Good tax policy

by Russ Roberts on December 19, 2008

in Government Intervention, Taxes

Commenter jwilliams writes in response to my post arguing that the reduction in capital gains on housing in 1997 may have been the decisive event that started the rocketing upward of housing prices that created the mortgage mess and subsequent financial collapse:

What conclusions do you draw from this interpretation?

That the government should not have reduced taxes on home capital
gains? That the taxes should have been decreased more gradually? That
all capital gains taxes should be equal to avoid favoring one investment
over the other?

The latter. You don’t want to tax-advantage one investment over another or you induce a disproportionate flow of capital into that asset. That’s the tragedy of the last ten years that’s hidden. Tax policy and what came afterward caused trillions of dollars (not millions, not billions, but trillions) from China and here and elsewhere to go into building new and bigger houses rather than into more productive assets. It was a colossal mistake approved by a Republican Congress and signed by a Democratic president.

The defenders of such policies usually argue that you want more capital to flow into homes because home ownership creates a good society of responsible individuals. Maybe. Maybe not. But such talk is accepted most readily by those who benefit from the policies.

Ever-increasing home ownership is not the American dream. It’s the dream of the National Association of Home Builders.

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{ 46 comments }

Ike December 19, 2008 at 2:36 pm

Anytime you extract a worm from the can, you inevitably end up extruding more annelid than you intended.

Sam Grove December 19, 2008 at 4:14 pm

But what about spending?

Dave December 19, 2008 at 4:15 pm

I would advocate not just applying the same capital gains tax rate and exemptions to all investments rather than favoring home sales, but also get rid of the mortgage interest deduction as well and give everyone the same deduction whether renting or buying. Why should those who rent subsidize the housing purchases of those who buy?

Keith December 19, 2008 at 4:26 pm

What would be the effect of making the tax benefits of buying a house equivalent to renting?
For those at the beginning of a 30 year mortgage, the payments are mostly intrest and therefore tax deductable. Renters don't get any such benefit, at least not directly. Presumably the landlord's tax benefit it passed on to the renter, so that he gets an indirect benefit.
Since rent and mortgage intrest are not the same thing, there is no reason to think that they should be taxed the same way, but from the consumer's perspective rent and mortgage payments are very similar.

Russ Wood December 19, 2008 at 4:28 pm

Russ,

You may recall that I commented at Econtalk.org and highlighted this tax change as the driver of housing following your talk with Professor Shiller.

I think the 1997 tax cut for housing was a powerful incentive, and that the first and most important conclusion to be drawn is the simple but often overlooked fact (eg CBO static scoring) that market participants react to incentives.

I share your support for one level of taxation applied across assets, and not the current system of promoting one over another. However, the 1997 tax change, for all its faults, did have many positives. It did effectively make the captial taxation of housing zero for almost all market participants. As the optimal capital tax is zero, this was a move in the correct direction. Although it favored housing over other assets, that is a result of the capital taxation on other assets remaining too high, not housing being taxed to little. The 1997 law was also a great simplification over the prior system for taxing housing gains. In general, simpler, broad based taxes have higher compliance than more complex schemes.

The 1997 housing capital tax change moved toward a simple, universal, low tax structure for that asset. All of this was positive. The problems you highlight should have been address by improving the capital tax rules for other assets.

I fear your criticism leads to an attitude that we should not attempt to improve the tax system because we can often only make marginal or partial improvements. I disagree. Good tax policy is worth pursuing, even in a piecemeal fashion.

Charlie December 19, 2008 at 4:30 pm

Just to reiterate, if I asked you in 1997 what the result of the new law would be, you'd dutifully say, "There will be more invested in housing than there should be and housing prices will rise relative to other assets," albeit, you would use folksy language. But you wouldn't predict a housing bubble. That is the problem. That is why people are looking towards non-orthodox theories in economics.

Charlie

Oil Shock December 19, 2008 at 4:40 pm
Sam Grove December 19, 2008 at 5:14 pm

So easy credit/money causes inflationary trends, and other policies determine where the bubbles are formed.

