More Housing Subsidies or Just Bad Tax Policy

February 5, 2009

Much of the debate on fiscal stimulus has focused on whether it should emphasize taxes or spending. The rationale of stimulus is simply that, with the economy faltering, government action is needed to boost consumer demand, which, in turn, will help strengthen the economy. The main reason that some have argued that taxes are superior to spending is that advocates of tax cuts claim that they will get money into the economy faster. Thus, tax cuts will be more effective at helping to boost consumer spending spending. Clearly, this is not a shut and close case. There are arguments and research on both sides, but even one of President Obama’s top economic advisers, Christina Romer, has suggested that the tax cutters may well be right.

That said, the devil is also in the detail – the type of tax cut may matter a lot and some tax cuts may make matters worse, not better. Consider several proposals that have surfaced in the last several days. One would extend, enhance and expand the first-time homebuyer’s credit. An amendment offered and approved in the Senate stimulus package now includes a $15,000 first time homebuyer’s credit. Another proposal, put forward by Chris Mayer, Columbia Business School, wants lower government-sponsored interest rates for home purchases to reduce the interest cost of home finance.

These two proposals, at first glance, would seem to be right on target. We have a housing bubble that burst, and that cratered the financial markets. These proposals would help address the rapid and steep decline in housing values. This might address the initial source of the current economic problems. But, further increasing government subsidies for housing subsides may increase the long-term risks to the economy by increasing the imbalances the contributed the current economic crisis.

The problem is not that we have had a rapid and steep decline in housing values, but that we had a housing bubble in the first place: Too many people without the financial means became overleveraged (i.e., too much debt) and were not well diversified (i.e., held most of their assets in housing). When the bubble burst, they were not able to absorb the decline in assets values. The losses were transferred to the financial sector, which, as we know now, also had not been able to absorb the decline in asset values.

Perhaps the last thing that should be done at this point is to further encourage people to stay in homes that they cannot afford. The tax code already has imbedded in it very substantial subsidies for homeownership and debt finance that likely contributed to the current problems.

Consider this: According to the U.S. Treasury Department, the effective marginal tax rate on investment in owner-occupied housing is already close to zero (U.S. Department of the Treasury, Background Paper: Treasury Conference on Business Taxation and Global Competitiveness, July 23, 2007, Table 4.1, page 24). Similarly, the effective marginal tax rate on debt-financed investments is either negative or zero (U.S. Department of the Treasury, Approaches to Improve the Competitiveness of the U.S. Business Tax System for the 21st Century, December 2007, Table 4.2, page 92 In contrast, the effective marginal tax rate on equity financed business investment is roughly 25 percent. What this means is that there is a very large tax bias that favors homeownership and debt finance.

The result is that, just because of the tax treatment, more capital in the economy is held in the form of owner-occupied housing. Also, more investment in housing and investment generally is financed with debt, not equity. The tax bias for debt finance means both households and businesses are more leveraged than they would be otherwise just because of the tax bias. More leverage means that households and businesses are more likely to financial distress during periods of economic weakness. Sound familiar?

Further accentuating these imbalances with additional increases in housing subsides may well be politically popular, but it is likely to expose the economy to further risks in the future. To the extent fiscal stimulus is even a good idea in the first place, it should be about coming up with the best way to boost consumer spending, not worsening the imbalances that contributed to the problem in first place.


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