Economics of Home Ownership Subsidies

Renters do not benefit from the mortgage interest deduction. Individuals are generally prohibited from deducting interest. Congress has elected to permit deductions for one’s primary residence.

A person renting out a housing unit will not be using it as his or her primary residence, so the mortgage interest deduction will not apply. Instead, the general investment interest deduction will apply. These are two entirely separate and unrelated deductions.

Arnold is right that landlords benefit from an interest deduction. But the real difference is that owners do not pay tax on the flow of benefits that come from living in the house (often called “imputed rent,”) while the cash rent received by the landlord is taxable.

Thus it’s not generally true that “If markets were highly efficient, then high-bracket taxpayers would buy properties and rent them out to low-bracket taxpayers,” because owner-occupiers benefit from the zero tax rate on imputed rent, while landlords do not. (I’m very surprised to see Arnold making this error.)

The externality argument seems plausible to me, but suggests tax breaks by local government, not by the federal government. (The suggested externalities would not, by and large, flow very far.) The externality also would seem to have very little to do with how much of the cost of the property is being financed. Exempting the first $50,000 of owner-occupied property from local property taxes would make more sense to me than allowing the deduction of mortgage interest.

For some reason, I have an awful hard time believing that the mortgage deduction has zero distributional effects.

Interest was deductible from the introduction of the income tax. It was considered income to the lender and an expense to the borrower, and the desire to tax income only once. Should we also make interest nondeductible for business? Why consider that an expense then? As for not taxing imputed income, this is what the property tax does. There are no subsidies that are not incorporated into to the price, so the only effect of a change is to induce a capital loss or gain and what would be point of that?

The federal government subsidizes home ownership through the mortgage interest income tax deduction.

But doesn’t property tax counteract that?

When I see one household paying $16K/year in property taxes on a somewhat modest $400K home vs. another household paying $8K/year in total rent (which property tax is a small part of), I don’t see how government is subsidizing the home ownership.

For a good illustration of the popular view that there are major positive social/cultural externalities associated with home ownership, see the movie “It’s a Wonderful Life.” Such a popular view, articulated while FDR was still president, explains institutions such as the FHA, Fannie, the income tax code, FHLB, and the peculiar structures of the late savings-and-loan industry.

It would be good if economists could join with other social scientists to test the theory of the social benefits of home ownership.

There are those who attibute some of the drop in the US crime rate to rising home ownership and more stable neighborhoods.

As for the property tax issue, while it is true that the negative effects of higher property taxes are capitalized in real estate values, so are the positive effects of local gov’t spending, such as on roads, parks, police, fire, and schools.

Finally, in a theoretically perfect income tax system, aren’t all interest expenses deductible and all interest received taxable? If so, the problem is not that mortgage interest is deductible but that all interest is not deductible.

Working through it, one major distributional effect, as for any subsidy, would be to direct resources towards the real estate industry from all other industries. Government deciding which industries are more important than others is not a good thing. However, among the owners and tenants, I would have to consider that not everybody receiving the mortgage deduction is renting out their place to a tenant. Therefore, I fail to see how the tenants would be getting their “fair share” of the subsidy.

Although it would depend on the meaning of “fair share,” I would think an economist would define it as high enough to make the economic costs of renting and buying equal. Which, of course, would be high enough to eliminate the added incentive for homeownership that was supposedly the purpose of the subsidy.

Market Urbanism: can you clarify what you mean in the quoted statement? Who is getting a deduction who isn’t using the land for as their home, business, or rental income? or speculation?..

Sorry, I’d neglected to quote what I was responding to.

Mark Seecof: As Prof. Kling pointed out…the mortgage interest deduction does not favor homebuyers over renters since landlords also deduct mortgage interest and in a competitive market…renters get their share of that deduction.

perfectlyGoodInk: …I would have to consider that not everybody receiving the mortgage deduction is renting out their place to a tenant. Therefore, I fail to see how the tenants would be getting their “fair share” of the subsidy.