Collins December 19, 2008 at 5:57 pm

Are there any estimates of the tax savings from this policy? It would be interesting to compare that number to the TARP funds and other efforts to "fix" the current situation. I realize home sales were higher than they would have been without the policy and this will distort the number but it would still be an interesting comparison.

Mike December 19, 2008 at 6:05 pm

One *important* caveat. Houses aren't like stocks or bonds. If I move from one state to another, I don't have to sell all of my Intel stock and buy Caterpillar. Whereas if I move, I pretty much have to sell my house and use the gains to buy another one.

So imagine I buy a house for $150k. The market goes up. Moving and buying an equivalent house will now cost be $180k. But in selling my old house I lose several thousand dollars into the bargain to capital gains.

I actually this law is OK, as long as (1) you were living in the house for a period of time — as I understand it, that is the case; (2) the money is applied to another house in which you live for a period of time.

Methinks December 19, 2008 at 6:17 pm

The defenders of such policies usually argue that you want more capital to flow into homes because home ownership creates a good society of responsible individuals.

Of course they say that. Home buyers tend to vote for incumbents, it turns out. It makes sense because if you're long an asset, you're short volatility and the election of someone new may bring new policies. I'm willing to bet that most of the people who were defending the tax break were politicians and people with a vested interest in real estate.

Anonymous December 19, 2008 at 6:23 pm

But you wouldn't predict a housing bubble. That is the problem. That is why people are looking towards non-orthodox theories in economics.

People are looking for unorthodox theories in economics because life is messy and not perfectly predictable. There is no solution to that problem and that drives them insane.

Nobody can predict a bubble nor can anyone predict the size of the bubble and when it will pop. That's what's so annoying about bubbles. But, we can say with certainty that when incentives are so skewed, there is a higher probability of bubbles and I'm pretty sure that a lot of people who were not builders, Real Estate agents and politicians were saying just that. In a world where none of us are clairvoyant, the only tool we have to make decisions is probability. Once the decision is made, the outcome will be what it will be and no amount of inflicting unorthodox economic theories on a self-interested public will change that.

Methinks December 19, 2008 at 6:24 pm

The above was mine. Sorry. Typepad is suddenly letting the post go through without a name and email address.

Frederick Davies December 19, 2008 at 7:09 pm

OT: Shouldn't one of you be adding your names to this: http://gopleader.gov/jobs/? Just a thought…

Thanks to Division of Labour for the tip: http://divisionoflabour.com/archives/005424.php

Sam Grove December 19, 2008 at 7:11 pm

Yes, you must either enter all your info, or go to preview, where your information will appear automatically (cookie dependent).

LowcountryJoe December 19, 2008 at 8:23 pm

The best answer is to probably exempt dividends and interest from taxation. This solves two problems: 1) put debt instruments on a more level playing field with real estate 2) creates more people willing to provide loanable funds to the market.

It could solve a third problem if politicians didn't raise taxes elsewhere…starving the beast. One can only dream.

jpm December 19, 2008 at 8:32 pm

Russ's premise is insulting. You don't deserve lower cap gains on homes because if you get them, you will be STUPID!!. This "housing bubble" banter is largely a media myth. ANYBODY can buy a lot and call Lowe's and have plywood, concrete and roofing delivered and assemble a house, Sure, the stupid and lazy have to hire roofers and carpenters) and that is what stops prices from getting out of wack. Not reducing ludicrously high tax rates.

I don't know why russell doesn't write articles for the Jihad times instead of posting his stupid ideas here

It's Friday night. wine anyone?

jpm December 19, 2008 at 9:04 pm

Russ is regressing into the insanity of the left and their hero John Maynard Keynes who said people are just too stupid to be trusted with their own money. The reality of this so called crisis rests with Democrats and their taxpayer slot machines Freddie Mac & Fannie Mae that were designed to pass out money to people who didn't have a prayer or an intention of ever paying it back. They bought all the loans written to those voters based not on equity but fictious income statements and bogus financial statements that under the cirmstances of honest creditors would never heve been made and this is the basis of the "bubble". loans to people that never could pay to begin with buying more than they could afford and the so called "bust of the bubble" is the chickens coming home to roost as there was a distorted demand and spike of supply of an asset for something people wouldn't buy under legitimate circumstances in the first place.

