Flying beneath our radar last week was a hearing on the tax treatment of debt for both households and business, held by the Congressional Joint Committee On Taxation (tip of the Stetson to Simon Johnson, who testified at the hearing).
We’ll focus here on the report on household debt prepared by the committee — and specifically on the issue of how the tax code favours homeownership over renting. (Interest on mortgage debt is deductible from personal income for tax purposes, as are capital gains of up to $500,000 on the sale of a primary residence. Rent payments are not deductible.)
We were going to say that it’s good to see the issue getting some attention given that the nation’s politicians are presently distracted by the debate over whether or not the country should be economically ruined. But it turns out that reducing or eliminating the mortgage interest deduction is reportedly one of the ideas being considered in the ongoing budget negotiations, according to the Washington Post.
We begin with two charts and a noteworthy conclusion from the report:
This chart shows that the majority of the runup in household debt since the mid-1980s was mortgage-related.
And you get a more detailed view of how the balance sheets of households evolved throughout the period from this table:
Home mortgage debt (including Helocs and second liens) increased nearly eleven-fold between 1980 and 2010, while other consumer credit multiplied roughly seven times, fluctuations notwithstanding.
So it’s not that other consumer credit didn’t rise meaningfully in that same period of time — it did. It’s just that consumer credit started from a much smaller base than did mortgage-related debt and grew at a slower rate.
Mortgage debt therefore was the big culprit behind the steep rise in the household debt-to-disposable income ratio beginning in the mid-1980s. This obviously matters to the situation in which we now find ourselves, at least if you buy the standard balance sheet recession narrative (which we do).
That said, the report is actually somewhat sceptical of how much blame to assign this special tax treatment for the debt binge (emphasis ours):
Though a comprehensive analysis of underlying causes of trends in household debt is beyond the scope of this document, an analysis of economic incentives together with the data in Figure 3 in Section 2 suggests the trends discussed in Section 2 above are not driven solely by Federal tax rules governing debt and interest on debt.
Figure 3 in Section 2 shows an increase in household debt over the last sixty years. The majority of this increase is due to an increase in household mortgage debt and a relatively smaller portion of the increase is attributable to more modest increases in consumer credit.
Over this period, the value of the mortgage interest deduction declined. This decline was partly due to declines in income tax rates. Also, the Tax Reform Act of 1986 and subsequent legislation imposed limits on deductions of interest related to acquisition indebtedness and on interest related to other debt secured by a taxpayer’s home equity. The declining value of the home mortgage interest deduction created incentives for households to reduce their quantity of mortgage debt. However, the concurrent increase in the quantity of mortgage debt appears to indicate that the overall trend in mortgage debt holdings by households is not entirely explained by tax rules over this period.
Similarly, interest deductions on consumer credit were generally disallowed as a Federal income tax deduction starting after 1986. However, Figure 3 in Section 2 shows consumer credit did not decline after 1986. This appears to indicate that the tax rules by themselves do not explain the trends in household debt over this period. While each tax rule by itself creates relatively straightforward economic incentives, the interaction of these rules with each other and with macroeconomic factors leads to more complicated results.
Those macroeconomic factors would include, of course, falling interest rates throughout the period (click to expand)…
… and one might add the supply-side narrative that the start of this three-decade climb in mortgage debt coincided with the advent of securitisation.
Given the interplay of variables, we still won’t rule out that the slope of the rise in debt would have been less steep without the preferential tax treatment for homeowners, but we’ll put that aside for now. (If such a discussion is beyond the scope of the report, it’s certainly beyond the scope of this blog post.) The point here is that the rising debt burdens of the last three decades weren’t just, or even primarily, the result of the tax treatment — that much we accept.
But this is different from arguing that eliminating the preferential treatment towards homebuying is a bad idea. We still think it’s rather a good idea, for reasons the report lays out.
If you want the short version, the tax treatment of mortgage debt …
… is highly regressive.
… reduces government revenues by tens of billions of dollars annually (see below).
… leads to over-construction of houses.
… only succeeds at its stated goal of increasing homeownership at the margins: many households that take advantage of it would have bought homes even without it.
… contributes to excess consumption.
But if you’re not into the whole brevity thing, here are relevant passages from the report (emphasis once again ours):
One study estimates that the mortgage interest deduction lowers the cost of capital for owner-occupied housing by seven percent. Some researchers argue that this creates economic distortions; the subsidized mortgage debt may lead households to demand houses that are larger and more expensive than would be demanded in the absence of the mortgage interest deduction. In markets where the marginal buyer itemizes, this increased demand for larger and more expensive homes leads to a rise in price for these homes above what the market dictates in the absence of the deduction. The mortgage interest deduction may also lower the cost of home mortgage loans relative to other types of debt. Households may increase their demand for owner-occupied housing instead of choosing from potentially higher pre-tax return investments in other sectors. …
Other research questions whether the home mortgage interest deduction serves its intended purpose of encouraging homeownership, noting that the deduction disproportionately benefits high-income taxpayers, many of whom would be homeowners in the absence of any deduction.
Within income groups, the largest benefits generally accrue to taxpayers who have higher loan-to-value ratios, and to those taxpayers purchasing more expensive homes. Table 7 below shows the distribution of tax expenditures for the mortgage interest deduction by income class in 2009. The largest tax expenditures accrue to those households with the highest incomes as they are more likely to own homes, are more likely to itemize deductions, face higher tax rates, and have larger mortgages.
Focus on that middle column for a minute. That’s a $77bn annual loophole we’d be closing by eliminating the deduction. (Well, sorta: it would actually be a bit less than that amount, as elimination would incentivise people to buy fewer and less costly homes.) And it’s a loophole that is mostly exploited by people who make more than $100,000 a year.
There’s more:
Table 8 shows homeownership rates by household income in 2009. Unsurprisingly, homeownership rates rise with household income, ranging from 40 percent ownership rates for households with $5,000 to $9,999 annual income to 92 percent ownership rates for households with greater than $120,000 annual income. Given the fact that homeownership rates are not closer to zero at very low levels of income, this data is again consistent with the notion that younger households borrow when their incomes are relatively low in order to smooth consumption over the life cycle. Because higher income households are more likely to itemize deductions, it is also consistent with the claim that the home mortgage interest deduction disproportionately benefits higher income households.
Got all that?
This is all before we get into the proper role of government in favouring the homeowner constituency at the expense of renters, whether the subsidy encourages suburban expansion at the expense of cities, energy usage — and did we mention the added revenues?
But we won’t go any further here — just thought we’d bring it to your attention.
Related links:
Could tax reform make the financial system safer? – Economix
Consumption conundrums continue – FT Alphaville