes for me for the next 30 years.

You don't mind a little bump in annual rent as I see fit do you?

[Jay]

"I have a couple of investment properties"

Are those investment properties in Vero Beach, Naples, San Diego, Phoenix? And were they purchased before 2003, between 2003 and 2006 or in the last 16 months?

"You don't mind a little bump in annual rent as I see fit do you?"

Well I'm not going to sign a 30 year contract that allows you to bump my annual rate without breaching the contract. I have the personal responsibility to myself to not be completely ignorant. It isn't the government's job to be my Nanny.

[Jay]

"The "cult of home ownership" is a Bush Administration creation, not one of the 1986 or 1996 tax changes cited."

Ken Houghton: Really???

http://www.4president.org/issues/clinton1996/clinton1996housing.htm

http://www.highbeam.com/doc/1G1-19037122.html

[save_the_rustbelt]

The basic tax treatment has been in place for decades. If it needs fixed, put a limit on the mortgage deduction.

So where the hell does everyone live? Let the peasants live in tents? Raise families in apartments? Permanent tenements?

As far as employment mobility, are we really moving toward a system of constant moving, maybe everyone should buy Winnebago. Tom Joad, are you packed?

Sorry for the sarcasm, but this guy would look at a field of roses and see only the thorns.

Ken: thanks, and it is "he."

[blackswan]

"Patently absurd drivel. In fact I would argue that if during 2003 to present if you are a renter I would call you intelligent, investment savy, etc. Just look at the mortgage payment to rental cost ratio over as much history as you get."

Jay, the first three duplexes I built for three individual investors in a NC beach town, I sold to them for $250,000. They resold them 12 to 15 months later for prices between $685,000 and $705,000. These people would not have been called intelligent by you. You would not have seen them as savvy investors (or did you really mean "savy"?). From your responses to everyone on this board, you are obviously the only one who you would classify as intelligent. Your views of others' opinions, however, appear to be somewhat solipsistic.

"I have the personal responsibility to myself to not be completely ignorant." Jay, please take that responsibility seriously.

Ken Houghton, your accountant is correct, it is $250,000 person and $500,000 per couple, tax free as long as you have lived in the house for two of the five years before the sale. If hardship can be documented, one can still exempt a percentage of profits from being taxed, even if one has lived in the primary residence for less than 2 years.

[blackswan]

Jay, I built those beach duplexes in late 2003.

[Jay]

I was a little sloppy with the date range for when one should have been renting and one should be buying. Depending on the market 2003 was still a reasonable time to buy, I expect this to be about the point at which many markets will bottom out. Anyone who bought while prices were skyrocketing and managed to get out before the crash was, how should I say it, lucky (unless you truly believe the top and bottom of markets can be timed). Some people got super rich like in the small example that you gave, but many got stuck with a $350,000 shacks in San Diego that should probably be fairly valued at about $180k.

Although come to think of it there is one more class of smart investors out there that I left out. Those with already poor credit scores that managed to buy a place they couldn't afford with little money down in a market where delinquency rates are out of control (ex: Miami). Don't bother making any mortgage payments, as there is a backlog to hear foreclosure hearings that can be as long as 9 months. That is 9 months of rent free living in a house you probably shouldn't be able to afford. Taking advantage of other people's (bankers and RE investors) folly also makes you a smart investor.

[evagrius]

For international comparisons;

http://www.internationalhousing.org/Supporting%20Files/White%20Paper%20Comparing%20Worldwide%20Tax%20Treatment%20of%20Housing.doc

[Winslow R.]

I think Thomas's timing is off.

No, mine is not that good either when it comes to politics but this one is a nonstarter at this point in the housing cycle.

2004 would have been a good time.

[wcw]

The IRS says, qualified housing interest "generally is deductible for alternative minimum tax purposes." Full stop. In short, if you are a homeowner with a mortgage who pays AMT, you should file amended returns yesterday and get your monry from the gubmint. The MI deduction may be abysmal policy, but there's no law saying you need to give it back. Now, the property-tax deduction is another story, but them's small potatoes.

Palley also correctly notes the ceiling on mortgages qualifying for interest deductibility. A married couple can deduct a million-dollar mortgage. It's the cap gains shield that's limited to $500k per couple. On balance, I'd say Palley is 2-for-2.

As for the effect on prices, I ran a toy monte carlo model a few summers ago to settle an argument. It turns out that against the alternatives (renting and investing and paying ordinary rates on coupons and gains rates as your stocks turn over), that interest deduction and gains shield are huge. So huge that even at 2005-6 prices, my model had owners in a nonvanishing fraction of possible futures come out ahead. If you want more of something, subsidize it. Tax policy is powerful stuff, and people are not stupid.

