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.