And people like Russ use this fraud as an excuse to bilk people of their earnings under the guise that now they can't be trusted with it.

Juan C. de Cardenas December 19, 2008 at 9:38 pm

jpm, That's not what Russ is saying. This should be a textbook example of the unintended consequences of distortionary tax policy or in other words, using the tax code for social engineering. I don't think people were stupid just for taking advantage of this opportunity, many make a lot of money while the bubble lasted, the stupidity was not realizing what was going on and keep carrying on an on by piling on debt until the bubble burst. Those who had capital to do this without borrowing and keep their heads cool certainly reaped a lot of money.
Now wait for the next round of malinvestments fueled by government policy and subsidies, both direct and through tax policy. Most likely it will be anything "green", especially in the energy sector.

jpm December 19, 2008 at 10:17 pm

Juan, I really don't see tax policy as "distortionary" because you make taxes lower. I do see distortionary when you give massive amounts of money to people under the guise of a "loan" when they, in fact, have no means beyond a sale of the non-wealth creating asset to be held accountable for it. That distorts the price.

Nobody "makes lots of money" on their home unless they own it with the intent of not ultimately living in it but instead flipping it for more than it is worth (or costs to build). People who live in their homes and fully intend to pay for them aren't affected by any so called bubble.

The favorable taxcode, when you get right down to it, does/did nothing for these people. The fact is, the standard deduction is so high and the ceiling for the Alternative Minimum tax so low, that, with the exception of the break of selling your home if you buy another, you get NO break from the tax code.

This is NOT a textbook example of "unintended consequences of distortionary tax policy". My point was, that "distortionary tax policy" is a straw man for the Kensian left, who know that higher taxes are better for the taxpayer and they know this no matter what the circumstances are.

Bubbles are NEVER created because taxes are low. That is just patentedly absurd. You may have surpluses, and you will have more of it, but it doesn't create a bubble. Higher taxes do cause, for all practical purposes, a "bubble" because no matter what, when you tax something, you are going to have less of it for the same effort.

jpm December 19, 2008 at 10:31 pm

Juan, lower taxes don't cause "bubbles". Making loans with other people's tax dollars to people who have non means and no intention of paying it back other than selling it for more than it costs to produce does.

When you consider how high the standard deduction is and how low the Alternative Minimum Tax is, the so called "tax policy" is absolutely of no benefit to people who actually buy their homes to live in them.

the "unintended consequences of distortionary tax policy" is nothing but the straw dog of the Keynsean Left who, no matter what the circumstances, see higher taxes as "better policy".

The fact is, lower taxes don't cause "bubbles"!!! You can have more of it, for the same effort. That is not a "bubble". Higher taxes, for all practical purposes create "bubbles" because for the same effort (price), you WILL have less of the item.

It's the typical leftest pie is only so big mentality that permeates the whole premise.

jpm December 19, 2008 at 10:32 pm

oops My post didn't show up for 10 minutes, so I rewrite it and look what happens!!!

Juan C. de Cardenas December 19, 2008 at 10:53 pm

jpm Nobody is saying bubbles are created "because taxes are low". For what I understand Russ is saying is that the lower taxes on housing RELATIVE to other investment had the effect to focus the bubble on the housing sector. I favored lower taxes across the board without distortions and discriminations in favor or against one asset or the other. And nobody is saying that lower taxes alone created the housing bubble, Russ, if you read carefully in the previous post mentioned four factors, one of them of course Freddie and Fanny. Also when I said some people did make money out of the bubble I was talking about precisely the house flippers, not regulars homeowners like me.

Willabus December 19, 2008 at 11:09 pm

I have been reading this blog for almost a year and this is the first time I have ever felt the need to respond.

