Somehow, in all my reading of other people’s blogs, I missed Kevin Erdmann, aka, The Idiosyncratic Whisk. My loss. His most-recent post, “Housing policy–please do the opposite,” is excellent. In responding to Robert Shiller’s claim that houses are a lousy investment because, over time, they appreciate so little, Erdmann writes:
You don’t buy bonds for capital gains. You buy them for income. Likewise, you don’t buy a house for capital gains. You buy it for the rent.
Some people do buy bonds or houses as speculative activities, but of course speculation is a zero sum game. That doesn’t have anything to do with whether they are good investments. How can Shiller make this statement? The question is, how much does the house cost, how much would rent be (corrected for homeowner expenses), and how does that compare to alternative investments?
In fact, the fact that home prices in the US have roughly tracked inflation suggests that thinking of a home as an inflation-adjusted bond is a pretty good first step for looking at aggregate home values. There is no way that 30 year TIPS bonds are paying a higher return now than the average rental home is. This has nothing to do with what home prices will do in the next 10 years.
This reminds me of my thinking when my wife and I bought our house in coastal California in 1986. The Tax Reform Act of 1986 was being debated and it was clear that the mortgage interest deduction would stay. But our marginal tax rate would be lower, which would mean that the value of our mortgage interest deduction and the value of our property tax deduction would be lower. My wife and I used every liquid dollar we had, plus gifts from her mom and my dad, to put just a 10% down payment on the house and handle closing costs. Our net worth at the time, including IRAs, was well under $50K, probably close to $20K. If the value of the house fell, we could easily have negative net worth. I was nervous. But here’s how I thought about it: “We’re on an escalator. We just don’t know if it’s an up escalator or a down escalator. If it’s up, we get a nice capital gain. If it’s down, we still have a house that we can live in for a long time.”
Erdmann’s post is chock-full of other insights also. One is about the mortgage interest deduction, which, at one point, but only at one point, he mistakenly calls the mortgage tax credit.
Here’s the part on the mortgage interest deduction that I found most interesting:
Normally, there would be a fear that ending the mortgage deduction would lead to a drop in home prices that was steep enough to cause an economic dislocation. But, real estate credit has been too hobbled for the mortgage interest deduction to lead to higher prices. Home prices are low enough to be profitable for investors, and at least until very recently, cash buyers have been dominant, so if the mortgage deduction was ended now, cash and institutional investors would keep prices from declining significantly.
This could suggest a “grand bargain” a la the Tax Reform Act of 1986: Eliminate the mortgage interest deduction and make it revenue-neutral by cutting all marginal tax rates by one percentage point or by whatever fraction of a percentage point would make it revenue-neutral in a static sense. The big losers from the loss of the mortgage interest deduction, as Erdmann notes, are the upper-income people. So maybe cut their marginal tax rates by double the amount that the government cuts marginal tax rates for others. So, for example, if someone at the 15% bracket gets a cut to 14.5%, someone in the 39.6% bracket gets a cut to 38.6%.
I guess, looking at the above, you could call this a “medium bargain.”
READER COMMENTS
LD Bottorff
Dec 28 2014 at 2:21pm
Try suggesting that we get rid of the mortgage deduction, and I suspect that you will get a lot of resistance similar to what you get if you suggest changing Social Security; any change is viewed as bad policy. Regardless of the details, any suggestion that we change the Social Security program for future beneficiaries will be heard as a threat to the benefits of current beneficiaries. Any proposal to eliminate the mortgage deduction will be seen as a threat to increase taxes on the two-income middle-class.
Mike Hammock
Dec 28 2014 at 2:49pm
David, if you haven’t listened to Planet Money’s fake candidate focus group test, you should do so. One of their fake candidate’s proposals is to eliminate the mortgage interest deduction. It did not go over well.
On the other hand, he didn’t pair it with a proposal to cut income taxes.
Kevin Erdmann
Dec 28 2014 at 3:01pm
Thanks for the kind words, David. And the edit.
