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.
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.