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Playing the Housing Blame Game

David Leonhardt|The New York Times
Wednesday, 2 Apr 2008 | 11:08 AM ET

In late 2005, when a panel of tax experts appointed by President Bush came out with a plan to overhaul the tax code, my editors assigned me to see how it might affect the housing market. My first call was to David Rosenbaum, a Washington correspondent for The Times who was writing the main article about the plan.

The year before, at the Republican National Convention, Mr. Bush had talked about the need for tax reform, and after winning re-election, he appointed an impressive bipartisan group to make recommendations. Connie Mack, the former Republican senator from Florida, was the chairman, and John Breaux, a Democrat from Louisiana who had also recently left the Senate, was the vice chairman.

After almost a year of work, the group called for simplifying the tax code with lower rates and fewer loopholes. Most noteworthy, perhaps, the plan would have limited the tax break for mortgage interest on expensive homes — but effectively extended the break to many low- and middle-income families who didn’t benefit from it.

Economists generally hailed the plan. John Snow, the Treasury secretary at the time, said he was optimistic that Congress would enact a version of it. News accounts gave prominent play to Mr. Snow’s prediction.

But my colleague was more skeptical. David, who died in 2006, had the ability to be at once knowing and upbeat, and he cheerfully advised me that day not to spend much time on the report. It had no chance of becoming law, he said, because the White House had other priorities. In the third paragraph of his article for the next day’s paper, he wrote, “President Bush had nothing to say about the report.”

The panel’s recommendations indeed went nowhere. And the willful neglect seems especially unfortunate these days, as Bush administration officials and members of Congress are scurrying to clean up the housing mess. As it turns out, the tax panel came up with an important part of the answer — maybe more important, over the long term, than the new financial regulations proposed this week by Henry Paulson, the current Treasury secretary. Changing the tax code now won’t end the current crisis, but it still makes enormous sense.

The real estate bubble of the last decade had many fathers. Investment bankers stopped worrying about whether borrowers could repay their mortgages. Alan Greenspan, the former Federal Reserve chairman, ignored pleas to crack down on this faith-based lending. Home buyers decided that house prices would soar forever. Real estate agents and mortgage brokers encouraged the fantasy.

Yet the people who created the current tax code — in the White House and in Congress, both Democrat and Republican — deserve some blame, too. They have built a system that treats home purchases more favorably than just about any other form of investment.

The biggest of the government’s real estate subsidies is the well-known and well-loved mortgage-interest deduction. It allows people to avoid taxes on any income that is used to pay interest on mortgages, whether the mortgage is for a primary residence or a vacation home, up to $1 million in combined loan value. “Effectively,” said Charles Rossotti, an I.R.S. commissioner under President Bill Clinton who served on the tax panel, “it encourages people to overinvest in housing.”

On top of the mortgage deduction, the Clinton administration and a Republican Congress added another break in 1997, in the name of encouraging home ownership. The new break essentially exempted families from paying taxes on the first $500,000 of a house’s appreciation after they sold it. So homeowners would not only get a better deal than renters on their annual housing costs, they would also get a better deal on their long-term investment than stock or bond holders (who typically had to pay taxes on all their capital gains). The law encouraged people to flip their homes for a profit, and flip they did.

In the Boston suburbs, houses that had appreciated by up to $500,000 since their last sale began going on the market more frequently after 1997, according to an analysis of local housing records by Hui Shan, an economics graduate student at M.I.T. (Ms. Shan controlled for the general rise in house sales happening at the time.) Bruce Bartlett, a former Republican Treasury official, has pointed out that the law went into effect just before house prices nationwide began to take off, suggesting that it played some role in creating the bubble.

Given all this, the truly amazing thing about these tax breaks is that they don’t actually do much to accomplish their purported goal of fostering the American dream.

The mortgage deduction, in particular, benefits only those homeowners — roughly half the total — who itemize their deductions. These itemizers tend to be upper-income families who would own homes even without a tax break. As James Poterba, an M.I.T economist who served on the panel, delicately puts it, the Jeffersonian ideal of a civically engaged nation of landowners “wouldn’t necessarily lead you to a policy that had the biggest benefits at the higher marginal tax rates.”

Over the last decade, as a result, lower-income families were left to deal with a cascade of rising home prices without the benefit of a generous housing subsidy. Many of these families were receiving meager pay increases at the same time. And many responded — unwisely — by taking out larger mortgages than they could afford. Along with the American economy and the global financial system, they are now paying the price.

The members of the tax panel came up with an elegant solution to this unfairness. They suggested changing the mortgage deduction to a mortgage credit, which would benefit all homeowners regardless of whether they itemized. The panel also recommended reducing the amount of mortgage debt that could receive the full benefit of the credit, to well below $1 million (with regional variation). Why, after all, should someone buying a $500,000 country house get a bigger subsidy than a first-time buyer moving into a $200,000 starter home?

On Monday, while talking with Mr. Rossotti, the former I.R.S. commissioner, I mentioned that the housing crash had seemed to give new relevance to the panel’s ideas, and he laughed. “This is what happens to these reports,” he said. “They get revived years later.”

Sure enough, Barack Obama has called for a new mortgage tax credit to make the tax code fairer. Politics being what they are, he hasn’t proposed a cut in the current deduction, but his idea still represents progress. John McCain has arguably gone further, saying that as president he would want to send Congress a tax plan along the lines of the Bush panel’s — and then demand an up or down vote with no amendments.

It would be nice if the next version of the plan also got rid of the needless 1997 tax break for house price appreciation. There’s just no reason the government should be encouraging people to invest a spare $100,000 in a bigger house rather than, say, in the stock market, where a company might be able to put the capital to more productive use.

By now, it should be obvious that not every dollar spent on real estate is such a good investment.

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