David R. Henderson
Dec 28 2014 at 4:49pm
@Kevin Erdmann,
You’re welcome, Kevin.
@Mike Hammock,
Right. It’s hard to get rid of a tax deduction without some offsetting tax benefit. Of course I, being an economist, paired two reforms both of which would reduce deadweight loss.
Mike Hammock
Dec 28 2014 at 7:00pm
You should still listen to the Planet Money story, though, as it is both interesting and amusing. Actually, based on the responses of the people on the panel, I’m not sure that even a tax cut would have persuaded them, but hopefully I’m wrong.
Jon
Dec 28 2014 at 7:08pm
David, the reluctance to drop the mortgage deduction is tied back to income being a meaningless concept. Remember, it used to be that any interest payment was deductible as the investor payed income tax on interest payments. We have now a definitional inconsistency which places a double tax on capital other than housing.
We should be concerned about definitional consistency, otherwise we inadvertently create pigou taxes on desirable activities.
I also read Shiller to be making a different point which is that owner occupied housing is consumption. With no capital gain, households should not treat it as an investment vehicle and should be aware of their consumption choice.
TMC
Dec 28 2014 at 8:34pm
As a homeowner and a landlord it seems to me this would be a bit unfair. I get a deduction for the interest paid on my rentals, and renters enjoy a reduction on their rents because of this. Seems I should enjoy the same.
Kevin Erdmann
Dec 28 2014 at 8:45pm
TMC: You claim the landlord rent as income for taxation. As a Homeowner, you don’t have to claim your implied rent as income. So as a homeowner, you get to deduct the cost of being a landlord but you don’t have to pay taxes on the income.
Kevin Erdmann
Dec 29 2014 at 12:59am
David,
Here is my followup post.
That post expands on a point I have made that touches on your description of your own home purchase. The narrative that blames recent economic problems on middle class income stagnation, and that uses increasing household debt as evidence, is terribly wrong. As with your home purchase, mortgage debt is associated with saving. Living in a house is consumption. But buying the house is saving, and with our conventions regarding real estate ownership, that saving is usually associated with a large amount of debt. Growing household debt is a sign of an aspirational middle class which is prudently engaging in a complicated set of financial transactions aimed at pre-paying rent using today’s abundance. Here is an earlier post on the issue.
ThomasH
Dec 29 2014 at 10:48am
Making the mortgage interest deduction into a partial tax credit (as other deductions ought to be) makes more sense as it channels more of the subsidy to lower income taxpayers, many of whom do not get any benefit from it and other deductions because of the standard deduction. If we had a progressive consumption tax then the principle paydown portion of the payment would not be taxed.
GU
Dec 29 2014 at 11:43am
I always get a kick out of people claiming that home prices would drop if we eliminated the mortgage interest deduction, ergo we shouldn’t eliminate it.
Another way of looking at it is: (1) home prices are artificially inflated due to the mortgage interest deduction; (2) this makes it harder for first-time home buyers to afford a house; and (3) the mortgage interest deduction is not justified in any case because the imputed rent isn’t taxed; therefore (4) we should get rid of the mortgage interest deduction as a matter of fairness, most of all for first-time home buyers.
The focus always seems to be on the sellers (who are usually older and wealthier), but the buyers matter too.
David R. Henderson
Dec 29 2014 at 1:30pm
@GU,
I always get a kick out of people claiming that home prices would drop if we eliminated the mortgage interest deduction, ergo we shouldn’t eliminate it.
In case you didn’t get it (and I’m not saying you didn’t) the argument Erdmann is making is more interesting. It’s that, putting aside the other issues that you address, right now the mortgage interest deduction is NOT keeping home prices much higher than otherwise. That’s at least what I found interesting. I agree with you that even if getting rid of the mortgage interest deduction would cause house prices to fall, we should get rid of it (and I say this as an owner of a house). But Erdmann’s point is that right now is an especially opportune time to eliminate it because one source of opposition will be muted.