On renting, get a grip. I've had some bad, bad landlords (my current landlord is a dream; practice makes perfect). Even in a rent-controlled city like Berkeley or San Francisco, a malign landlord with a good lawyer holds all the cards. In the rest of the country, it's even worse. You have to pick your landlords more carefully than your employees, I'd say. At-will employment makes a layoff easy. Putting all your crap in boxes and moving is a royal pain. Having the sheriff evict someone is filing a few forms and making a phone call. Putting a lien sale on your deadbeat tenant's vehicles is even easier. Suing your slumlord and collecting, now that's difficult.

And STR, just what's wrong with raising a family in an apartment? I can think of a few places where anything else is unusual -- strange, little towns like Tokyo or Vienna. Just because your philosophy limits itself to the single-family-detached doesn't make apartments evil.

Full disclosure: my family lives in an apartment. The single-family detached next door is on the market, though. Maybe you want to buy it for us out of the goodness of your heart. I think it's in the 1.5 range. Surely you have that in your spare day suit.

[reason]

I'm with the LVT people, but I don't know how to transition to it. We need to discourage people from mortgaging their souls to the bank.

I'm all for more intelligent infrastructure investment and building regulation so that there are more good places for people to live. Perhaps we could put them together LVT in place of all other state and local taxes in new urbanist environment with efficient public transit links to major centers.

[spencer]

Why don't we try to make the policy symmetrical and treat the capital gains from houses stocks or other businesses the same.
If we are going to give the capital gains of the wealthy favorable treatment, why not treat the capital gains for the middle class the same.

The same with the mortgage interest payment. Business can treat interest payments as a business expense. So symmetrical treatment would require the same treatment of mortgage interest payments for the middle class.

The idea of taxing mortgage interest payment and housing capital gains is just another scheme to shift the tax burden from the well off to the middle class.

[Real Person from the Real World]

from the article:
"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."

How many well to do elite live in a house that costs $500k or less? While $500k is certainly a lot of house, it depends on the location, doesn't it. I have seen houses in some locations that well below $500k are equivalent to $500k elsewhere. It all depends on location.

Ultimately a home is where you live, and while many really LOW paid people can only rent, I think we want to encourage home ownership in this society. Take away the mortgage deduction and you will develop a society where no one but elites own homes. There are other ways for the gov't to get it's money, like actually taxing those, especially in the financial industry that make more in one day then some people earn in a lifetime, but pay taxes less than people of modest means.

[fabian59]

I feel that this is one of the best and most rational articles on the housing market that I’ve seen to date. I’ve just never quite understood the societal fixation on mortgage interest deductions. It just seems like a choice as to whether or not you want to send your money to the bank or to the government, and it appears as though most U.S. citizens prefer supporting our banking system.

I particularly appreciate Dr. Palley’s statement regarding the inter-generational aspects of the recent boom in housing prices, saying that “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.”

Although I am probably not part of the younger generation per se (I’m in my late 40’s), I feel as though the recent run-up in housing prices has done more to reduce our household’s wealth than any other event during my lifetime. My wife and I were hoping to become first-time home buyers about 7 years ago. Unfortunately, we were overwhelmed by the rapidly escalating prices and the extreme bidding competition for houses (we live in the Washington, DC area). So, we continue to rent, our savings that we have built up over 20 plus years in the workforce seem pretty inconsequential, and we live in fear of future large-scale increases in rents. As Dr. Dean Baker indicated in one of his postings, it seems as though Congress is determined to keep housing unaffordable, primarily by taking actions that will effectively keep housing prices from falling back to their long-term trend.

[Less is not More]

"Rather than creating wealth, the tax treatment of housing redistributes wealth inter-generationally..."

This is a telling point. If Americans save in a form that increases productivity, we collectively create wealth. Each new generation then has a higher standard of living.

If instead of increasing productivity, Americans restrict the supply of essential products to drive up the price, this actually reduces the total supply of desired consumer products. It lowers the standard of living of each new generation, who now have to trade ever more hours of work for the same product that the previous generation worked half as many hours for.

Such a deal.

[Debt]

We need to increase the supply of desirable consumer items to increase the aggregate standard of living. Restricting supply does just the opposite. Borrowing ever more consumer items from overseas to make up the difference is not a sustainable strategy. Household debt now exceeds GDP for the first time in history, while total credit market debt is about 350% of GDP. Foreign workers will want to be paid back. As the rise in the price of oil/commodities shows, attempting to inflate the debt to foreigners away does not work.

[fabian59]

As a follow-up to my previous posting, here is a link to Dean Baker’s short posting on his “Beat the Press” blog regarding the desire that our Congress seems to have to keep housing prices unaffordable.

