The New York Times

November 17, 2005
Economic Scene

An Opportunity to Consider if Homeowners Get Too Many Breaks

THE President's Advisory Panel on Federal Tax Reform struggled long and hard to come up with some economically sensible and politically feasible ways to reform the tax code.

The report, available at, offers several interesting ideas. Some, like simplifying the crazy quilt of tax-deferred savings plans, are relatively noncontroversial. But proposals like eliminating the federal deduction for state and local taxes are much more contentious.

In the next few years, however, more and more families will be forced to pay the alternative minimum tax, which also limits deductions for state and local taxes. The panel's recommendation in this area may yet turn out to be the lesser of two evils from the taxpayers' point of view.

Certainly the panel's least popular suggestion is to limit the mortgage interest deduction. Under current law, homeowners can deduct interest on mortgages of up to $1.1 million, but the panel proposed that this cap be significantly reduced and that the deduction be replaced with a 15 percent tax credit.

A change of this sort would probably have a significant impact on housing values, particularly at the high end, and therefore would be unpopular with homeowners. Neither party wants to alienate solid middle-class voters, so this suggestion has not been greeted with enthusiasm in Washington.

But many economists would argue that the panel's proposal does not go far enough. It would make a lot of sense to eliminate the housing mortgage deduction entirely. The truth of the matter is that housing is highly subsidized in this country and we would probably be better off if the tax treatment of housing were brought more into line with that of other assets.

How is housing subsidized? Let me count the ways. First, there is the mortgage interest deduction. Second, the deduction for property taxes. Third, the capital gains exclusion, which allows couples to exclude $500,000 in capital gains as often as once every two years. Fourth, the deduction for points on mortgage loans. Fifth, the deduction of up to $100,000 on home equity loans. And there are many more tax breaks, among them home office deductions.

There are also more subtle ways that housing investment is favored by the tax system. The most fundamental subsidy is that homeowners are not taxed on the implicit rent they receive from their housing investment. Think of it this way. Suppose you buy a house outright, so there is no mortgage to complicate the analysis. If you rent the house out to someone else, you owe tax on the rental payments you receive. If you live in the house, you are effectively renting it to yourself, but no taxes are due on the transaction. Put another way, if you invest $500,000 in the bank, you have to pay taxes on the interest you earn. But if you invest $500,000 in a house, which you live in, you don't have to pay taxes on the rent you save.

True, you have to pay a local property tax on your house's value. But property taxes are used to support local services like schools, roads and fire departments, which also enhance the value of a house.

Effectively, when you buy a house you are purchasing a bundle of local services, and the price you pay for these amenities is your property tax.

Sure, homeownership is a good thing from society's point of view. Areas with high rates of homeownership tend to be good places to live - but it is hard to disentangle cause and effect in such statements.

Even if one thinks that homeownership deserves some subsidy, does it really deserve as much as it gets?

An excessive subsidy on one asset means that less will be invested in other assets. The money put into building those huge villas on the hillside could have been put into factories, office buildings and schools. Investment in physical capital and human capital makes the economy as a whole more productive, unlike investment in housing.

Given the huge subsidies to housing, it is likely that we as a country have overinvested in this area. Cutting back some of those subsidies would be good economic policy.

That being said, I hasten to add that this is unlikely to happen anytime soon. People have put substantial amounts of their wealth into housing in large part because it has been so highly subsidized. The housing tax subsidy has been built into housing prices, to some degree, and cutting back could lead to painful capital losses on home values.

If you give a lollipop to a baby, it may make him smile, but you will pay dearly for that smile if you try to take the candy away. The best thing to do is to distract the baby with other sweets, while you gradually extricate the lollipop from that sticky hand.

That is pretty much what the tax panel has proposed: it offers reduced tax rates on other forms of investment, along with the mortgage interest credit, to make cutting housing subsidies less painful. Carefully tuned policies of this sort may be a politically palatable way to reduce housing subsidies. But I'm not holding my breath.

Hal R. Varian is a professor of business, economics and information management at the University of California, Berkeley.