JPM:

You do not understand what Russ and Juan are saying. There are many things that added to the housing bubble. The main thing was the Community Reinvestment Act which began the government obsession for housing. The next was the subsequent strengthening of the CRA which further laxed lending standards in the mortgage industry. Affordable housing was further pushed by government by making it tax favorable to OWN a home. The Fed then threw the final fuel to the fire by slashing interest rates. ALL of these things contributed.

Russ and Juan are not arguing for higher taxes. They are arguing for lower taxes across the board. In order for any policy to be in accordance it must meet the conditions of the rule of law…meaning it must not be specific, it must be general. Therefore lower tax incentives (both cap gain deductions and mortgage interest deduction) that are targeted toward a specific activity are in violation with the rule of law. Also because they are in effect an attempt by government to centrally plan society they will have unintended consequences and misdirect resources.

You cannot understand any of this until you have familiarized yourself with the works of Hayek, Mises, Hazlitt, Rothbord, etc. You may want to start with Economics in One Lesson by Hazlitt where he specifically states that the government obsession with housing will eventually lead to malinvestment and readjustment of resources on a grand scale. The last edition of the book was 1978, just after the CRA was passed.

Methinks:

Austrian theory predicts every bubble because government tinkering with the economy leads to unsustainable growth.

Willabus December 20, 2008 at 1:23 am

From Stan Liebowitz's 'Anatomy of a Train Wreck'

"The hypothesis that currently seems to best fit with the evidence suggests that housing speculators were taking out many loans with the hope of a quick and profitable turnover. These housing speculators did not much care about the terms of their mortgages because they didn’t expect to be making payments for very long. But it is clear why they would prefer adjustable-rate mortgages. The hypothesis also is consistent with speculators often lying about their income on their loan applications and taking out teaser rates so they would qualify for larger loans, so they could make a bigger bet on housing. Under this hypothesis borrowers are adults, not witless pawns."

Thus it becomes clear that the elimination of the capital gains on housing would have been a signal to speculators (ie. flippers)to start buying up houses to turn a quick profit.

Again Liebowitz was not arguing that speculators are evil and should be banned,

"But let’s not blame the speculators here. There is nothing wrong with speculation or speculators. At fault is a mortgage system run by flexible underwriting standards, which allowed these speculators to make bets on the housing market with other people’s money. It was a system that invited the applicant to lie about income. It was a system that induced applicants to watch a video instead of providing solid evidence about their financial condition."

To follow up on what Sam Grove said, inflationary fed policy gives the bubble its volume while government fiscal policy directs it to the latest social goal.

Now seeing that the newest fad is 'green tech' and real interest rates are once again zero it would not be too big of a gamble to say that the next bubble will be in this area. However government is still trying to make it easier to purchase a home (mortgage rates are at historic lows) so its not too unlikely to have another housing bubble. Maybe we will be fortunate and see two bubbles burst at the same time! (sarcasm intended)

TrUmPiT December 20, 2008 at 6:14 am

I learned in econ class to proffer a pat answer whenever asked what determines the price of anything be it a house or a hoe: supply and demand. This surely holds true, even during a "bubble," otherwise economics professors would have nothing to sell their students or write in their books. The trick in a bubble is to take your money off the table before the bubble bursts. I have noticed that it is the insiders in the housing industry who did much of the cashing out, while the common greedy man (homoeconomicusavariciousness) was left holding the bag after "market discipline" corrected things back to a sustainable level. The same thing happened with the tech bubble, where most of the rich ceo/owners knew when to cash out their billions. Milton Friedman loved market discipline over his owned wife (everything was private property to his way of thinking). He had no problem with the Enron and Worldcom scandals. Market disciple would weed out the bad guys, OVER and OVER again. The Madeoff with 50 billion scandal is just the latest undiscipled example. Any system that has repeated failures is a failure itself and must be remade. Milton Friedman didn't get it, rest his soul. He was too busy marveling at how a pencil gets made.

JC December 20, 2008 at 7:56 am

Russ- you are wrong. Your commenters talking about the problem being people able to buy homes they can't afford is right (along with interest rates, Fannie/Freddie, Community Reinvestment Act, etc.)

IT DOESN'T MATTER IF HOMES RAISE IN VALUE BECAUSE OF A TAX BREAK!!!!!!

