Reducing the Tax Favoritism for Housing

In a pure income tax, what is the appropriate way to tax owned housing? Jack Grigg and Thornton Matheson of the IMF explain in Chapter V of the "United States: Selected Issues" report published as IMF Country Report 12/214.

"Neutral taxation of owner-occupied housing would call for taxing its imputed rental value, but allowing a full mortgage interest deduction." For those not indoctrinated into the jargon, the idea here is that when you live in a house that you own, you are--in a way--renting that house to yourself.  Thus, you are in effect paying rent to yourself, and paying mortgage expenses. In a pure income tax, you would pay income tax on the income you receive from your owned-and-rented-to-yourself property ("imputed rental value"), but you would be able to deduct from taxation the costs of that property--namely, the interest payed on the mortgage.

This logic may seem counterintuitive to many homeowners! But another way to think about it is that a pure income tax should not favor owning over renting. (That is, the decision to favor owning is a political policy decision that has costs and benefits, but it's not part of a pure income tax.) Thus, if I buy a house and rent it out, or if I buy the same house and live in that house, my income tax bill should look the same.

But practical difficulties surface immediately, of course. How would "imputed rental income" be calculated? Grigg and Thornton write:  "Taxing imputed rents has generally proved impracticable, however, although several countries have at one time or another done so. Belgium taxes imputed rent, but the value was last reviewed in 1975 and has been indexed to inflation since 1990, resulting in imputed rents generally below their market counterparts, especially for old houses. In the Netherlands, imputed income is calculated as a percentage (up to 0.55 percent) of a property’s market value. Norway abolished its tax on imputed rents, based on property values, in 2005, and Sweden followed in 2007. While property values provide a readily observable basis for taxing imputed rents, they are likely to represent an imprecise measure of the returns to housing. An alternative is to use house prices and average price-to-rent ratios to estimate imputed rents, but this requires regular updating."

The administrative tax of figuring out an appropriate imputed rent in the enormous and diverse U.S. economy may be impractical. But then, if the gains from imputed rental income are not included in the income to be taxed, there is an argument for not allowing the deductibility of mortgage interest, either. The authors write: "As imputed rent taxation is thus generally unattractive on administrative grounds,
tax neutrality could be better approximated by phasing out mortgage interest deductibility." Indeed, countries like Denmark ad France give only very limited mortgage interest deductions.

The U.S. tax treatment of housing is very generous by the standards of OECD countries. We don't tax imputed rental income: doing so would raise $337 billion in taxes over the next five years, according to Office of Management and Budget estimates. We do let mortgage interest be deductible for first and second homes up to $1 million, which reduces income  tax revenues by $606 billion over the next five years. In addition, we have various provisions so that capital gains in housing values are untaxed, which reduces income taxes by an estimated $171 billion over the next five years.

But the issues go well beyond costs to the government in a time when we need to be scrutinizing the spending and tax sides of the federal budget to find a trajectory toward smaller budget deficits over the medium and long term.  Tax breaks for housing create economy-wide distortions in the allocation of
investment across sectors. The authors explain: "The marginal effective tax rate on housing investment in the U.S. is currently only 3½ percent, as compared to 25½ percent for business investment in equipment, structures, land and inventories. This discourages investment in productive assets, to the detriment of long-run economic growth."

Of course, it's never wise to make dramatic changes to tax policies affecting the housing market, because the existing tax policies are part of the conditions of demand and supply in the current market. The still-shaky U.S. housing market doesn't need another sudden shock. But the example of the United Kingdom shows how the mortgage interest deduction can be gradually phased out: set a ceiling on the total amount of the deduction, and then over time, reduce that ceiling in real terms and reduce the tax rate that can be applied to the deduction. Grigg and Thornton write:

"The UK experience offers a lesson in how the mortgage interest deduction can be gradually phased out. Until 1974, mortgage interest tax relief (MITR) in the UK was available for home loans of any size. In that year a ceiling of £25,000 was imposed. In 1983, this ceiling was increased to £30,000, below the rate of both general and house price inflation. From 1983 onwards, the ceiling remained constant, steadily reducing its real value. Beginning in 1991, this erosion of the real value of MITR was accelerated by restricting the tax rate at which relief could be claimed, to the basic 25 percent rate of tax in 1991, and then to 20 percent in 1994, 15 percent in 1995 and 10 percent in 1998. These ceilings on the size of loans and restrictions on the tax rate at which relief could be claimed chipped away at the
value of the tax deduction, paving the way for its complete abolition in 2000 ..."

Similarly, one could phase in limits on the special treatment for capital gains in housing, limiting it to primary residences and to a maximum amount.

I'm acutely aware that, given the fall in U.S. housing prices over the last few years, many homeowners would love to see housing prices soar again. But the U.S. economy and U.S. households have now absorbed most of the pain of the housing price decrease. The goal over the medium terms should be to make the housing market less tax-favored. It would benefit the U.S. economy to focus less on housing and more on investments that generate future economic growth. Most of the tax benefits of housing  go to those with well above-average incomes--since these are the people who are living in bigger houses and itemizing deductions. The additional revenue from reducing the favored tax treatment of housing can be part of a package to reduce marginal tax rates and trim future budget deficits.