from Follow the Money

Are tax breaks for houses at risk?

October 14, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Last weekend's Los Angeles Times (via the Economist's View) article on Bush's advisory commission made it pretty clear that at least one member of the commission, Charles Rossotti, had  tax breaks for homes in his sights: 

A presidential commission on tax reform will take up the subject for the first time Tuesday. "Everything's on the table," said Charles Rossotti, a panel member who was commissioner of internal revenue from 1997 to 2002.

The mortgage-interest deduction saved homeowners $61.5 billion last year. No one expects the commission to recommend its elimination.

Instead, the panel may consider scaling back the deduction for mortgage interest on second homes or home-equity loans, and changing the deduction for property taxes, among other things.

The stakes in such a discussion are huge.

More from the LA Times:

Changing the tax benefits for homeowners, even if done slowly, could cause short-term convulsions in the market as buyers recalculate what they can afford. The tumult could be most pronounced for homeowners in states with the highest home prices, such as California. In the long term, housing could become more affordable as some of the stimulus that has sent prices soaring is removed.

Any proposed shift would encounter strong and possibly overwhelming resistance. But with a rising federal budget deficit, the prospects for change are much greater than they've ever been, say those involved in the debate.

Homeownership wasn't initially a favored child. When the individual tax code was created in 1913, all types of interest were deductible. Most fell away over time, but housing remained and became even more special.

Eight years ago, capital-gains taxes were eliminated for home sellers who had profit of as much as $250,000 (for individuals) or $500,000 (for couples). That has created a vast amount of wealth and helped power a housing boom that has seen prices double or triple in Southern California and other hot markets.

Some policymakers and analysts are beginning to wonder whether such breaks are providing the wrong incentives, giving hefty deductions to millionaires buying Beverly Hills estates as well as to speculators snapping up Las Vegas ranch houses, hoping to turn a quick profit
.

I initially doubted Rossotti spoke for the commission; after all, the commission's marching orders included a charge to take into consideration the importance of homeownership.  That seemed like a pretty clear signal not to touch housing subsidies to me.

It seems like I was wrong.  The commission seems to be taking the need to come up with "revenue-neutral" proposals seriously, and if you want to get rid of the alternative minimum tax, that means finding other sources of revenue.  The New York Times:

At its last meeting, in July, the commission agreed to recommend abolishing the alternative minimum tax for individuals, a step that would cost the federal government $1.2 trillion in lost revenue over 10 years.

With a mandate to develop a proposal for changing the tax system that is revenue neutral - meaning it neither raises nor lowers total tax receipts - the commission must find enough revenue to offset the amount now generated by the alternative minimum tax.

That is mainly what led to an examination of ways to modify the deductions for mortgage interest and health insurance, two of the largest tax breaks now available to individuals. Together, the two deductions will cost the treasury about $250 billion this year, with the benefits going disproportionately to the most affluent taxpayers.

I do not doubt for a second that most of the benefits of these deductions go the affluent - deductions by their nature are most valuable to folks in the highest tax bracket, and at least for now, we still have a progressive incomes tax (at least until you get into the really high tax brackets ... ) A serious proposal for increasing access to health insurance needs provide tax credits - which cost more but also benefit more people - not just tax deductions.   Still getting rid of tax deductions for health care at a time when more and more Americans lack access to health insurance hardly seems like a step in the right direction, or likely to fly politically. 

Cutting tax breaks for homes - particularly if not offset by cuts in other taxes -- would contribute to global rebalancing in two ways: more revenues for the government would lead to smaller deficits, all other things being equal, and cutting tax breaks on mortgage interest would presumably have an impact on housing prices and cut into the housing ATM that has supported consumption.   Such a policy change certainly would be one way to making the US economy less housing centric.  Listen to James Poterba, quoted in the FT:

Jim Poterba, an economics professor at MIT and a member of the panel, said there was only shaky evidence that the existing system encouraged homeownership and a strong case that it led to overinvestment in residential property to the detriment of other investments.

And as the Los Angeles Times article points out -- housing-related tax breaks have proven far more costly than expected back when they were passed.

U.S. Comptroller General David M. Walker said provisions such as the capital-gains exemption were costing the government much more money than anyone forecast when they were first proposed. In a new study, the Government Accountability Office calculated that the exemption drained $29.7 billion from federal coffers last year.

My Midwestern chauvinist side has long thought that housing subsidies have gotten less ire than they deserve from the oped pages of the major East Coast papers.   They prefer to opine against farm subsidies that benefit farmers in South and Midwest farmers, rather than subsidies that benefit their core readers, who often have high-incomes and have borrowed to buy expensive real estate!   Yet the foregone tax revenues from housing subsidies -- $100 billion from the capital gains exemption and the mortgage interest tax deduction - is far larger than the $20 billion or so budget cost of farm subsidies last year.  Don't get me wrong: I realize that farm subsidies often also benefit high-income farmers and I also realize that there are ways of supporting farmers -- sugar tariffs for example -- that help the Treasury but hurt US consumers.

Still, the commission's proposals are probably even more unlikely to fly than proposals to zero out farm subsidies.  

The alternative minimum tax has a big impact on forecasts for future budget deficits since it is expected to generate far more money in the future than it does now.   I would bet that most people expected to fall into its web don't realize that they are expected to fall in its web - they won't thank the commission for getting rid of a tax they never expected to pay.   Conversely, lots of folks right now do benefit from housing subsidies - and they (and the home industry) won't give them up easily.  You don't need to be Karl Rove to see that the politics don't work.   Rove always has preferred giving people upfront benefits while deferring the costs - this proposal seems to have upfront costs and deferred benefits!

In an ideal world, the price of agricultural land would already reflect the risk that farm subsidies will be pared back over time, and the price of homes also would reflect the risk that tax subsidies for housing will be scaled back.   The risk that such subsidies would be cut would be "priced in" to use the market lingo. 

I am no expert, but I suspect the opposite is the case: the market for homes fully prices in the continuation of housing subsidies, and the market for agricultural land prices in a strong expectation that agricultural subsidies will continue.  That is one reason why cutting back established subsidies is so hard - the subsidy ends up driving up asset values, and getting rid of the subsidies potentially would have a big impact of some folks net worth.

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