Deficit Commission Presents Final Report: Impact on Housing

The president’s National Commission on Fiscal Responsibility and Reform has issued a final draft – entitled The Moment of Truth –  of its tax, spending and entitlement policy proposals with the aim of reducing the federal government’s long-term structural budget deficit. The final report incorporates elements from the commission’s initial co-chairs’ proposal and the subsequently issued Domenici-Rivlin plan. The commission failed to achieve 14 votes to support its recommendations. Nonetheless, its proposals are expected to shape the ongoing debate of U.S. fiscal policy.

Macroeconomic Targets

The commission’s final report proposes that in 2020 federal revenues will increase to 20.6% of GDP (up from an approximately 18% historical average) and federal outlays will be 21.8% (lower than the present policy trajectory of 24.5%) producing a deficit of 1.2% and debt level of 65% of GDP.

Tax Proposals

For tax policy, the document offers only an “illustrative” example of how the commission would set tax rules to achieve its economic goals. The document endorses certain principles concerning taxation, including lower income tax rates, a broader taxable income concept (“broadening the base”), and a general hostility to tax expenditures (which the commission, with some editorial intent refers to as “spending in the tax code,” although many would argue that allowing taxpayers to keep their own income is not equivalent to other forms of government spending).

The commission also seeks to restructure U.S. tax policy to lower the deficit, in a period when government spending is scheduled to increase significantly due an aging population, as well as maintain or even increase the tax code’s progressivity (a progressive tax system is one in which the average or effective tax rate paid increases as an individual’s income increases).

Finally, the proposed reforms seek to maintain U.S. business competitiveness at home and abroad.

But a great deal of detail is not provided. For example, any comprehensive tax reform plan must include transition rules; rules designed to phase-in new provisions or phase-out present law tax rules, which shape current taxpayer behavior and are capitalized into current asset prices. An immediate effective date for new tax rules could cause economic disruptions – some would say chaos – as prices reset and people seek to change investments and other economic behavior. 

However, the commission’s report is silent on this key element stating:

In enacting tax reform, Congress and the President should design appropriate transition rules that minimize economic distortions, achieve the necessary revenue targets, and allow taxpayers to adapt to the changes.

The lack of transition rules and a definitive set of proposals means that it is difficult to imagine what the full set of changes would mean for specific families, businesses or individuals. 

The commission does provide one example set of “illustrative” proposals:

Though the precise details and exact transition rules should be worked out in a variety of ways by the relevant congressional committees and the Treasury Department, the Commission has designed an illustrative set of reforms that would accomplish the necessary parameters for tax reform.

The proposal contains the following general tax policy changes set to become effective, in general, in 2013:

  • Three income tax brackets (12%, 22%, 28%)
  • AMT, Pease and PEP limitations eliminated
  • All present law itemized deductions eliminated, thus everyone claims the standard deduction
  • Capital gains and dividends taxed as ordinary income, at rates up to 28%
    • Recapture real estate depreciation (“exit tax” in the industry) remains taxed at 25%
  • Charitable deduction becomes a 12% nonrefundable tax credit, but only for amounts above 2% of AGI
  • Tax-exempt state and local bonds become taxable investments

For housing, the following specific changes are proposed:

  • The mortgage interest deduction would be eliminated
    • Mortgage interest allocable to a primary residence (up to only $500,000 of debt) would be claimed as a 12% nonrefundable tax credit
    • No credit allowed for second homes or home equity loans
  • The real estate tax deduction would be eliminated
  • The $500,000 / $250,000 gain exclusion for the sale of a principal residence would be eliminated
  • The Low-Income Housing Tax Credit (for the construction of affordable housing) would be eliminated
  • The 27.5 year depreciation period for residential rental housing would be eliminated
  • The completed construction contract rule for home construction would be eliminated

It is worth noting that the last four items, beginning with the gain exclusion, are not explicitly listed in the report as on the chopping block. Nonetheless, it is reasonable to assume that they would be eliminated given the “nearly all other tax expenditures eliminated” text found in the report and the fact that these rules are listed as tax expenditures in other reports. 