THE PERSON BUYING THE HOME FROM SOMEONE CASHING IN ON THE TAX BREAK SHOULD BE ABLE TO AFFORD IT. POINT BLANK.

IF NOT, THAT IS THEIR OWN PROBLEM.

The reason that we have so many problems is that government spits out never-ending propaganda promising that it will take care of its people financially.

What have we gotten from trusting the government with our money?

Social Security? GET A CLUE
A stronger dollar? GET A CLUE
A balanced budget? GET A CLUE

This is absurd.

Chuck E December 20, 2008 at 9:29 am

Keith wrote:
For those at the beginning of a 30 year mortgage, the payments are mostly intrest and therefore tax deductable. Renters don't get any such benefit, at least not directly. Presumably the landlord's tax benefit it passed on to the renter, so that he gets an indirect benefit.

No. Not even in principle. Consider these two hypotheticals:

1. I buy a 200k house with an 5% interest-only loan. I pay 10k/yr in interest and write it off so that my effective payment is only, say, 7k/yr.

2. A landlord buys it and rents it to me at cost. So he pays 10k/yr in interest. He charges me 10k/yr. He has 10k in income and 10k in expenses, so they net out for tax purposes. He can't just charge me 7k! If he did, he'd lose 3k, which he could write off, but he'd still be in the red.

So there's no way I can get the tax benefit to pass through.

The tax break benefits homeowners relative to renters. No two ways about it.

LowcountryJoe December 20, 2008 at 10:20 am

Odds are that if you've purchased — and are paying on the note of — a $200K house, the interest deduction that you'd be able to take will not even be enough to reach the standard deduction that's offered.

Also, can one even take the home interest deduction on a residence that's being rented out to another family?

Sam Grove December 20, 2008 at 1:27 pm

Presumably the landlord's tax benefit it passed on to the renter, so that he gets an indirect benefit.

No, rents are determined by supply and demand, the market. Even people who own their property outright, if they are renting it out, would charge the market rate.

Sam Grove December 20, 2008 at 1:29 pm

I have noticed that it is the insiders in the housing industry who did much of the cashing out,

Excuse me, have you any citations here?
The bailouts are going to who?

The Albatross December 20, 2008 at 4:10 pm

No single explanation for the housing bubble—fiddlesticks!
I love the NYT and their continuous assertion that the regulators were asleep at the wheel. They were not asleep at the wheel but very busy driving. For thirty years the government has pushed the fetish of home ownership. To be fair, Libertarians have turned a blind eye towards this as it promoted an “ownership society,” which they thought would foster a belief in property rights. Anyway, say you are a bank and some schmuck with lousy credit asks you for a loan. Under normal (unregulated) circumstances you would say no, but you know you can immediately sell this loan to Freddie, Fannie, and Ginnae. They buy the loan and you (the bank) find some other schmuck with even worse credit (or a real estate speculator) to sell a new mortgage to—wash and repeat. Meanwhile, Freddie, etc. package the mortgage into a mortgage-backed security, which they guarantee and sell to investors (usually conservative ones—insurance, etc.). The investors send money to Fannie, etc., who then pass it on to banks—wash and repeat. Meanwhile, the credit agencies see these institutions with the mortgage-backed securities and give them an AAA rating. Why would they do something so foolish? Because they know sed securities are backed by Freddie et al. (and an implicit guarantee from the Treasury) and the underlying value of the asset is the house, which they can (in the worst case recover). Furthermore, the trend for the last fifty years has been for house prices to go up (something echoed by economists) and all this talk of sprawl and zoning restrictions has seriously endangered the future of cheap housing. In short, the credit rating agencies act like clever people who are not complete retards and validate the holdings of the investors (who think they are being conservative) and the latter has then completed the risk-adverse section of their portfolio—you get the point. Ok, so that is the 50,000 foot projection, but let us not forget the interference from other government entities. I shall now devolve into anecdote. When I was in graduate school HUD gave me a loan to buy a home, which I then dwelled in and rented the two remaining rooms out. The thing was that I was a GRADUATE STUDENT with an INCOME of $6,000 a year. HUD knew this and was perfectly happy to give me the loan (this was a Clinton era program for those ergo people out there). The moral of the story is that when you subsidize something you get too much of it, as in a bubble. Those who blame this on deregulation are either liars or have no working knowledge of things like incentives. The amazing thing is that we did not see this coming. My only explanation for this is that we saw the subsidization of housing as a benign eveil, whicg we are paying for now.

