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Thomas Palley Questions Housing Subsidies

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An odd set of voices is beginning to question the wisdom of America’s extraordinarily generous subsidies to homeowners. Paul Krugman once remarked that American like to consume houses, while the French prefer to consume vacations, but we shouldn’t overlook the role of incentives in those choices.

At the Milken Institute Global Conference, a true disciple of Milton Friedman. Gary Becker (University of Chicago), was the only one to argue that the considerable benefits lavished on homeowners didn’t make for great policy. But for Becker, that is part of a general libertarian, anti-interventionist stance.

Thomas Palley, who comes from the opposite end of the political spectrum, is also opposed to housing incentives. He believes that they fed the housing bubble and are regressive, since taxpayers in higher income brackets get proportionally greater subsidies than the less well off (although in high income tax states, the AMT undercuts the writeoffs). He minces no words, describing a “cult of homeownership” and pointing out an unpleasant fact: tax breaks make housing more costly, so the subsidy, now that it is in place, is eroded by higher prices. To put it even more bluntly, the main beneficiaries are those who profit from higher priced housing units, namely, builders and brokers. But no one wants to see the sacred mortgage tax deduction as ineffective (in terms of its intended beneficiaries) and a hugely inefficient, expensive benefit to a small sector of the economy (the housing sector is 5% of GDP).

But Palley goes even further than that, claiming that the allure of homeownership leads to more dual income families which produces broader social costs. That claim isn’t inconceivable; I know couples where one partner would be working less were it not for the home payments. But Palley’s assertion begs for empirical support. Interest expenses have long been tax deductible; it was only in the 1980s that individual filers lost the ability to deduct interest on loans unrelated to housing. Similarly, mortgage interest was deductible in the 1950s, the Ozzie and Harriet age of stay-at-home moms. Other factors have contributed to two earner households, such as a long generation shift in attitudes toward debt and more attractive opportunities for women to work.

To Palley’s credit, he provides a short list of reforms which would not be too painful to implement (but finding the political will to touch this third rail issue is a completely different matter). Note he does not discuss phasing out Fannie and Freddie, but that would seem to be part and parcel of this sort of program.

My view (and I suspect that of at least some readers) lies in the middle. Housing subsidies in America are sacrosanct. It would be easier to cut Social Security than housing benefits (not that I favor cutting Social Security; the entitlements problem is not as intractable as critics suggest). Yet from an efficiency standpoint, it’s nuts to encourage so much investment in a sector that does nothing for our national competitiveness. With energy costs rising, the McMansions of the recent boom, the product of big tax deductions, are going to start looking like white elephants. Given our low savings rate and burgeoning federal deficits, we are going to have to make some tough fiscal choices. Housing is a logical, if controversial, place to cut.

From 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.

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27 comments

  1. Anonymous

    Please explain why social security is always called an “entitlement program” when lots of us have paid into the darn thing every month for 25 or 30 years? It can be called a lot of things– mismanaged, stolen from, abused, etc., —”Entitlement”, No I don’t think so!!!

  2. Anonymous

    Eliminating the mortgage deduction has about as much chance of passing as snow in July in North Carolina. It would cause a housing price collapse worse than what is happening now with subprime and alt-a.

    Such a dreamer! But I like dream.

  3. Anonymous

    there was an article in the economist a while ago about the ineffectiveness of the mortgage deduction. the example they cited was of england, whose property market actually did quite well without it. (i’m not sure if they had it and then eliminated it, or never had it at all). anyway, eliminating it just might not cause a collapse like most believe.

  4. Martin

    Once one is prepared to see mortgage interest deductibility as a form of subsidy, it does strike one as odd that it gives a higher subsidy to people in higher tax brackets. (Over here -the Netherlands- it’s on the same principle, if I understand correctly.) If you deduct the same amount at 32% marginal income tax rate, it leaves you with paying 68% yourself, but at a 52% marginal tax rate, you pay 48% percent yourself. It’s a bit like having three prices for admission to a museum: the wealthy guy pays EUR 4.80 and the other guy pays EUR 6.80… But there are far too many vested interests to expect this system to change.

  5. Anonymous

    RE COMMENT BY “MARTIN”..
    the wealthy are already paying more out of pocket via the higher marginal rate. using your museum example, lets say the admit fee = the US marginal tax rates. the wealthy pay 36 eur to get in and others pay 28 eur. the museum offers a 36% discount to wealthy, who pay a net 23.04, and a 28% discount to the others who pay a net 20.16..
    its amazing how the over-educated libs always forget this simple math.

