Perverse satisfaction?

Today's New York Times notes that a tax break for homeowners, enacted in 1997, may have contributed to the housing bubble that (coupled with pathological defects in our financial markets) did so much to bring us to our grim current economic situation.

Specifically, Congress in 1997, acting at the behest of President Clinton, provided that up to $500,000 of home appreciation would be tax-free on sale. Clinton was practicing silly but no doubt poll-tested populism, boasting that, due to the rule, middle class Americans would never again face capital gains tax on their homes.

Now let's roll the tape forward 11 years. According to the Times:

"[M]any economists say that the law had a noticeable impact, allowing home sales to become tax-free windfalls. A recent study of the provision by an economist at the Federal Reserve suggests that the number of homes sold was almost 17 percent higher over the last decade than it would have been without the law.

"Vernon L. Smith, a Nobel laureate and economics professor at George Mason University, has said the tax law change was responsible for 'fueling the mother of all housing bubbles.'

"By favoring real estate, the tax code pushed many Americans to begin thinking of their houses more as an investment than as a place to live. It helped change the national conversation about housing. Not only did real estate look like a can’t-miss investment for much of the last decade, it was also a tax-free one.

"Together with the other housing subsidies that had already been in the tax code — the mortgage-interest deduction chief among them — the law gave people a motive to buy more and more real estate. Lax lending standards and low interest rates then gave people the means to do so.

"Referring to the special treatment for capital gains on homes, Charles O. Rossotti, the Internal Revenue Service commissioner from 1997 to 2002, said: 'Why insist in effect that they put it in housing to get that benefit? Why not let them invest in other things that might be more productive, like stocks and bonds?'”

I happen to know a couple of people who got into the business of buying fixer-uppers, doing renovation work, and then selling for tax-free capital gain, thus achieving exemption for their labor income. There, at least, there was productive activity - but still distortion of economic choice by the tax incentive.

One further idiotic incentive effect was that, as soon as your home begins to approach $500,000 of appreciation, you have an incentive to sell it immediately and buy a new home for the current market price, so that you can run the exemption from zero all over again. Happily (?), however, that is no longer a problem in today's market.

Whenever something like this comes out about special tax breaks that don't merely create perverse incentives but seriously aggravate major economic problems, I have to admit to feeling a twinge of, well, perverse satisfaction that the rules I spend some of my time studying are at least important. Plus I duly note that the problems come from failure to heed the recommendations (e.g., for a relatively broad-based and neutral tax) that nearly 100 percent of the experts in my field would make. An unworthy sentiment, to be sure, but I'm only human.

Another big example is the role of the tax system in overly entrenching employer-provided health insurance as the dominant mode of provision, to the degree that, while few would advocate building on employer-provided insurance if we were starting fresh, many believe that at this point we need to just accept it as an entrenched feature. Thus, for example, one of the big criticisms of Senator McCain's healthcare plan was that it would have undermined employer-provided insurance without sufficiently putting something else in its place.

The home exemption story is admittedly a bit more complicated than just being a case of stupid Clinton-era populism. Prior to the 1997 enactment, people could generally roll over gain when they sold one home and bought a new one (for at least as much money) within a two-year period. Plus, gains on home sale were otherwise taxable while losses were nondeductible, creating apparent (and some actual) tax bias. The underlying problem is that a "correct" approach would have treated gains and losses symmetrically (leaving aside the issue of taxpayer choice whether or not to sell) when they resulted from market swings, while disallowing recovery only for declines in home value that resulted from home use. Richard Epstein, before he became a libertarian icon, actually wrote an article on this, suggesting that the basis of homes be reduced by depreciation (which would not, however, be deductible since it reflected personal rather than business use), with gain or loss relative to the adjusted basis being equally recognized. That is actually a pretty logical approach, within a standard income tax accounting framework, and the failure to do it, meaning that in some cases properly deductible investment losses were being disallowed, may have helped contribute to the 1997 silliness.

Still, the predominant message here remains: stupid tax breaks interacted with other defects in our economic system to help create the current horrific circumstances we face. It's happened before, and it will happen again.