Tuesday, November 01, 2005

Housing Interest Deduction

There will be a pretty good national conversation on tax reform, simplification, obfustacation, and the means to the end of government. Some of it, as Brad DeLong illustrates, is juggling the feet of angels as they attempt to tapdance on the tip of a pin

Here is how the Wall Street Journal describes the panel's home interest rate deduction change:

The panel suggests turning the deduction into a tax credit equal to 15% of eligible mortgage interest, which means the tax break for interest on a $100,000 mortgage would be the same for every taxpayer, regardless of income. It suggests lowering the $1 million ceiling to the size of an average mortgage, using Federal Housing Administration regional data.......

The change would mostly affect only taxpayers in higher brackets with above-average mortgages. Under current interest-deduction rules, a taxpayer in the 35% income bracket with a $500,000 mortgage at 6% in the country's pricier urban corridors can reduce his or her taxes by just over $10,000. By contrast, under the new proposal, that same individual could claim a credit of roughly $2,800, according to Goldman Sachs.

Dr. Polley writes that this will be a fairly good long term change to the tax code as it will discourage overinvestment in housing, which as Calculated Risk at Angry Bear notes is an increasing portion of GDP.

Dr. Polley performs some very simple, back of the envelope calculations with standard interest rate assumptions and asserts that the net present value of the mortgage tax deduction for a top bracket individual buying a $500,000 house is roughly $100,000. Using an extraordinarily simple division, the net present value of the projected change in the treatment of home income tax deductions would be worth $20,000. Assuming that people are completely rational, or at least the market will force people to act as if they are rational, this change will decrease the value of a $500,000 house to somewhat above $420,000 as there will be some upbidding but the haircut is pretty large for someone trying to sell their house at the top of a bubble.

Kash at Angry Bear notes that the US savings rate is negative and has been negative for the past couple of months. More importantly, real income growth, and real disposable income growth has been extremely weak over the past five years. Additionally, what real disposable income growth is occurring is being eaten up by a combination of higher energy prices and increased debt and financial obligations.

Kash notes: "A negative savings rate is only sustainable for a short period of time, and depends on rapidly rising asset prices."

Consumption,residential investment and export growth have been driving GDP growth over the past year as the following nifty chart James Hamilton shows. The tax policy change would have minimal to slightly positive impact on net exports as it should increase net savings by decreasing current consumption growth. However consumption is a much larger component of GDP growth than growth, so this change in tax policy is most likely leads to a reduction in current or short term growth instead of an acceleration.

If this tax policy change is implemented in the next year or two, even if it is implemented with a start date of several years in the future, it will significantly decrease the value of housing as it will be transferring the expected value of the tax expenditure of the deduction back to the federal government and to the general pool of taxpayers including renters. It will also sharply cut into the ability to borrow against home equity as the tax treatment will dramatically reduce non-collatoral equity available. That means this tax change will have significant effects on consumer spending, savings rates and the general economy.

And here is the problem, all else being equal, reducing or eliminating preferential treatment of one particular form of capital investment and consumption streams of primary homes, is a long term good thing. The ideal tax code should not encourage people to over or under investment in particular sectors, and the preferential treatment of mortgages led to an initial overinvestment in housing and now is just a transfer payment to homeowners. However, the short term pain is likely to lead to one hell of a nasty fight and therefore no action because there are very few resources available in the federal budget to sugar coat some of the pain which will be concentrated on the individuals who own homes today and want to sell them in the post-change environment.

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