  6. R

    My Ozzie and Harriet era friends and I often reflect about how our parents provided us such a wonderful childhood – on one income. It’s simple – they bought only what they could afford; one mortgage; and maybe, maybe one credit card. We’ve become hedonists. Having recently returned from many years in southern Europe, I’m constantly amazed at the frenetic pace of Americans, now conditioned to go 24/7 as they seek to pay down the levels of debt required to “have it all”. Isn’t the the dramatic rise of the divorce rate since 1965 indicative that our living/working values are all out of whack?

  7. Anonymous

    The absurdity of it is mindboggling.

    Policy makers have lent the full force of the government to insure unaffordable housing for all.

    Just think about it. Housing prices go down 10% and the sophists scream “CRISIS!”

    But can you imagine them howling “CRISIS” if the price of gasoline, which is much less of a neccessity than a roof over your head, were to go down 10%?

    It’s insane.

  8. Anonymous

    R said…
    My Ozzie and Harriet era friends and I often reflect about how our parents provided us such a wonderful childhood – on one income. It’s simple – they bought only what they could afford; one mortgage; and maybe, maybe one credit card.

    hate to be so blunt, but this is a wrong conclusion. the primary reason that dual incomes are needed today is because of the debasement of our currency by the fed and the increased tax burden (federal, state, exise, etc.) a stable dollar and low taxes would allow households to have a decent living on one income.

  9. Anonymous

    Both England and Sweden abolished the mortgage deduction in the 80s and 90s abruptly. Housing prices tumbled, but both markets recovered in 5-10 years.

    The Netherlands still has a similar mortgage deduction system, and is looking to abolish it gradually. Actually doing it is nearly impossible though, since it would put the last buyers (= the younger generations) deeply underwater on their mortgages

    The reasoning by Palley that the mortgage deduction makes houses unaffordable for young people is a fallacy. The TCO of owning a house is going to be largely unchanged, mortgage deduction or not. Higher price with deduction or lower price without deduction leads to same TCO.

    The tax deduction for capital gains on this asset class in the US leads to a far bigger distortion in asset allocation.

  10. Anonymous

    ☺☺R said…
    “My Ozzie and Harriet era friends and I often reflect about how our parents provided us such a wonderful childhood – on one income. It’s simple – they bought only what they could afford; one mortgage; and maybe, maybe one credit card. We’ve become hedonists.”

    “How advertising turned into a force acting on the public mind so successfully that it now serves to propel every kind of purpose, dogma, political and private ambition, health measures, and private or public institutions is a long chapter of cultural history that has yet to be writen…

    “In short, those were the years when Comfort was replaced by Convenience…

    “The modern situation has been described in detail by a Swedish scholar who explains ‘the decline of service in a service economy’ and gives the mathematical model for the relation between increased mechanization and loss of free time. (His book, brief and non-technical until the last chapter is: ‘The Harried Leisure Class’ by Steffan Linder.)

    “Long ago, John Stuart Mill pointed out that mechanizing man’s work had changed but not lightened his toil. But it has not been noticed that mechanizing the home has laid another load on the laborer’s back: it has made simple poverty impossible. No household today can remain without the conveniences, beginning with the telephone and other utilities (as they are called), and going on to the car, radio, and television. Needed for holding one’s job or socially imposed by the neighbors and one’s children, they are part of an oppressive ‘standard of living.’ For some families this means moonlighting or perpetual debt, for others, who refuse the struggle, it is abject poverty instead of the tolerable life that an earlier age might have afforded.”

  11. Peripheral Visionary

    I like the idea of reducing the subsidy over ten years. A sudden change would ruin the markets, but a slow and gradual change, especially be simply dropping the cap in the deduction, makes sense and would allow people to plan in advance. It will also result in a reduction in home prices, but given that home prices are already dropping (and are likely to overshoot), now would be the time to do it.

    The elimination of the capital gains tax would also dramatically reduce speculation in residential real estate, but given that speculation in real estate is currently a smoldering ruin, now would also be the time to do it.

  12. Richard B

    All tax systems create distortions. Perhaps it’s time to consider an alternative to our current mess. The automated payments transaction tax proposed by a University of Wisconsin economics professor a number of years ago is worth considering.

    http://www.apttax.com/

  13. Anonymous

    The Federal Gov’t will be looking to increase revenue in the future so I expect housing to lose some if not all its tax saving incentives. With high energy cost builders will not be inclined to turn raw Ag land into subdivisions and with that long term decline their political power and popularity with Congress will decline.

