More Bad Ideas for Housing Tax Credits

 
 
April 03, 2008

Fiscal Fact No. 122

Today Democrats and Republicans in Congress are considering yet another special tax incentive for housing as a response to the current crisis in the housing sector. Bipartisan though it may be, no current tax idea is more counterproductive.

The Wall Street Journal reported on Saturday, March 22, that Sens. Debbie Stabenow (D-MI) and Johnny Isakson (R-GA) have floated proposals on Capitol Hill to create a temporary tax credit for buying a home, hoping to prop up the flagging housing market.

Sen. Isakson proposes a $5,000 tax credit that could be claimed by homebuyers in three circumstances: (1) the house is vacant; (2) the house is occupied by an owner in default on his mortgage; or (3) the house has been foreclosed on. The non-refundable credit could be claimed for three consecutive years and total as much as $15,000. Sen. Stabenow's refundable, one-year credit has different strings attached. It would be limited to first-time homebuyers who, if filing a joint return, could claim $6,000 or 10 percent of the home price, whichever is lower. Note that both of these provisions are credits that allow people to subtract that amount directly from their final tax bill, saving them much more money than deductions from taxable income like the mortgage interest deduction.

The tax code is already littered with special tax provisions that favor housing, and public finance economists all along the political spectrum agree that they are excessive, to say the least. From the mortgage interest deduction to the deduction for real estate taxes paid to the capital gains exclusion for primary residences, the federal tax code funnels more than $100 billion dollars annually into the housing sector.1 That's nearly 10 percent of total federal income tax collections, enough so that if the subsidies were repealed, we could cut every personal income tax rate by 14 percent.2 And that's without counting the billions spent directly by the Department of Housing and Urban Development (HUD) and the government-created entities known as Freddie Mac and Fannie Mae.

Most sacrosanct among all these subsidies is the mortgage interest deduction, advertised by real estate agents, homebuilders and other special interests as if it were Mom's apple pie. Of course, interest payments on loans taken out to earn taxable income should be deductible, and those payments have been deductible since the income tax was born in 1913. But mortgage loans taken out by homeowners on their primary residences are not used to produce taxable income, so mortgage interest should not be deductible.3

The President's Tax Reform Panel recommended in 2005 that the home mortgage deduction be scaled back and rechanneled to taxpayers with lower incomes. It recommended repealing the property tax deduction in its entirety. Importantly, these changes proposed by the Tax Reform Panel exchanged some of the housing tax subsidies for lower tax rates overall.

The objective of most sound tax policy is for the tax code to interfere with household and business decisions as little as possible—that is, to let decisions be made on economic fundamentals, not based on their tax treatment. Housing tax subsidies have violated this tenet of sound tax policy and distorted household decisions in several important ways. First, they encourage investment in housing over investment elsewhere in the economy, namely business investment. Secondly—and this is something that should be appreciated more right now—the deductions for mortgage interest and real estate taxes paid grow with the size of the house and the mortgage, encouraging the financing of oversized houses with oversized loans. It would go too far to blame the current housing crisis on the existing tax subsidies, but they certainly haven't helped matters. Similarly, the large, temporary credits offered by Sens. Isakson and Stabenow would make matters worse.

Why Hurt Business Investment to Favor Housing Investment?
Recently, the U.S. Treasury Department calculated that economy-wide, the effective tax rate on new investment is 17.3 percent. However, the same study calculated an effective tax rate on investment in residential housing of only 3.5 percent. In other words, housing already receives very special tax treatment compared to other types of investment.4

Every year the federal government preserves these tax advantages for housing investment, it must continue to impose higher income tax rates on other people and industries. If either the Isakson or Stabenow credit were to be piled on top of the existing credits, the only way to prevent further tax hikes on other people and industries would be to cut government spending at the same time. We know how unlikely that is.

The usual rationalization for giving housing investment a substantial preference is that spillover benefits, or "positive externalities," flow from homeownership. Lower crime is one that's frequently cited. Under this justification, there is no "distortion" from housing subsidies, but rather a positive market correction that admittedly tilts investment toward housing, but for good reason. Realistically, however, there is no plausible proof that the glow of homeownership is so beneficial to the rest of society that it's worth such a mammoth subsidy in its current or proposed form.

How Would These Temporary Credits Affect the Price of Housing?
If permanent tax credits have in any way helped push people into subprime mortgages in recent years—and there is every reason to think they have abetted that process—would the same thing happen with temporary credits such as those offered by Stabenow and Isakson?