[Francois]

"I have the personal responsibility to myself to not be completely ignorant. It isn't the government's job to be my Nanny."

As it occurred to you that maybe, just maybe, a level-playing field could be welcome sometimes?

Why is it that so many people are deluded by this "I can do anything by myself?" attitude.

Does everyone need to be exposed without any protection whatsoever to other people with much more advantages than they have?

Did we build societies as a playground to screw each other, or to seek individual well-being AND cooperating for mutual benefits?

[Don C]

Why does this discussion ignore property taxes?

[Jay]

"Take away the mortgage deduction and you will develop a society where no one but elites own homes."

This is sheer idiocy. What you will see is a combination of lower house prices and lower mortgage interest rates (split based on the bargaining power of all parties involved). The mortgage deduction only serves to distort markets. Not to mention I would love to see your proof that a "homeownership" rate higher than the current one is desireable. In fact would you go out on a limb and say the maximum utility is at 100% "homeownership". I use quotes because some people are convinced you own a home if your liability nearly equal your asset.

[paine]

how does jay do it ???

" .. there is a major flaw
that ken quickly used
in his non-sequitor....
you used the transitive property ....
By "low interest rates"
do you mean low risk premium spreads...
... your argument is based on
a biased sample with size N=2."

his own petard:
"Patently absurd drivel"

comes in a logic tweeeezer variety too
good round here for seperating
the canary droppings
from the cage grit

[paine]

palley is stuck in 1979
so am i

these are old bromides indeed
major method :
convert deducts into credits

i like
replacing the uncle tax ex
on mort service
with a real fisc ex on housing stamps

but i liked it back in 1979 too

was that too soon or is this too late

[paine]

the cap gains razzle ???
is
repub populism
"share the ever enlarging
tax free
unearned income zone
with mr and mrs schmulligan "

to axe this
you'll need a two for one
"swing voter bene-sub "

[paine]

The "cult of home ownership"
as fed gub policy
ken

goes back to the truman GI bill years

let me suggest this

the old politics --pre pearl harbor--
had its cult of the farmer

well
after "THE war "
and facing the huge occ share shift
from farm to burb ...
great american prosperity

from growing golden wheat fields
to mowing 1/4 acre lawns

change without change

[paine]

"I think we want to encourage home ownership in this society."

why rp ???

"It just seems like a choice as to whether or not you want to send your money to the bank or to the government, and it appears as though most U.S. citizens prefer supporting our banking system."

fabian forte
great passage

[paine]

"Foreign workers will want to be paid back"

nice way to put this

indeed
it is the " foreign .."export"..workers "
as well as our domestic job losers
taking the short sheet
in the process

through
"the underpricing "
of their exported products

through the collusional forex gimmicks
which have bipartisan support of the winner groups
(foreign firms
plus
trans nats )
the globalizers are very lucky
both sides gubs are controled
by their two respective winner groups

[paine]

"The idea of taxing mortgage interest payment and housing capital gains is just another scheme to shift the tax burden from the well off to the middle class"

you may
need a better chart of where the treasures and bodies are buried in the great american wells vs mids class struggle

my take on the location
of the front line spencer
don't lead to such diabolics

to be fair to tp
he presents a package
not just a naked deduction removal
and indeed
granting the uncertainty of any "net class burden effects given the plausible oddity
cross elastcities can produce
in an ultra complex web like our modern ownership economy
my guess remains --as it was in 1977---
tp's proposed changes
---taken as a package---
if enacted and given time to settle in
ought to
shift tax burdens quite the opposite way
then you seem to imagine

that is an overall net shift
from mids to wells
not as you suggest
from wells to mids

[reason]

Paine, you and I tangle sometimes, but it seems when it actually comes down to policy we are actually on the same side. Now in this case I would like to see housing cheaper, neighbourhoods better and transaction costs in the housing market much lower. That is why I think the Georgians have a point here - better to pay the government and get infrastructure for our money than pay the banks and get Mansions on Long Island.

Its time for a new "I have a dream speech" (this time about boring pragmatic themes like lots of walkable, social amenity rich neighbourhoods with rapid transit links making for higher living quality, the benefits of density and public space together. That should be what we aim for in the 21st Century. Everybody should be reading and contributing to "World Changing" http://www.worldchanging.com/

[reason]

Important world missing...
and get mansions on Long Island for them.

[Zach]

Real Person,

The $500k limit is on the gain, not the sales price. In order to have a $500k gain, you'd have to have a house worth much more than that (or else some pretty phenominal growth). For example, if you bought a home for $1.5 mil and sold it for $2 mil, you'd still owe no capital gains tax (assuming you were married).