Hope that makes more sense now. A good portion of the subsidy goes to homeowners living in their homes and who do not pass any share of it to any tenant. Money flowing to them from taxpayer funds. So one distributional effect of the mortgage interest deduction is a transfer from tenants to homeowners, right?

Lord:

Renting is cheaper than owning because of this.

Yes, cheaper before accounting for all the intricate costs and benefit differences. I think that’s what you meant.
If you calculate the total cost and value of deductions, capital appreciation, opportunity cost of capital, etc. and control for quality and location it’s usually slightly cheaper to own in most places. Mostly because of the tax deductions and subsidized borrowing and lower property tax rates raises owned housing prices.

Otherwise, more people would rent…

That subsidy does not accrue to the owner as such, but to the debtor. The tax system is designed to encourage borrowing for the creation of wealth. Renters don’t undertake this risk so don’t benefit from it unless they leverage their investments. Now they may want to avoid this risk, but it means foregoing the return as well.

Social Security is not a wealth transfer in your sense. A growing population requires a greater investment in uprearing children and building infrastructure. A stable population doesn’t entail these investments. Social Security only appears to provide a higher return because these costs are not considered part of the system. The secondary reason it appears less is increased life expectancy.

There are two reasons owning ends up cheaper than renting in most of the country. Inflation works for the owner and against the renter over time, and the owner earns a return on his equity that the renter doesn’t make. In expensive areas, one can rely on appreciation above inflation over time as well. Renting is generally cheaper than owning initially though, often substantially so in expensive areas.

Inflation works for the owner and against the renter over time, and the owner earns a return on his equity that the renter doesn’t make. In expensive areas, one can rely on appreciation above inflation over time as well. Renting is generally cheaper than owning initially though, often substantially so in expensive areas.

False. The expected growth in rental income is baked into the value of the rental property by what’s referred to as a Cap Rate. The cap rate is the net-operating income of next year’s income over the value of the property. In areas where income growth is expected to be high, cap rates are low, raising the property value relative to the rent. (or you could say lowering the rent relative to the property value)

r = y + g
total return = yield (cap rate) + growth

This applies to home ownership as well. Areas where appreciation is expected to be high, have higher home prices relative to the equivalent rent.

The kind of irrational myth you are describing is what causes bubbles.

Lord: Retirees paid into Social Security at a lower rate because they could do so. They raised more children, build more infrastructure, made more investments, to make that possible.

Again, you have shifted discussion from whether there is a transfer to whether such a transfer would be fair.

And although what you said might have been true for some generations, it is not true for the one that is causing the biggest problems for Social Security: the Baby Boomers. They had fewer children, resulting in fewer workers paying retiree benefits, causing the (projected) shortful which was the reason that the Social Security tax rates were increased.

Lord: While it’s intent is promote risk taking, or at least not discriminate against it, I don’t think it actually does so. It only sets up the tableau in which to determine whether those investments are worthwhile.

Yes, the taxation is one of several things that “sets up the tableau,” if by tableau you mean all the conditions affecting economic decisions. The interest rate itself is one of them. Any policy that raises or lowers the interest rate or the taxation rate on the interest changes risk/reward ratio and thus the amount of total investment. To choose to treat interest income differently from other income changes the risk/reward ratio in the new “tableau”, creating incentives for people to attempt to make money by assuming more risk than they otherwise would have in the old “tableau.”

Lord: The taxation of interest was established with the origin of the income tax, reasonably to me. It could have been treated differently but wasn’t.

According to this excellent 2006 New York Times piece, the history isn’t that straightforward. To summarize, the evidence indicates that Congress did not intend to create incentives for homeownership, because most homeowners at the time didn’t have mortgages. Congress probably had business interest in mind instead. The rise of credit cards caused Congress to close the loophole, but the incentives created by that tax break had, by that time, created a real estate mortgage industry too large for lawmakers to do anything about the mortgage deduction.

The quote to take away from all this:

Since 1986, there have been some 15,000 amendments to the tax code, always to help some interest or other but each time distorting free-market incentives. To an economist, when someone invests for profit, that’s good. When they invest to take advantage of a tax break, that’s bad. “It’s a standard canon of economics,” Poterba says. It means that capital is being diverted from its best use, and the economy suffers as a result.

