The Housing Bubble and the Mortgage Interest Deduction

 
 
March 02, 2006

An excellent piece by David Leonhardt on the economics and politics regarding the housing sector appears in today’s New York Times Business Section:

In New York, inflation-adjusted prices dropped almost a third in less than a decade. The fall was even worse in Los Angeles, and it wasn't pretty in Boston, San Francisco or Washington, either. Thousands of families were forced into much smaller homes. Many have never lived as well as they did in those giddy pre-crash years. It was a painful preview of what the dot-com meltdown of 2000 would bring.

What? You don't remember any of this? You think I just made up those numbers about plummeting house values?

I didn't. The real estate crash really happened. The median house price in the New York area fell 12 percent from 1988 to 1995, which is nearly 33 percent in inflation-adjusted terms.

But the rest of it did not happen. Large numbers of people did not lose their homes. If anything, the drop in prices allowed a lot of families to buy their first house or trade up to one that they never could have afforded in the 1980's. You may know one or two people like this, and they probably still annoy you by bragging about the great deal they got.

He goes on to discuss how tax policy has played a role in fueling these rising housing prices:

So there is a good argument that society has a compelling interest in keeping house prices from getting too high. Reasonable prices allow young, middle-class families to buy a house without going into too much debt. They also let people live where they want. Right now, there are a growing number of workers making long commutes from places like Hagerstown, Md., and Stockton, Calif., solely because they cannot afford a decent-size house in a close-in suburb.

They can blame our tax policy for part of their plight. It pushes up home prices by handing out $80 billion a year in subsidies for home ownership, mainly through the mortgage interest deduction. People who get that deduction love it, for the same reason that any of us would love a government policy that sent us a few thousand dollars every year.

But there really is no sound argument in favor of it. It overwhelmingly benefits well-off families who would buy a home even if it didn't exist. About 70 percent of tax filers get nothing from the deduction, in large part because many don't make enough money to itemize their tax returns. Consider that other countries without the deduction, like Australia and Britain, have home ownership rates just as high as this country does.

To read the full text of the article, click here. (Registration is required for NY Times online access)

While reform of the mortgage interest deduction may be appear to be a long shot to some, these points made by Mr. Leonhardt on the economic costs of the mortgage interest deduction need to continue to be made, especially as the status of the housing sector continues to receive close attention by media, investors, and current and prospective homeowners.

But it is also interesting to ponder what could happen with regards to tax policy at other levels of government should the housing market stumble. One likely consequence that has not been discussed closely is that local governments that rely heavily on property tax revenue (like school districts) could be put in a revenue bind should prices, and thereby assessments, fall. Let's hope most districts understand the possibility of this future budget trouble in their current spending decisions.

For more on housing and tax policy, check out a recent Tax Foundation piece that puts a face on the home mortgage interest deduction. Also, check out our previous blog posts here, here, here, here, here, here, here, and here.

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