Any tax credit, permanent or temporary, will to some extent be capitalized into the price of housing. In other words, sellers can and will charge more for a house if they know the buyer will be getting a tax credit. From the homebuyer's perspective, he might be willing to pay more, knowing that he'll be getting the amount of the credit refunded to him when he files his tax return. How much of the credit will be captured by the seller, propping up the price of housing, and how much will be captured by the buyer, boosting home purchases?

If the tax subsidy of the Isakson or Stabenow credits were fully capitalized into the price, then the seller—a homebuilder if the house is new and a homeowner if it isn't—would capture the entire value of the credit. In the case of the Isakson proposal, every potential buyer of a qualified home would be eligible, so the seller might be expected to capture close to the full $15,000 value of the credit. With Stabenow's credit, only first-time buyers would be eligible, and the credit's value would double for married couples. So every seller's ideal customer would be that couple who qualifies for the maximum tax credit of $6,000 and could therefore pay that much more for the home. The next best buyer would be a single person buying his first home, permitting the seller to try to extract an additional $3,000 from the buyer. Other buyers would not qualify for the credit and would therefore be less willing to match the prices offered by first-time buyers. In each case, if this capitalization occurs, the credit would accomplish little to make homes easier to buy because the seller would be capturing a large fraction of the credit.

More realistically, the tax credit would be partially capitalized into the price of the home, thereby increasing the prices somewhat but also increasing investment into housing by some amount. Therefore, the distortion created by this credit would be twofold. First, it would increase investment in housing at the expense of other investment, which will help our economy far less than an across-the-board tax cut would. Secondly, any politically targeted tax cut like Isakson's or Stabenow's forces taxes to be higher somewhere else, forces spending to be cut, and/or causes the deficit to increase (i.e. future taxes to increase).

Overall, while a housing tax credit by itself might increase investment in that sector, there is no free lunch here. Like any spending program, a tax credit for housing must be paid for.

And that brings us to an interesting question: What is the difference between subsidies delivered through the tax code, like the new tax credits proposed by Isakson and Stabenow, and the spending programs of HUD? In principle, there's no difference. It's just that one can be called a "tax cut" by its supporters while the other can be criticized as a big spending program. In reality, allowing homeowners to take an additional $5,000 or more off their tax bills is a handout to homeowners and those in the housing industry.

If the proposed credits put forth by Sens. Isakson and Stabenow were accompanied by elimination of the deduction for real estate taxes paid and a scaling back of the mortgage interest deduction, as recommended by the Tax Reform Panel, they would dramatically improve the federal tax code. But, as Senator Obama did with his housing tax credit proposal, Isakson and Stabenow want to pile new credits on top of the excessive tax subsidies that the housing market already receives.

Ideally, American political leaders would actually explain to the people why the government should be pushing renters to buy houses they may not be able to afford instead of continuing to rent. Unfortunately, as with much of tax policy in Washington, short-run political interests, the tyranny of the status quo, and heavy influence from special interests prevent a true discussion of what tax policy should be.

Sources

"Background Paper: Treasury Conference on Business Taxation and Global Competitiveness," Department of the Treasury, July 26, 2007.

S.1566: http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=110_cong_bills&docid=f:s2566is.txt.pdf

S.1988: http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=110_cong_bills&docid=f:s1988is.txt.pdf

Gregg Hitt. "Tax Breaks for Homebuyers Gain Support," Wall Street Journal: March 22, 2008. Available: http://online.wsj.com/article/SB120614866511156783.html 

Notes

1. Some high-income taxpayers are ineligible for the full value of these housing-related tax benefits. See Publication 936: Home Mortgage Interest Deduction; Publication 523: Selling Your Home; and Publication 17: Your Federal Income Tax, all on the website of the Internal Revenue Service, http://www.irs.gov/.

2. Tax Foundation microsimulation model.

3. The mortgage interest deduction is justifiable when the house is a rental property because the rental income is taxable. Hypothetically, a pure income tax would actually tax the "net imputed rental income" that a homeowner receives from housing services even if he doesn't rent the home out, thereby justifying the deduction. But because this calculation is not feasible, the fairest, most practical solution is to disallow the deduction.

4. A study performed by the Congressional Budget Office in 2005 found a similar spread between effective tax rates on all investment, 13.8%, and the rate on just owner-occupied housing, negative 5.1 percent. See "Taxing Capital Income: Effective Rates and Approaches to Reform," Congressional Budget Office (December 2007) at www.cbo.gov/ftpdocs/67xx/doc6792/10-18-Tax.pdf.

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