I’m very confused. I’m not following how making investment decisions based on tax avoidance is bad. Of course a good financial adviser would cover tax benefits before someone makes an investment – why do you think some people put their money toward traditional IRAs, Roth IRAs, 401ks, or common mutual funds? Unless you misspoke, I can’t see how it is a mistake for someone to consider the tax benefits before choosing to put their money in a Roth IRA as opposed to investing in a mutual fund.
What’s more, a house isn’t purely an investment – it’s also a place to live. I don’t think anyone has ever said that the mortgage interest deduction is reason enough to buy a house, but that is one of several factors (ya gotta live somewhere, building of equity, opportunity for appreciation, etc) that may incentivize people to make that investment.
And apparently I’m really not following what you mean by “distort the market.” (Or for that matter what you think is a strawman.) I asked an honest question – why do you consider the interest deduction to be a distortion, but zoning laws are not? I take it you mean that the deduction creates a market for housing that is not economically sustainable (hence “distortion on markets” rather than “impact on markets”). I’m not following why a deduction on interest is more disruptive than any other government policy that impacts the housing market.
I’m not zamboni racer, but I consider a tax provision that causes investors to choose an option they wouldn’t have without that tax, a distortion of the market. In the absence of either a tax on interest received or a mortgage deduction, then it’s a wash whether you pay off the loan with your savings account at the same percentage rate. If you tax interest received but not allow interest paid out to be deducted, that’s a distortion.
Yes, all interest was deductible, when the income tax was designed in …1894 (and overturned by the Supremes) and 1913. This was before credit cards. Heck, this was before consumer credit which arose in the 1920s. Congress had businessmen and farmers in mind. Most bought homes with cash, until the 1930s when Fannie Mae was created.
So the mortgage deduction is a pure historical accident.
Tax reform in 1986 put an end to deducting credit card interest and other consumer loans: the mortgage deduction was capped: “Today, a taxpayer can deduct the interest on mortgages worth up to a total of $1 million on his or her first or second homes. Also, you can deduct up to $100,000 on a home-equity loan. (And what prevents you from using a home-equity line to buy a flat-screen TV and then deducting the interest? Absolutely nothing; go for it.)”
In this century, the tax reform committee appointed and ignored by our Dear Leader wanted to swap the deduction for a 15% tax credit, phased in over … 5 years. Although that seems short, I’m willing to go with it since the experts quoted in the article are pretty smart, in my view. The maximum credit would be capped and would only apply to principle residences, not summer homes.
Howls of protest emanated from the real estate lobby. Apparently luxury homes have fat margins.
What would be the effects of such a plan? “Though no one knows, a plausible estimate is that prices at the upper end of the housing spectrum would fall by 10 to 15 percent. Prices of less expensive houses would probably rise a bit, because people who don’t get a break now would get the tax credit and thus could spend a little more.”
Yeah, but I can jam all those policies into an externality framework, with ease (R&D) or with difficulty (growing the proper crops such as sugar beets, rather than carrots. This one might take a while.)
More seriously, some of these policies are exercises in the art of the possible: we can’t tax carbon or adjust fuel economy standards --heaven forbid!-- but we can shower some tax credits on hybrid buyers. So let’s do that.
Still more seriously, I think I could make an economic case for R&D (positive externality) or sin taxes (following JS Mill). I’ll note in the last case that while governmental tax subsidies tend to entrench protected commercial interests, at least higher taxes depend upon broad rather than narrow appeals.
But here is what I’m not following: folks are throwing around the term “distortion of the market” like it is the worst thing that can possibly happen. But 401k’s and various IRAs use tax policy to encourage someone to make an investment, but surely nobody is going to say that we have to get rid of those schemes? Gasoline and cigarette taxes distort the market for those items. Payroll taxes and the minimum wage distort the market for labor. All this simply means that it is impossible for the government to tax or regulate anything without having some kind of impact on markets, but one can’t win an argument buy throwing out the term “it distorts the market!!” without explaining why the distortion is undesirable.
Distortions of the market are absolutely bad when government action creates a situation when the economics of the market are unsustainable – like if the government decreed that gasoline shall cost 50 cents a gallon, so when supplies run short and the price cannot adjust to limit demand, we face shortages rather than higher prices. That’s a bad distortion of the market. But seeing as how we’ve had the home mortgage interest deduction for the better part of a century and the housing market (taking into account the inevitable ups and downs) doesn’t seem to be destabilized or unsustainable or even at-risk because of the deduction, I’m pleading for someone to explain why this distortion of the market isn’t something that is actually a good thing.