Emphasis mine. In addition, the article notes that the transfer from tenants to owners doesn’t even create incentives for tenants to become owners because most tenants don’t make enough money to itemize deductions.

I found the link via the Tax Foundation’s Tax Policy Blog, which had this to add:

The article is right – the mortgage interest deduction essentially treats individuals’ housing expenses like a business expense, allowing them to deduct it from taxable income. But the big difference between a business deducting interest and an individual deducting housing-related interest is that the business must pay taxes on the net income for which that expense was incurred, whereas no one pays tax on the imputed income they earn from owning a home.

My previous comment got stuck in moderation, probably because it contained a couple of links. Am attempting to repost without those links.

Lord: Retirees paid into Social Security at a lower rate because they could do so. They raised more children, build more infrastructure, made more investments, to make that possible.

Again, you have shifted discussion from whether there is a transfer to whether such a transfer would be fair.

And although what you said might have been true for some generations, it is not true for the one that is causing the biggest problems for Social Security: the Baby Boomers. They had fewer children, resulting in fewer workers paying retiree benefits, causing the (projected) shortful which was the reason that the Social Security tax rates were increased.

Lord: While it’s intent is promote risk taking, or at least not discriminate against it, I don’t think it actually does so. It only sets up the tableau in which to determine whether those investments are worthwhile.

Yes, the taxation is one of several things that “sets up the tableau,” if by tableau you mean all the conditions affecting economic decisions. The interest rate itself is one of them. Any policy that raises or lowers the interest rate or the taxation rate on the interest changes risk/reward ratio and thus the amount of total investment. To choose to treat interest income differently from other income changes the risk/reward ratio in the new “tableau”, creating incentives for people to attempt to make money by assuming more risk than they otherwise would have in the old “tableau.”

Lord: The taxation of interest was established with the origin of the income tax, reasonably to me. It could have been treated differently but wasn’t.

From what a fascinating New York Times piece by Roger Lowenstein from March 5, 2006 entitled, “Who Needs the Mortgage-Interest Deduction?” (which you can find by Googling the terms “mortgage deduction history” and clicking the link from the Tax Foundation), the history isn’t that straightforward. It used to be that all interest was deductible. Furthermore, Congress most surely did not intend to use the tax code to create incentives for homeownership, because most homeowners at the time of the deduction’s creation didn’t have mortgages.

Congress probably had business interest in mind instead of the subsidizing of consumer purchases. Therefore, the rise of credit cards caused Congress to close the loophole. However, the incentives created by the tax deduction had, by that time, attracted enough people into the real estate and mortgage industry, making it too large and influential for lawmakers to do much of anything about the mortgage deduction. So it stayed.

The quote to take away from all this:

Since 1986, there have been some 15,000 amendments to the tax code, always to help some interest or other but each time distorting free-market incentives. To an economist, when someone invests for profit, that’s good. When they invest to take advantage of a tax break, that’s bad. “It’s a standard canon of economics,” Poterba says. It means that capital is being diverted from its best use, and the economy suffers as a result.

Emphasis mine. In addition, the article notes that the transfer from tenants to owners doesn’t even create incentives for tenants to become owners because most tenants don’t make enough money to itemize deductions.

The Tax Foundation’s Tax Policy Blog had this to add:

The article is right – the mortgage interest deduction essentially treats individuals’ housing expenses like a business expense, allowing them to deduct it from taxable income. But the big difference between a business deducting interest and an individual deducting housing-related interest is that the business must pay taxes on the net income for which that expense was incurred, whereas no one pays tax on the imputed income they earn from owning a home.

The quote from the Lowenstein piece to take away from all this:

Since 1986, there have been some 15,000 amendments to the tax code, always to help some interest or other but each time distorting free-market incentives. To an economist, when someone invests for profit, that’s good. When they invest to take advantage of a tax break, that’s bad. “It’s a standard canon of economics,” Poterba says. It means that capital is being diverted from its best use, and the economy suffers as a result.

