Today's New York Times details how the 1996 presidential election campaign created a capital gains tax cut for homeowners that came back to haunt us a decade later. This is a rare glimpse of how some political necessity and a second best tax policy choice helped fuel the 2005 housing bubble.
In 1996, President Bill Clinton was intent on getting reelected. His opponent, Senator Bob Dole (R-KS), proposed a massive capital gains tax cut, which Clinton felt he needed to counter. As we often say in Washington, "You can't fight something with nothing." So after Treasury Secretary Robert Rubin shot down matching Dole's tax cut, he proffered Clinton a capital gains tax cut limited to the first $500,000 of gain on the sale of a principal residence as a replacement for the longstanding deferral of capital gains tax on the sale of a principal residence "rolled over" into a new home with two year. This seemed like an adroit compromise: replacing one tax break with another that was much simpler without losing much additional revenue. Taxpayers had serious problems proving to the IRS what they had paid for their various homes when it came time to pay capital gains tax upon the sale of the last one decades later. This eliminated most of that problem. However, it created another problem. People flipping spec homes got a big tax break along with that of homeowners. Hui Shan of the Federal Reserve just published an econometric study of that effect. It showed a 13% to 22% jump in the semiannual sale rate of homes studied in the Boston area after the law changed in 1997. It also showed that capping the benefit at $500,000 of gain "locked-in," or reduced the sales of houses with capital gains in excess of $500,000 by 24%. We'll never know for sure how much this tax change contributed to the housing bubble as compared to easy mortgage financing, but this study suggests it had quite an effect. Now we're picking up the pieces from the worst housing crash since the Depression.
Color me skeptical
Being that the housing bubble was world wide – and bigger in countries ranging from Australia and Japan to Ireland and Italy than in the US, if one can believe The Economist -- I have a hard time seeing how it could have been caused by any single factor in the US, Greenspan himself, the tax code, whatever.
(If Greenspan really can drive the world-wide economy like that, maybe we should bring him back and give him marching orders.)
And I think the effect of this one tax break is exaggerated by the Times. It didn’t make “real estate” can’t miss or tax-free, it made only gain on a single home at a time lived in for at least two years tax free. It didn’t apply at all to any of the investment property homes and flipped homes that accounted for a very disproportionately large part of the bubble and mortgage defaults.
Moreover, home sales were effectively tax-free before this break was enacted, in that all gain on a home was tax-free if you bought a replacement home of at least equal value (even if you took the gain on the home sale out in cash), which could be done perpetually -- with $125,000 tax-free on a home sale available after age 55 without buying any replacement home, or if one “downsized” into a less costly one.
The Times says:
People flipping spec homes got a big tax break along with that of homeowners.
But that's just not true -- only homeowners of at least two-years' standing got the break. Or maybe the writer thinks that actually living in a home you own for at least two years before selling it is "flipping a spec home". Though if you did that, you could take your gain tax-free anyway under the prior law by buying a replacement home or being over age 55.
The Times story also notes the law change didn’t lose much revenue compared to the prior home-sale breaks – but ignores the implications of that.
So it’s not like there was no significant tax break on home sales before this. (In fact, the old law's requirement of the purchase of a new home to take home-sale gain tax free would seem to have supported the home-sale market, and the new law dropped it). So it seems to me the effect of the new law on the big scheme of things could be little more than marginal.
If one wants to say that the combined US govt subsidies for home purchases –- loan interest deductions, property tax deduction, gain tax breaks, govt loan subsidies, the GSEs, regulations pushing lending towards low-income borrowers, et.al. –- together cause significant over-investment in housing, I’ll buy that.
But being how long-standing they all are, I don’t see how they all-of-a-sudden created the recent bubble, much less a world-wide bubble bigger in many places outside the US than here. The big cause of the bubble has to be elsewhere.
Tax preferences
I agree with Jim, the tax change just wasn't that important. In addition, there are plenty of other tax preferences--municipal bonds, say--that haven't resulted in bubbles in those assets.
Something else happened about the same time as the tax change, the CRA was changed and aggressively enforced in the name of 'affordable housing' and anti-'red-lining', based on an academically disreputable paper published by the Boston Fed. That's a much more likely culprit.
Color the Tax Policy Center skeptical too.
From its TaxVox blog:
~~~~
Did the Capital Gains Tax Break on Home Sales Help Inflate the Housing Bubble?
No.
... Hui Shan did not conclude that the 1997 law increased housing prices — only sales of houses that qualified for the gains exclusion.
~~~~
It then makes me happy by going on to expand on points I made in my prior comment, with data...
[] "before 1997, almost nobody paid capital gains tax on homes."
[] The pre-1997 tax break generally required investment in a replacement home, which spported home sales, deterred "downsizing" of homes, and caused over-investment in homes. The 1997 law eliminated this.
"How does eliminating that distortion inflate housing prices???"
[] The political point of offering the new tax break in 1997 was that it had very little tax revenue cost -- the Times reported this but ignored the obvious implication.
"the tax subsidy for owner-occupied housing declined by $18 billion. And that inflated the bubble?"
Conclusion: "eliminating a tax that encouraged people to consume too much housing while raising virtually no revenue was a good thing. And it certainly is not a significant factor in the housing bubble."
The Times is my home town "paper of record", but I haven't particularly trusted its reporting on anything for 15 years. It gets the most obvious things wrong, even in page one stories, often in cases where the logic of stories is self-contradictory.
In this case, how was a tax break that costs no revenue to the government supposed to be so valuable to taxpayers that it fueled an investment bubble? That question never occurred to the reporter or editors?
One doesn't have to be an expert to find such howlers in its stories. One prior example of which I had personal experience:
In late 2001, just before the US military response in Afghanistan after 9/11, the Times ran not one but two consecutive Page One stories by its military correspondent doubting that the US people would have the stomach for a fight in Afghanistan in light of the 15,000 dead and "hundreds of thousands wounded" the Soviets had suffered there.
I have no expertise at all about anything military but even I knew that was ridiculous, as a high wounded-to-killed ratio means superior medical treatment for the wounded, the highest ratio in any war ever was like 5-to-1 for the US in Vietnam, and Soviet army care was famously awful -- so the claim of "hundreds"-to-15 seemed absurd on its face.
Via the wonders of the Internet I quickly looked up the facts at mulitple authoritative sources and found the Soviets suffered 37,000 wounded.
Then I e-mailed this correction to the Times with data sources, they promised to print it, and proceeded to ignore it indefinitely -- until I finally sent a last request for a correction that was cc:d to the WSJ and Smartertimes.com, after which they printed a very grudging, waffling one.
Those Page One stories about impending war were a lot more important than this one about a tax break -- and just obviously, even-to-an-amateur factually wrong.
So beware the Times. There's a reason why its stock price is plunging. Murdoch's Post is far more entertaining and just as accurate.
Taxes just magnified the problem
Just another scape goat. The housing crisis was caused by many factors, cheap money/credit being the key one. Taxes just magnified the problem, not created it.
Very interesting article.
Very interesting article. Thanks