Ravenman, I agree that the mortgage deduction hasn’t destabilized the market, but I’m arguing that the deduction is in place so that the market here not be distorted. Removing it would be a distortion. Read my previous post for the explanation why.
You’re right that we frequently distort the market to encourage certain behaviors, and they often are good things. I don’t see how eliminating the deduction would be a worthwhile goal, so would prefer that we not distort the market in that case.
Obviously to really figure out if the house was a good investment, you have to compare the mortgage payment against a rent payment for a comparable house. It is very likely that the mortgage payment would be more than comparable rent. Then add the time-adjusted value of the difference each month to the down payment to determine the total invested.
Odds are that you’ll find that the house isn’t a particularly stellar investment. Historically, houses have returned < 1% annually, adjusted for inflation.
Certainly for the first few years, but rents tend to drift upwards. If you ask somebody who bought their house 20 years ago what their monthly mortage payment is, I would expect that it is usually a lot less than what it would take to rent a comparable house.
You also need to take into account expenses associated with the house, tax deductibility of mortgage interest, etc.
Yes, but any proper comparison takes into account the amount that investing the early difference would make during the early years. I’ve played around with spreadsheets a bit, and depending on the assumptions you make, it’s reasonable for either the buyer or the renter to come out ahead in the long term. I keep meaning to take my spreadsheet and put it up on Google Docs or something, but I haven’t done it yet.
Absolutely.
Robert Shiller’s Irrational Exuberance. An excerpt:
I suppose that part of the advantage of buying is that it’s a bit of a forced savings program. Certainly if you look at people who bought 20 years ago, they seem to be doing pretty well.
That’s interesting. Anyway, 0.4 percent per year over inflation is not a terrible return considering that you can leverage the return and you get a place to live as part of the deal.
According to a web search, the current rate of inflation is about 3 per cent.
So if you buy a house for 100k and inflation stays about the same, from Shiller’s estimate you can expect it to be worth about $140k ten years later. If you had put 20k down, that means your rate of return is approximately 11.5% per year. Not too shabby.
One other thought on “distortion of the market.” The lease-buy decision would be distorted, since (if the mortgage deduction were eliminated) a landlord could deduct the interest on his loan, but a private person couldn’t.
This would skew the market towards leases (which has already happened to a smaller degree with cars).
Hovering in the background is a framework presented in introductory and intermediate microeconomics.
Actually, there are those who oppose all of the policies that you have mentioned (except I admittedly have not come across an anti-401K argument).
Here’s one rather abstract presentation. You grow carrots and sell them for a buck. I buy them. In this example, If you sold them for $2 I would buy only a few; at 50 cents I buy twice as many as I do at $1.
The idea is I get diminishing utility from each additional carrot purchased. In contrast, the farmers face increasing per unit costs (at least over the short run) when growing carrots, as they need to plant on increasingly marginal land.
In my example $1 represents perfection: for the last carrot purchased my additional joy exactly equals the additional costs faced by the farmer – at the “Equilibrating price”, that is.
Enter the mean old government who taxes carrots at 20%. If this happens mutually beneficial trades can’t be made. They are blocked. I’d like to buy carrots at $1.10; the farmer would be glad to sell them at that price. The fact that such trades can’t be made lowers public welfare.
I’ve simplified. If this were a respectable argument I’d emphasize relative prices: carrots vs. onions say. And I wouldn’t directly compare consumer utility with production costs. We would see that a tax on carrots was as an artificial burden on carrot farmers and a boon to onion growers.
Back in the real world, benefits of the interest deduction accrue to higher income groups, since they are in a higher tax bracket. So somewhat luxurious houses receive a tax subsidy: investment dollars follow.
Somewhere, there’s an individual choosing between putting his savings into a factory (via the stock or bond market) or into a ski condo. Tax subsidies can tilt the decision away from the equilibrating outcome, which (via various theoretic prestidigitations ) is implied to be optimal. (Sort of. The theory of the second best notes that even the most sophisticated version of the above argument is bogus anyway. At that point, we turn to the sort of arguments that Sam Stone articulates. Alternatively, we do a careful empirical study.)
I suspect its a cheap shot at “the middle class” - between the cap on deductions and the high probability of hitting AMT “the rich” doesn’t often get a mortgage deduction currently - especially if your state tax bill is high.