Sinclair Davidson December 20, 2008 at 5:20 pm

Owner-occupied housing has always been capital-gains tax exempt in Australia. While housing prices did rapidly rise in the past ten years or so, they haven't fallen as much as US prices have fallen. (The government did introduce a 50% discount to CGT in 1999.) The rise in Australian prices is explained by things like land supply restrictions and the like. A tax-change driven explanation doesn't seem to explain the two environments.

andy December 20, 2008 at 6:55 pm

I don't buy the argument. If you lower the capital tax on houses relative to other assets, the result should be higher production of houses given new tax regime.
The "bubble" could be burst, if you changed the tax regime again (lowering taxes of other assets/reimposing tax gains on houses). Any change in the overall conditions (climate, taxes etc.) reveals some malinvestments that wouldn't have been done if the change in conditions was anticipated.
However, if you just lower the taxes and don't change them in the future, the new investment structure should logically reflect the next structure, however I don't see how it should lead to any bubble?

Marcus December 20, 2008 at 7:09 pm

"However, if you just lower the taxes and don't change them in the future, the new investment structure should logically reflect the next structure, however I don't see how it should lead to any bubble?"
– Posted by: andy | Dec 20, 2008 6:55:48 PM

I think you have to keep it in context with other things which were happening.

Imagine if Congress eliminated the capital gains tax on stocks.

Simultaneously, brokers started offering low interest loans for investing in stocks with no margins required.

Put those together with state government laws which say, in essence, if you get upside-down with your investments you can walk away and stick your broker with the loss.

Would there be a bubble?

Keith December 20, 2008 at 8:31 pm

Consider these two hypotheticals:

1. I buy a 200k house with an 5% interest-only loan. I pay 10k/yr in interest and write it off so that my effective payment is only, say, 7k/yr.

2. A landlord buys it and rents it to me at cost. So he pays 10k/yr in interest. He charges me 10k/yr. He has 10k in income and 10k in expenses, so they net out for tax purposes. He can't just charge me 7k! If he did, he'd lose 3k, which he could write off, but he'd still be in the red.

So there's no way I can get the tax benefit to pass through.

The tax break benefits homeowners relative to renters. No two ways about it.

Posted by: Chuck E | Dec 20, 2008 9:29:56 AM

Chuck E –
I didn't realize that landlords can't get the mortgage intrest deduction on their rental properties. I get it.

Did anyone listen to This American Life's show called Giant Pool of Money? It has a series of interviews with people in the real estate finance business from mortgage brokers all the way up to securities traders. I went into it assuming that the people who bought the securites backed by "liar loans" that required no proof of income didn't know that they were loaning money to people who couldn't pay. The show made the point that the securites were made up of mortgages that had been sorted by the type of credit check that was done. The people making the mortgage loan knew that the homeowner couldn't pay, the middle man knew it, and the investor could have known it if he had looked past the AAA rating. Given that story, I don't feel sorry for the investors who were left holding the bag. Especially since they are apparently "to big to fail" and will be given billons to pad their backsides while they fall on their butts.

TrUmPiT December 20, 2008 at 11:23 pm

Gertrude:

Mozilo's compensation during the United States housing bubble of 2001–06 has come under scrutiny. During that period, his total compensation (including salary, bonuses, options and restricted stock) approached $470 million.-Wikipedia

But I was actually referring to the builders of homes like the billionaire founder of home builder KB Home, Eli Broad. When things got "frothy" in the housing market his company and other home builders were making a mad dash to liquidate their properties. What did they know that you and I, and Greenspan didn't?

