Arnold Kling  

Thoughts on Housing Policy

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Two Aphorisms... Thoughts on Financial Regulati...

I am getting my thoughts together for a piece on what to do in the long term about financial markets and housing policy. Here are a couple of thoughts on housing policy.

1. Why subsidize home ownership among people who are relatively low on the economic ladder?

2. Why subsidize mortgage indebtedness?

In economics, the rationale for a subsidy is a positive externality. The government taxes me in order to subsidize your actions, because your actions benefit me.

For example, if you own your home, then you may take better care of it, and that may help our neighborhood and raise my property values. So I might want to participate in a program that gives you a subsidy to own your home. But it is worth carefully thinking about how important these externalities are. We have a pretty intensive involvement of government in trying to get people in the bottom third of the income distribution to try buying rather than renting. Are the social benefits of that policy commensurate with its costs?

On point (2), off the top of my head, I cannot come up with any reason to subsidize mortgage indebtedness. How does your having a mortgage loan benefit me? Does anyone have an answer for that? Bueller?

I think that mortgage subsidies emerged pretty much by accident. The income tax deductibility began when hardly anyone paid income tax, and it has been grandfathered in ever since. In the 1930's, government decided to reshape the mortgage market, and that effort evolved into government agencies, such as Fannie Mae, FHA, and Freddie Mac. Fannie and Freddie were subsequently spun out to private shareholders as government-sponsored enterprises, but Congress never let the GSE's forget that they had a "mission" to provide subsidies to low-income borrowers. Whether you blame the privatization or the Congressional pressure, the results were not pretty.

Reshaping the mortgage market away from short-term balloon finance was a good idea. But creating a huge industry built on taxpayer guarantees was not a good idea.

All in all, I would say that the mortgage subsidies have given us systemic financial risk, which is a negative externality. A HUGE negative externality. What it has given us lately is a toxic financial spill, which is very hard to clean up.

I also think that promoting home ownership among low-income households may be something of a negative externality. Home ownership with low down payments poses systemic risk. As I've said before, when buyers don't put down much money initially, their equity has to consist of price appreciation. When prices are rising, everybody can buy. When prices are falling, nobody can buy. Instability is the natural result. If you stick with 20 percent down payments, then the market will not rise as much as it might otherwise, but it will not fall as much as it might otherwise, either.

Instead of handing a low-income home buyer a subsidized mortgage with a low down payment, I'd rather hand the buyer a check to use for part of the down payment. Then the buyer starts out with equity in the house, and we don't pile on so much systemic risk. But before we hand out checks for down payments, we ought to go back and estimate the extent of the positive externality that is involved in switching from renting to ownership.


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COMMENTS (16 to date)
BFH writes:

Quick question: do people lower on the income ladder tend to move more frequently or less frequently to seek employment?

Phil writes:

Mortgages are a way to force people to save -- you have to put away $X every month or lose your home. People with low incomes might be those less likely to save (they might have a higher preference for current consumption, which might be why they're low income). This ensures they put away a certain amount of wealth, and may mean they need less support from others in their old age.

In my experience, people do seem to think buying a house is a sure thing. Some of my friends asked me if I thought they should buy a second house for investment. When I suggested buying a REIT instead, to avoid tenant headaches, they thought I was crazy, because the stock market is WAY too risky. They assumed borrowing $200K to buy a $300K house was safe, but putting $100 non-borrowed money in an REIT was risky.

So there may be a bias among the public for investing in anything other than a house. Encouraging home ownership may be the most effective way of getting low-income people to save.

Of course, whether it's a good thing for low-income people to save more is another question.

Alan Watson writes:

The main positive externality from widespread home ownership that I've heard is that owners are more likely than renters to be committed to social stability, and as a result American society is less liable to serious unrest and extreme politics. I have no idea if there is good evidence to test this hypothesis, but I suspect that financial overextension and failure tends to have the opposite effect.

Handing the home buyer a check to cover part of the down payment might be a more direct way to subsidize ownership, but the precedent of even more blatant wealth shifting by the government would be another huge negative externality on our free market economy. Let's avoid the temptation to jump out of the frying pan and into the fire.

Dr. T writes:

Regardless of any small positive externalities of home ownership, the federal government has no duty, business, or need to subsidize it. If local governments wish to do so for city development and social engineering purposes, that's their call.

Similarly, the federal government has no duty, business, or need to subsidize reproduction. I shouldn't be taxed more for choosing to spend my money on skydiving instead of on child-rearing.

(from a home owning father of two teens)

bjk writes:
The income tax deductibility began when hardly anyone paid income tax, and it has been grandfathered in ever since.

If I'm not mistaken, all interest was deductible up to the Reagan tax reform. Mortgage interest has been grandfathered for the same reason that investment interest is also deductible. If you don't allow a private homeowner to deduct interest at the same rate as a landlord, then the landlord has a clear advantage and renting is in effect subsidized relative to homeowning.