Emphasis mine. In addition, the article notes that the transfer from tenants to owners doesn’t even create incentives for tenants to become owners because most tenants don’t make enough money to itemize deductions.

The Tax Foundation’s Tax Policy Blog had this to add:

The article is right – the mortgage interest deduction essentially treats individuals’ housing expenses like a business expense, allowing them to deduct it from taxable income. But the big difference between a business deducting interest and an individual deducting housing-related interest is that the business must pay taxes on the net income for which that expense was incurred, whereas no one pays tax on the imputed income they earn from owning a home.

In case the moderation wasn’t due to the links, here’s the Lowenstein piece I found via the Tax Foundation’s Tax Policy Blog.

[perfectlyGoodInk–Eek! Sorry about the moderation. I think I’ve now figured out what was triggering it and fine-tuned the spam software a little, so I don’t think you’ll get moderated now. (It wasn’t the links last night, though that was my first thought, too. I think the Lowenstein quote purely by happenstance used a word that coincidentally included a series of letters that had gotten marked for moderation because that series had recently appeared in a lot of spam. No wonder it was driving you crazy! It was a challenge for me to find it, too.) I’ll keep an eye on it to be sure. Please email me at webmaster@econlib.org if it happens again and I’ll get on it right away. I don’t enjoy the time involved with my moderating any more than you enjoy the delay of being moderated, so the fewer moderations, the better. I’ve also removed a few of the duplicates you submitted as experiments, but I’ve left in some track records so as not to expunge your clever efforts to figure it out. Good going, but next time, don’t stay up all night! Just email me.–Lauren Landsburg, Econlib Ed.]

Lord: Retirees created the economy they retired on.

No, I think it would be more accurate to say that they played a role in creating the economy that they retired on. Who created the economy would be the sum of the efforts of the retirees, the previous generations, and the generation of people who are currently working.

The answer to the complicated question of how exactly to weight the contributions constantly changes, and these changes do not propagate themselves to the separate question of how to fund the benefits of current retirees from the incomes of current workers. That separate funding question is determined mostly by how many children each generation bears, as well as advances in life expectancy. Those two factors certainly do not correlate very well with the amount of productivity gains from technological progress. Note that as an economy develops, birthrates traditionally go up before they go down even though technological and economic progress is continually made.

Lord: The entire reason to change tax laws is change how people behave.

And as I’ve mentioned, economists know that any distortions in the tax code will divert capital flows from their most efficient uses. So an equally valid reason to change tax laws is to remove such distortions. Please read the Lowenstein piece. For an article in the New York Times, it actually does a decent job fairly depicting the economist’s point of view.

Lord: It is certainly possible to favor equity and denigrate debt. I have serious doubts this would be any improvement.

This means you believe there was an efficiency gain from choosing to favor debt and denigrate equity. A tax code that is neutral to behavior would treat all income equally with zero deductions or credits. A tax deduction for interest income influences market players towards debt. This increases the amount of risk taken on by the overall market. In addition, the choice has an opportunity cost, as the tax code is creating incentive for players to deviate from what would have been the most efficient behavior.

Unless you believe the free market’s existing incentives for people to assume risk were somehow too low.

Growing population eases the retirement burden but increases the working burden, so it isn’t easy either. Among the best analyses of Social Security available is http://bruceweb.blogspot.com/

Making interest payment nondeductible would definitely be a bias against debt to me. Debt already pays through taxation of interest. Double taxation of it would not be neutral in my opinion and likely wasn’t either to the original designers.

Interest is taxable to the recipient. Making it also taxable to the payor taxes capital twice. There is no difference in efficiency between these two because tax is still collected on the interest earned. Now if you want to discourage saving and lending I can’t think of a better way.

The way to think about this is the lender becomes a silent partner with income passed through to the partners in the proportion of interest to remainder. Therefore elimination of the deduction can be circumvented simply by filing. It essentially just drives lending to internal sources.

Home ownership is a good investment unlesss you invest in a good investment firm. The government must also inspect those investment firms anually.