Kevin
Dec 30 2014 at 9:31am
Does Erdmann have convincing evidence that backs up his assertion that the mortgage interest deduction is not keeping prices materially higher than they otherwise would be? I clicked through and didn’t see any. It’s an interesting possibility, although his use of the word “dominant” instead of the more relevant “marginal” in the paragraph you quote invites concern that he may just be musing.
These are nice discussions because they surface the strange stuff people feel entitled to – in this case a right that a policy nominally installed for social engineering purposes by a capricious government never be changed.
GU
Dec 30 2014 at 10:39am
@D Henderson,
I noticed that, and if it’s true, even better. Admittedly, I used your post/Erdmann’s post to go on a little rant of my own.
But I’m skeptical that housing is underpriced right now. It’s not merely the mortgage interest deduction which artificially inflates the price of homes–access to credit does so as well. In a world where mortgages were strictly forbidden, the price of housing would come tumbling down, since people would have to pay in full and would not want to wait 20 or 25 years to save up for a house before moving in.
The housing market of the 2000s to which Erdmann wants to return featured mortgages with little or no down payments required. I believe that state of affairs contributed mightily to the run up in housing prices. In the no mortgage world, a person might have to save for 10 years in order to purchase a $100,000 house. In a $0 down payment/100% mortgage world, the same house is available to you now, except that it costs $300,000 (plus interest).
Requiring a significant down payment, say 20%, limits buyer demand by limiting the number of potential buyers, which lowers housing prices. No or low down payment mortgages have the opposite effect. It seems to me that “increasing access” to the housing market simply means “increasing the debt load of the middle classes.”
Banks are already loosening mortgage standards again, which is in their best interest, because it will raise prices, leading to higher mortgages and more interest income therefrom. They’re not worried about another bubble–they know they’ll be bailed out, and even if they aren’t, management will cash out before the smoke clears.
So I’m not very sanguine on “easy” mortgages for personal residences, but still agree that the mortgage interest deduction should go.
Kevin Erdmann
Dec 30 2014 at 3:40pm
GU,
Why stop at housing? Maybe we should require investors to post a 20% down payment on all assets. You want to own some Microsoft? First, save up $100 billion for a down payment.
Since we don’t require this, does that mean that stocks are overpriced?
Harold Cockerill
Dec 30 2014 at 7:05pm
I’ve been building houses for about forty years and, at least in the northern Virginia area, for a long time the houses were mostly modest three and four bedroom houses that worked well for the average family. Then there was a change as the government decided that the best thing for America was that everybody should own their own home. Also the rollover rule was done away with and you got a capital gains exclusion on a large chunk of profit.
Houses got bigger and became vehicles for speculation. When poor people couldn’t join in the government made it easier for them to participate. It became discrimination to not lend money to people who probably couldn’t pay it back. How did the government get so smart it knows what kind of real estate investments make sense? People that worked for Freddie Mac who pointed out the risk were fired. Everyone knew that house prices always go up. What could go wrong?
We have an industrial policy that rewards the housing industry. An industrial policy that favors any industry is stupid. Every sector of the economy should be treated the same and let the free market work out the best place for the money to go. And if you put your money someplace stupid and it disappears too bad for you.
I’m not foolish enough to think this policy will ever be implemented.
Bostonian
Dec 31 2014 at 8:52am
The mortgage interest deduction is often singled out as a “tax break”, but it is the inability to deduct non-mortgage interest that is arguably inconsistent with the rest of the tax code. If interest earned increases taxable income, it is reasonable for interest paid to reduce taxable income.
David R. Henderson
Dec 31 2014 at 10:04am
@Bostonian,
The mortgage interest deduction is often singled out as a “tax break”, but it is the inability to deduct non-mortgage interest that is arguably inconsistent with the rest of the tax code. If interest earned increases taxable income, it is reasonable for interest paid to reduce taxable income.
All true. But then the income should be taxed. So it would follow that the mortgage interest should be deductible and the imputed rental income on a house should be taxed.
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