Well-Intended Tax Policy Helped Cause the Crisis

Plenty of blame has been passed around for the current financial crisis, mainly because there is plenty of blame to pass around and many share that blame. One factor that has not been much discussed is tax law.

GMU economist Russell Roberts in this post explains how a change in tax law created some of the perverse incentives that helped fuel the housing bubble. This piqued my interest, having had a career as a tax man earlier in life.

Years ago when I worked for IRS, people age 55 or older could exclude up to $125,000 capital gains on the sale of their home, provided it had been their primary residence in at least 3 of the preceding 5 years. But you could only do this once in your lifetime.

The way it worked back in those days was that each time you sold your home and bought a new one, you would reduce the basis of your new home by any long-term capital gain on the sale of your old home. There were limits on how much time you had to make the transition, but it worked out for most people. (Oddly, while taxpayers have always had to recognize the capital gain on the sale of their home, they are unable to recognize any capital loss should they sell at a loss.)

Then when you were a senior citizen and sold your home, you would take the lifetime $125,000 exclusion on the long-term capital gain from the sale. This prevented seniors from getting whacked with a big tax bill from simply selling their home because, arguably, the net present value of the capital gain over 30 or 40 years was roughly the rate of inflation. In other words, the home seller really didn’t make any money on the sale when the time value of money was figured in.

Then back during the Clinton/GOP Congress years, lobbyists for the real estate and banking industries were successful in getting Congress to change the exclusion as part of the Taxpayer Relief Act of 1997, which enjoyed broad bipartisan approval. Our nation had become far more mobile, went the argument. There are many people under age 55 that must sell their home for one reason or another and for various reasons are unable to purchase a new home within the legal time limit.

So the law was changed to permit the exclusion if the sold home was your primary (or in some cases even your secondary) residence in 2 of the preceding 5 years. The gain limit was raised to $500,000. The age requirement and the limit on using the exclusion once in a lifetime were dropped. Plus a plethora of “unforeseen events” were specified that allowed the exclusion to be taken even if the 2-year time period was not satisfied.

Here’s where the law of unintended consequences kicked in. This tax law change created a huge incentive for people to turn their homes into speculative investment properties as opposed to low- (or no-) growth savings mechanisms. Instead of having to wait 30 years to get tax-free gains from the sale of a home, you now only had to wait two years.

OK, children, let’s ask this question. If you invest in equities or bonds for two years and sell them at a profit, you’re going to pay 15% federal capital gains tax plus state and local taxes on that profit. If you invest in a house for two years and sell it at a profit, you’re going to pay no taxes on the gain at all. Which investment are you going to choose?

It’s true that our politicians probably felt that the law change would encourage more home ownership, which is viewed as a positive thing. But Chris Farrell at Business Week wrote in 2005 that as a result of the tax inequity, “Money is pouring into concrete foundations rather than high-tech innovation.” Once again, we see an example of how government action created incentives that perversely skewed the marketplace, based on the best of intentions and lots of lobbying money.

It was well known that the home building boom couldn’t go on forever, but many wanted to get as much out of it as they could for as long as they could. Just as a binge drinker knows he will have a hangover in the morning, it was widely known that the housing market would eventually bust. But only the doom-and-gloomers came close to accurately predicting how bad it would be.

The change in the tax law I have discussed was, of course, not the only source of the sub-prime crisis that we are experiencing today. It is just one factor that seems to have been overlooked in most analyses of the problem.

Now, here’s my prediction. You won’t see the Bush administration, the next administration, this Congress, or the next Congress rush to do anything to correct the capital gain tax inequity. Thus, the incentive for behavior harmful to the economy will continue to exist.