  14. Anonymous

    Thanks for posting Palley’s wonderful piece, Yves. I don’t know that I agree with all its’ conclusions, but I certainly agree with him that the current tax subsidy system has produced or contributed to a deep inter-generational inequity and unfairness. One of the most annoying aspects of the current housing debacle is listening to the self-satisfied lecturing from older boomers like “R” above, who shake their fingers and drone on about how the people who are now in foreclosure situations “lived beyond their means” and were “too hedonistic”. People like R never want to admit the obvious: by pure dumb luck, they won the demographic/historical lottery. The conditions which produced cheap-relative-to-cost-of-living housing were unique and not reproducible now. Aging boomers like R aren’t any morally better than Joe Twentysomething, who just lost his 500K house, they’re just much luckier. If I have to listen to any more “moral hazard” drivel I’m going to toss my Wheaties. The actual economic and social data–not Boomers’ pleasantly self=satisfied fantasies of moral superiority–show clearly that by any objective standards, most people now are working much harder, feel endless anxiety about their future, and are enjoying fewer real benefits.

  15. Lord

    The system has accommodated to existing law. What would be unfair is to change it. Perturbing taxation is merely a means of temporarily increasing revenues until the system adjusts to compensate. Playing the tax game is so pointless for a society and leads to nothing productive. Just say no to such lame ideas.

  16. ScottB

    Palley seems to argue that a housing subsidy leads to a net higher cost of housing, thus leading to two-earner families, etc. This is absurd on the face of it.

    Some kind of subsidy for home ownership is arguable due to the alleged spillover effects of ownership–neighborhood stability, etc.

    Palley doesn’t mention that a large percentage of the current interest subsidy has gone to second homes (vacation homes) for upper income families.

    So I guess I would agree with his main point, that some reconfiguration is due.

  17. bobo7874

    I have heard commercial real estate people complain that some 1980′s amendments to the tax code (the so-called passive activity loss rules) made the 1980′s real estate contraction much worse by drasticly restricting the ability of individuals to offset depreciation deductions against their ordinary income (from working, operating a business, etc). Some econometrics professor has probably done a study on how badly instituting these rules hurt the commercial real estate market in the 1980′s, and from that, one might be able to draw conclusions on how badly drasticly restricting tax benefits for residential housing would hurt the residential real estate market currently.

  18. Anonymous

    The Naked Capitalist doesn’t think our entitlement problems are as bad off financially we think they are? Please explain.

    Nobody disputes the eye-popping numbers. So what is his solution?

    Republicans want tax cuts and don’t seem to care about anything else.

    The Democrats refuse to even acknowledge the problem. I think that they assume that all we will have to do is “tax the rich”. Trouble is, those deficit projections are based on optimistic economic growth. Higher and higher taxes will inhibit that growth and make the problem worse.

  19. Yves Smith

    Anon of 9:28,

    Dean Baker, and to a lesser degree Paul Krugman have pointed out that the Social Security payment increases aren’t terribly alarming or unmanageable. The problem is Medicare, and that in turn is NOT a demographic problem, but a health care cost problem. The scary growth is due to assumptions on health cost care increases.

    Our medical system costs substantially more as a % of GDP as that of other advanced countries, and delivers no better health outcomes. Treating the Medicare problem as an entitlement problem is a mis-diagnosis. We need to do something about health care, pronto.

  20. macndub

    The Ozzy and Harriet era worked for a lot of people, but it didn’t work so well if you were black, nonunion, or a soldier. Society was relatively stable, but the sharing of benefits was unsustainable, and indeed, was not sustained.

    This brings us to the tax system. Business profit and productivity is not an end in and of itself. Wealth is the reward that society confers on those who do socially rewarding things. We measure social reward partly by profit–taking that which is cheap and turning into that which is expensive. So capitalism isn’t an end. Rather, it’s the means by which society allocates its productive resources most efficiently.

    I love capitalism. It’s given me, the child of immigrants, a very good life. But I also don’t mind paying my way. There are public goods that people value, such as infrastructure and social security. There are private goods, such as medical care, that are subject to serious agency problems and therefore must be socialized in order to provide the service at a reasonable cost. Bottom line, society needs taxes.

    Taxes, in order to be equitable and efficient, must collect the required revenue with as little drag as possible on the economy, and as broadly as possible. So, if one were to design such a system from scratch, it would probably include consumption taxes, steeply progressive income taxes (marginal utility of money declines as wealth increases), a social security system that offers a minimum income that gets clawed back at some prescribed rate, to motivate work. And probably very low or nonexistent corporate taxes.

    Housing interest deductions would have no place in this world, but I guess that flying pigs would.

  21. Anonymous

    Yves,

    This is anon 9:28.

    You are correct that the Social Security problem is not unmanageable…….until it is unmanageable. Do you see any politicians calling for raising the age to collect payments based on life expectancy? Because that is how it was originally written. The lawmakers back then were ruthless with the rules. Life expectancy was 62…..the age which you collect payments.