Arnold Kling writes:

bjk,
That is a fair point.

Mercutio.Mont writes:

I am surprised no one has mentioned the simplest negative externality associated with homeowning subsidies: Rising home prices.

Home subsidies let people bid up home prices beyond where they would be sans subsidy. The less homes cost, the more people have to spend on other stuff, so higher home costs are certainly a negative.

Lord writes:

The question is really far more general than that. How does someone else's debt benefit me? There are many ways. It unlocks wealth that is otherwise trapped in assets. It enables expansion of capital intensive business. It enables the debt market which provides another investment vehicle. Many small businesses are actually funded by loans on the proprietor's residence. Much lending would be driven to internal sources and much less money would be made available on the market without it. Borrowing to invest would make much less sense. It would also present another tax avoidance incentive since borrowing on deductible assets would then be diverted towards nondeductible assets. Real property is a productive asset despite assertions to the contrary.

Martin writes:

Suppose a municipal policy will lead to doubling house values but else yield no benefit or damage to current residents of the municipality.
Owners will vote in favor of the policy (doubles rental income), renters against(doubles rent).

If everyone owned, there would be a lot less of opposition by residents to development, even if it had some negative consequences (traffic, ugliness etc) on existing residents.

R. Richard Schweitzer writes:

Deductions from amounts (or valuations)subject to taxation are NOT SUBSIDIES.

To allow a taxpayer to retain more of the taxpayer's own money (by not taxing it away) gives that person nothing additional that was not earned or possesed in the first instance.

Of course, if the premise is that all values and all earnings are derived commonally and not individually, thus belong to the collective - then all that is "allotted" to the taxpayer is a subsidy.

Is the "subsidy" the "services" received via the collective (governments)for which "adequate" or "proportionate" taxes have not been paid? If so, say so.

Bruce Bartlett writes:

All interest was deductable from the start of the income tax in 1913. I assume that is because people in those days didn't borrow except for business purposes. At least through the 1930s, mortgage debt was rare; people usually paid cash for houses. If they borrowed it might have been for five years.

Phil writes:

I wish to disagree with bjk and Arnold -- non-deductibility of mortgage interest is NOT a subsidy to renting.

That's because the implicit value of the worth of the house is not taxable to the owner.

Owner buys a house for $200,000, pays $10,000 interest the first year and receives $11,000 worth of rent. He's up $1000 tax-free (assuming no interest deductibility).

Landlord buys a house for $200,000, pays $10,000 interest the first year, and receives $11,000 in rent. He deducts the interest and winds up with $1000 taxable.

The owner is still ahead.

The interest is deductible to the landlord BECAUSE THE RENT IS TAXABLE. For the owner, if the interest is not deductible, and the rent is not taxable, they cancel out, same as the landlord.

But the owner has an advantage in that (a) any capital gain on sale is not taxable, and (b) any excess implicit rent above and beyond interest paid is not taxable.

The interest deduction is a third, and huge, subsidy to owners over landlords.

bjk writes:

Phil is right that the big difference between a homeowner and a landlord is the tax status of the rent. The implicit or imputed rent is not taxed, and apparently there is a large literature on this, or so I'm told. (The cap gains exemption for gains under $250k is relatively recent).

Phil failed to mention that the landlord gets to deduct depreciation, which the homeowner cannot do.

Second, imputed rent is difficult to wrap my head around. when would imputed rent be taxed? And would imputed rents only be taxed on land but not the house? A house is both a durable consumer good (the structure) and an investment (land). If houses were like cars and broke down after 8 years, presumably you wouldn't have to worry about imputed rents over and above the purchase price.

A better way to solve that inequity (if it is one) would be to allow deduction of rental payments, which is what Massachusetts does.

It's not a simple problem. Milton Friedman suggested a Henry George tax, which is a tax on land only, which would discourage speculation on land relative to the housing stock. The current system seems to promote speculation in land values.

Arnold Kling writes:

Good point, Phil

Phil writes:

Right, depreciation. Forgot about that. Thanks, bjk.

I assume that the depreciation is recaptured as a capital gain when the property is sold? So it's mostly a deduction, but a little bit deferral.

I'm not up on the capital gains deduction (I'm Canadian), but hasn't it always been the case that if a homeowner buys a new residence after selling the old one, the capital gains tax is deferred? I have no idea if landlords get the same deferral.

R Richard Schweitzer writes:

If this is to go on, please define or describe "subsidy," as distinguished from "tax advantages."

The rentier and the "homeowner" have differing objectives, arising from differing motivations. Citations of the differing impacts of taxation on the two serve no purpose of comparison. The economic comparison of the renting to ownership of dwelling may be valid, but not the position of the rentier.

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