Marcus December 20, 2008 at 11:41 pm

"When things got "frothy" in the housing market his company and other home builders were making a mad dash to liquidate their properties. What did they know that you and I, and Greenspan didn't?"

Umm, that things got "frothy"?

andy December 21, 2008 at 5:56 am

Marcus, there would be a bubble but not because of the capital gains tax, but because of those other factors.
For the sake of argument suppose that free banking does not lead to bubbles. Let's suppose the state discouraged banking. No bubble.
Let's suppose the state discouraged banking but at the same time introduced moral hazard. This might lead to some very small bubble.
Let's suppose that the state was indifferent to banking, at the same time moral hazard was in place – this definitely leads to bubble.
Let's suppose no moral hazard was in place and state didn't care about banking – no bubble.

I would conclude that moral hazard leads to bubbles. The same with taxes: it is other governmental regulation that leads to bubble; not the elimination of the capital gains tax. Elimination of the capital gains tax only made the other regulation very "effective"…

Chuck E December 21, 2008 at 7:27 pm

"Chuck E –
I didn't realize that landlords can't get the mortgage intrest deduction on their rental properties. I get it."

Keith, they can deduct (AFAIK) the interest in my example since it's a business expense. But the rent they're collecting is revenue which is taxed. So the two net out.

Net result: No tax benefit to the landlord. Rent = Interest on mortgage.

DCLawyer December 22, 2008 at 11:24 am

Russ,

Thanks for the pointers. One question – didn't the tax break only apply to primary residences, or am I mistaken? Given that a lot of the bad mortgages are focused on rentals and investment real estate (despite the news emphasis on people losing their residences), wasn't the impact of this subsidy lessened (obviously, they compete to some degree and you need to pay more for a rental if bidding against someone who'd use it for a home).

John Townsend December 22, 2008 at 12:05 pm

While I agree with the principle that all capital gains should be taxed equally, remember that the 1997 tax law changed the old treatment which exempted sales of homes entirely from tax provided that it was one's primary residence and provided that another primary residence was bought within 18 months of the sale. In high priced markets this had the effect of reducing the supply of homes on the market because sellers didn't want to be hit with capital gains on the sale amount above $500K. When Bush lowered the rate to 15%, supply tended to be freed up. The point is that the pre-97 total exemption was far more favorable to housing, yet didn't produce a bubble. Why not ? The answer is that the tax rate was a minor factor.

Methinks December 22, 2008 at 2:51 pm

Meanwhile, Freddie, etc. package the mortgage into a mortgage-backed security, which they guarantee and sell to investors (usually conservative ones—insurance, etc.). The investors send money to Fannie, etc., who then pass it on to banks—wash and repeat. Meanwhile, the credit agencies see these institutions with the mortgage-backed securities and give them an AAA rating.

Albatross, you forgot one step! The banks can then own GSE preferreds to meet their reserve requirements and get exposure to the same trash they securitized to get off their books, only now it's laundered through the GSE's and rated AAA. While it's true that more foreign banks owned the GSE preferreds, American banks had plenty of it as well. It was a giant asset laundering operation.

Methinks December 22, 2008 at 6:21 pm

John Townsend,

I don't think that Russ is arguing the difference in tax treatment alone produced the bubble, the argument is that completely eliminating the tax on one asset class but no others contributed to the bubble. How much it contributed is debatable.

Did the pre-1997 tax on the sale amount above $500K apply even if another primary residence was purchased within 18 months? Just curious.

Russ Wood December 22, 2008 at 9:08 pm

Prior to the 1997 law, housing gains were taxed unless you put an equivalent amount or more into another home within a certain time period. I don't recall exactly but I thought the period was 12 months, not 18. So the old law had perverse incentives as well, resulting in more capital flowing to housing at curren or higher levels, yet no bubble. Clearly, more than the tax law change was at work here.

The 1997 law was meant to apply to the primary residence, but the definition allowed it to be used for any residence in which you resided 2 of the 5 years prior to sale.

Sam Grove December 24, 2008 at 2:56 pm

the argument is that completely eliminating the tax on one asset class but no others contributed to the bubble.

Or determines in which sector the largest bubble will appear.

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