Is this the stupidest provision of the U.S. Tax Code?

by anonymous on 1 October 2010 · 6 comments

Two guest posts in one week! On this occasion, the Mule is yielding the soapbox to an anonymous and unqualified cynic who wants to talk about tax (his own words).

House and diceDecline in housing affordability relentless“. So screams the Real Estate Institute of Australia in its latest Deposit Power Housing Affordability Report, and they’re not the only ones. Of course, what they’re really screaming about is the (in)ability of people to purchase their own home – private renters, constituting a mere 25% of households, or social housing tenants at a mere 5%, only very rarely rate a mention. Why? The answer, in part, lies in just how beneficial it is to be part of that home-owning majority. The Australian tax system provides many advantages to the home-owner. The holy trinity of exemptions, in order of their estimated value in 2005-06 Australian dollars, are shown in the table below.

Tax Exemption Value
Land tax Owner occupiers are exempt from state-based land taxes $3.5 billion
Tax on imputed rent* Imputed rent is not taxed, nor is it captured by GST $11.7 billion
Capital gains tax Owner occupiers are exempt $29.8 billion
Table 1: Tax concessions to homeowners

These benefits are designed to encourage home ownership, which is seen as a social good. This argument is typically justified either on cultural grounds (the importance of home ownership to our society, or the centrality of home ownership to the “Australian Dream”) or occasionally on economic grounds, in that home ownership is said to produce positive externalities (for example, children of homeowners may have a higher likelihood of finishing school, or a lower likelihood of criminal behaviour). However, others argue that any social good which is intended by these benefits is undermined by the fact that the concessions are distributed inequitably, with high income households receiving a much greater advantage than low income households. In particular, the capital gains tax exemptions are worth seven times as much to the top income quintile as they are to households in the lowest income quintile. But Australians concerned about efficiency and equity in the tax system might take some heart from the fact that the grand-daddy of all tax concession to homeowners is missing from Table 1: home mortgage interest deduction.

In the United States, mortgage interest repayments are fully tax deductible on up to two homes, capped to a debt level of $1 million. Historically, this deduction was available across all interest repayments. Rising levels of household debt in the United States throughout the 1970s, associated with the rising popularity of credit cards, led to a rethink of the wisdom of interest deductibility. However, the deductibility of housing mortgages remained, ostensibly to facilitate ever increasing rates of home ownership, but perhaps more honestly as a nod to the middle class who had come to think of this deductibility provision as a birthright, as the keystone to the “American Dream” (a dream which is eerily similar, it seems, to the aforementioned Australian Dream). While it is true that home ownership rates in the United States have increased over the past fifty years, it is not clear that this is as a result of this particular tax benefit. Indeed, home ownership rates in the United States are comparable to those in Australia, which has no such concession (although both countries offer similar capital gains exemptions).**

Country 1961 1990 2007-08
Australia 70% 69% 68%
United States 62% 64% 68%
Table 2: Home ownership rates

Many argue that home ownership rates have increased far more substantially as a result of financial innovation and the deregulation of the mortgage industry – although, of course, the net benefits of these innovations are still being debated. In fact, many economists argue that, far from enfranchising aspiring homeowners, tax deductibility of interest is a regressive policy measure which affords a much more substantial benefit to the wealthy than the poor. There are three main reasons for this.

Firstly, the size of the concession is obviously related to the size of the mortgage, and as such wealthier households accrue a greater benefit, in absolute terms. Secondly, the deduction is more valuable to taxpayers in the highest income tax band. Thirdly, the deduction can only be claimed if an itemised tax return is submitted. However, lower income households overwhelmingly fill out a so-called standard deduction, not an itemised one. In fact, while 98% of households with incomes above $125,000 itemise, the figure is only 24% for households with incomes below $40,000, and therefore the remaining 76% would not be eligible to receive the benefit. One model estimates that in 2009, 68% of the total tax change associated with mortgage interest deductions went to the top income quintile, while nearly 90% of the total tax change went to the top two income quintiles.

Even more economists argue most against the mortgage interest deductibility provision on the grounds of its being so expensive. The 2010 United States Federal Budget calculates the cost of the mortgage interest deduction at US$131.2 billion. By comparison, the next largest housing tax expenditure was attributed to capital gains exemptions, which came in at US$49.6 billion. Another potential side effect of this concession is to encourage leveraging at the household level. In its latest Economic Survey of the United States, the OECD argues that increased preponderance of interest-only mortgages was a symptom (if not a cause) of the housing crisis. Interest only mortgages are particularly attractive in terms of the mortgage deductibility, as it makes repayments deductible in their entirety.

The Bush administration convened an expert panel to develop tax reforms, one of which was a proposal to change the home mortgage deduction to a 15 percent credit and making it available to all filers, regardless of itemization status. This was immediately rejected out of hand. The Obama administration more recently suggested that home mortgage interest deductions would be capped at 28%. However, commentary on this proposal suggests it has failed, although everyone appears more  focused on the politics of such a measure, not the economics.