    We are spending twice as much per GDP as any other country on health care yet were are not getting extra benefits as you noted. It is indeed a health care problem.

    Trouble is, Washington simply can’t solve any of these problems. They have created a monster with entitlements, and they know it. The half measures and compromises that democracies come up with to solve problems will not work. The special interests (AARP, Big Pharma, trial lawyers, doctors) are two entrenched and too powerful. Our out-of-control legal system is a study in interest group politics.

    At the end of the day serious cuts are going to have to be made yet nobody talks about this. And you can’t raise taxes much more without capital flight, emigration and eventual currency controls

    I suspect the USA will do what all bad governments do when they run into problems like this: print money, monetize the debt and blame others………a de facto default. And hope the overseas bond holders don’t notice they are being robbed.

  22. Anonymous

    Assuming efficient markets, the mortgage interest deduction is predominantly a subsidy to the home building and mortgage lending industries.

  23. Anonymous

    Yves said:

    “Our medical system costs substantially more as a % of GDP as that of other advanced countries, and delivers no better health outcomes.”

    I agree with the former part of your statement, and that something has to be done, but if we deliver no better health outcome, then why do Canadians come over the border to pay for services in the U.S. all the time? Because we have better services.

  24. Yves Smith

    Anon of 9:28,

    I agree that the will to act is appallingly absent. Everyone is unhappy with health insurance (one of many possible examples of festering problems), yet no one is willing to take the industry out and shoot it (and I don’t necessarily mean a single payer system, it seems anything that might cut their profits is verboten. Hell, that’s precisely what needs to happen here. We’ll throw factory workers on the dust heap, but not companies that are standing in the way of a badly needed restructuring).

    I am really perplexed at what has happened to this country. Is everyone anaesthetized by TV, on Prozac, or so burned out by the daily grind as to have no energy left for outrage? When I was a kid (and the very fact of TV was still exciting and fresh), CBS ran a documentary, “Poverty in America” which showed vividly how bad things were in certain parts of America. I am convinced that it helped galvanize the Great Society programs, the same way the lurid footage from Vietnam fueled the war protests. But now that movies and TV programming have far more gory images than the news, maybe the media have lost their impact.

  25. Anonymous

    to anon of May 7, 2008 12:26 PM:

    the only way to buy a pot to piss in, is if you save enough to buy it. It has nothing to do with the lottery of demographics excuse that my generation (30-40 year olds) unfortunately uses to justify living beyond our means. Our parents generation created wealth the only way it gets generated: saving and re-investment. My generation for some reason has forgotten this. Until we re-discover this and stop trying to prop up housing with tax payer money, not only will this country spend the next 10 years as Japan has, people like me who save will have to wait that much longer before housing hits bottom. Ridiculous.

  26. Anonymous

    Going back to the Ozzie & Harriet references of the idealized 1950′s nuclear family, recall that this was the definition of middle-class. Now compare that to today’s TV household. If not the spoiled rich brats from “The O.C.”, it’s “Pimp My House” or some such other over-the-top celebration of shallow excess.

    In Ozzie & Harriet’s day, keeping up with the Jones meant getting a larger lawn mower. Nowadays it means trading the lease in on the X5 in for a new lease on a Range Rover. To, of course, be parked in the 3-car garage attached to the 3000 sq. ft. home. Thus requiring dual incomes to support.

    Contrary to the Robin Hood economic polices of the anointed chattering classes, the middle class isn’t shrinking. Nor is it under attack. It simply has allowed its narcissistic obsessions with instant gratification to overwhelm its financial resources. Instead of looking inward for a solution, “Honey, maybe it’s time to downsize our lifestyle?” they blame storm government, business, and even capitalism itself.

    I don’t give the boomers any pass on this however, as it was them who were raised by Ozzie & Harriet — only to become Ozzy & Sharon to their own children.

  27. Yves Smith

    Anon of 4:08 AM,

    Can you provide some supporting evidence? I happened to be plugged into the Canadian sports mafia, and US pro sports teams hire certain Canadian doctors as consultants (an interesting loophole, that). They wouldn’t do that if they didn’t think they were top notch. For instance, the best foot doctor in North America (according to my US sports sources, who have a vested interest in knowing who is really tops) is outside Montreal.

    Similarly, I’ve never run across anyone from Canada coming to the US for care, Indeed, I am told by people in the health business that it isn’t safe to go to a New York city hospital without your own private duty nurse. Suburban hospitals are apparently better run, but if you have an emergency, you don’t exactly have the luxury of choice.

    Finally, this article ran today in the Canada’s National Post lamenting that Canadian expats game the system, and fly in from abroad to use Canadian care. If it wasn’t reasonably good, cost alone wouldn’t justify going to the trouble of getting on a plane.

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