It seems that this is yet another example of “Murphy’s Law of Economics” – the overwhelming weight of expert opinion is no match for the American Dream. Must we, then, accept that this is an instance of the truism of tax concessions, which is all too apt when one is talking about the family home: that they are easy to introduce, and near impossible to repeal?

* A renter has to pay rent from income that is taxed, but the homeowner does not. It can be argued that the homeowner effectively earns an income from their property, in that they pay an “imputed rent” – to themselves. This effective income is not taxed, although some would argue that it should be.

** A limited home mortgage deductibility scheme was part of Gough Whitlam’s “It’s Time” package. It was designed as a response to rising interest rates, and was specifically targeted at the lower end of the income scale. As he said in his 1974 policy speech: “All taxpayers whose actual income is $4,000 or below will be entitled to deduct 100% of their interest rate payments. The percentage of total interest payments which is deductible will be reduced by 1% for every $100 of income in excess of $4,000.”

Data Sources: J. Yates, Tax expenditures and housing, AHURI, September 2009; U.S. Census data; Australian Census of Population and Housing

Photo credit: Copyright creative commons by woodleywonderworks

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{ 6 comments… read them below or add one }

1 An Anonymous Zebra October 1, 2010 at 8:34 am

Anonymous post on taxation. I sense a Trojan horse.

2 Stubborn Mule October 1, 2010 at 8:39 am

Anonymous to the world, but I know exactly who he is. Just web-shy perhaps.

3 An Anonymous Zebra October 1, 2010 at 5:44 pm

Greg Jericho?

4 Stubborn Mule October 1, 2010 at 6:46 pm

Oooooh…..getting close!

5 Mark L October 2, 2010 at 4:40 am

I’m sure if one looks long enough, one can find even more stupid provisions in the US tax code. But anonymous certainly makes a strong argument for the stupidity of this one. The opening point that “housing affordability” should only refer to renters is most welcome too. Nice work, whoever you are.

6 Marco aka Cracticus October 2, 2010 at 11:55 am

Hey Anonymous!

That was an impressive piece. I share all your concerns and then some.

During the 1990s a part of the economics profession (like Paul Krugman) was puzzled by the increasing inequality within the US. See for instance:

The Rich, the Right, and the Facts (The American Prospect, 1992).
http://www.prospect.org/cs/articles?article=the_rich_the_right_and_the_facts

I say one part of the economics profession puzzled over inequality, because the other, larger part, was busily trying to deny any increase in inequality, as Krugman reports in the article above.

But, granted that inequality did increase and that this does matter (more on this below), what would be the cause of such an increase in inequality?

Two answers were possible:

(1) Changes within the US local economy (say, “economic rationalization”);

(2) Changes in the global economy, outside the US (say, “free trade”).

Clearly, these were two extreme positions and most economists would fall somewhere within the continuous.

Krugman, for instance, initially seemed to favor the notion that changes in US economic policy (largely taxation policy) were accountable for most of the inequality. And there were some valid reasons for this, too. (As a side note, your piece seems to fall largely within this category of explanation.)

For an insider’s view of taxation policy-making during the Reagan era, see for instance:

William Greider. The Education of David Stockman (The Atlantic Monthly, 1981).
http://www.theatlantic.com/doc/print/198112/david-stockman

For an abbreviated account:
What Stockman Said. (Time magazine, 1981).
http://www.time.com/time/printout/0,8816,922687,00.html

At the other hand, as a theorist of international free trade (being awarded the 2008 Nobel Prize for said work), Krugman appears to have considered that phenomena associated to international free trade, as practiced in the last half of the 20th century (namely, outsourcing and financial globalization), were essentially irrelevant compared to the presumed benefits of international free trade. Thus, Krugman assumed the role of public advocate of international free trade. For instance, see his pieces:

The Accidental Theorist. (Slate, 1997).
http://www.slate.com/id/1916
(Note: this piece was directed against William Greider, see above, who also opposed globalization).

In Praise of Cheap Labor. (Slate, 1997).
http://www.slate.com/id/1918/

By 2006, however, Krugman’s position had changed considerably, as evidenced by the following two pieces:

The Great Wealth Transfer. (Rolling Stone, 2006).
http://www.rollingstone.com/politics/story/12699486/paul_krugman_on_the_great_wealth_transfer

Trouble With Trade. (The New York Times, 2007).
http://www.nytimes.com/2007/12/28/opinion/28krugman.html

Further, Krugman now seems to find a connection between growing inequality and the US mortgage crisis.

But this comment is already growing way too long!

Just a couple of closing comments:

This debate concerning globalization must certainly be relevant to Australia, given our tendency to follow the US in economic policy. I believe that the implications for Australia are quite clear.

You may be focused on just one stream (albeit an important one) of the problem. Related elements of internal economic policy (a few of which are hinted at in The Great Wealth Transfer) are also important. I would mention inflation targeting and labour market “flexibility”.

Keep up the good work!

PS: If you haven’t read it yet, have a look at Dean Baker’s The Conservative Nanny State.
http://www.conservativenannystate.org/

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