Housing Sector Impact

Transforming the mortgage interest deduction into a 12% credit (the 12% is the percentage of the lowest income tax bracket of the commission proposal; it is 10% under present law) would certainly reduce housing demand, particularly for first-time homebuyers who typically spend a larger share of their family budget on mortgage interest (because they have less equity in the home than someone who has been paying on their mortgage for 10 or 20 years). The 12% rate also means that for all homeowners and homebuyers who face a higher than 12% marginal tax rate today, this change would be a tax increase. The resulting reduction in housing demand will drive home prices down.

For example, suppose a married couple, both of whom work and earn $45,000 for a total household income of $90,000. The family faces a 25% marginal income tax rate. Under present law, a dollar of mortgage interest paid is worth 25 cents of reduced tax liability. Under the commission’s proposal the value would fall more than half to 12 cents. For an average sized home and mortgage for a family with this income, the MID is worth about $3000. Under the tax credit, it would be worth less than $1,500.  That is the equivalent of raising their mortgage payment by $125 per month.

The other changes proposed for the housing tax rules would have similar impacts for homeowners and homebuyers. Declines in home values would reduce property tax receipts for local governments, perhaps leading to reductions in local services, like schools, fire and police, absent other tax increases.

Particularly harmful for housing prices and families’ household wealth would be the elimination of the capital gain exclusion. If enacted (and again, it is not clear if this rule is one of the other tax expenditures proposed for elimination, but it appears to be the case), this change would reduce housing values and significantly reduce the value an older homeowner could extract from their home during retirement years. It could also reduce housing demand by increasing the time older homeowners remain in their homes in order to avoid a large tax bill.

Keep in mind that under the proposal, capital gains would be taxed as ordinary income. So someone selling a home that they have lived in for 20 or 30 years would report a substantial amount of income, hundreds of thousands of dollars for example, placing themselves easily in the top tax bracket for the year of the sale (this is sometimes known as the “king for a day” problem). Under the commission’s recommendation, the homeowner would go from paying a 0% tax rate on home sale profit (up to $500,000 excluded if married under present law) to a paying up to a 28% rate on all profit from the sale. Eliminating almost one-third of retirees’ housing wealth, plus additional value eliminated by housing price declines produced by this and the other housing-related tax rules, would be very harmful for homeowners.

Distributional Considerations

Clearly, knowing who is hurt and by how much is important for evaluating the merits of the plan. The report does include some income-distribution analysis, although the analysis is cited to the Tax Policy Center, a well-respected think tank, rather than the Department of the Treasury or some other government agency. Unfortunately, the analysis uses income quintiles (not an immediately intuitive income classifier, compared to gross income or the IRS’ AGI). Nonetheless, it is interesting to note that the largest percentage increase in tax paid falls on the second lowest income quintile, whose taxes increase 13.5%. In contrast, taxpayers near the top of the income range, from the 80th to 99th percentiles, would see tax increases from 5% to 6.5%

More fundamentally however, given the strong focus on real estate in the tax proposals, and the impact of cost-of-living differences that make comparing taxpayers in high and low cost areas tricky, it is important that the analysis of this or future tax reform proposals also include geographic and generational distribution analysis. If weakening the tax rules concerning housing disproportionately affects future homebuyers, who would face higher after-tax interest payments, and recent homebuyers, who would see house value declines, then these impacts should be presented in an age-related distribution table.



0 replies

  1. All of these crooked changes are doing nothing but
    making a fool out of people that one day thought they
    would be home owners for sure.
    When you go through all those changes to buy into a
    house, that does not make you a home owner. It makes
    you owe more money to a home mortgage loan that takes
    forever to pay off because the bank that financed the
    loan wants to make money off of people and could care
    less if they ever become home owners.
    Every last credit, deduction, incentive etc. that a
    person can get to keep them in the home and one day
    owning the home is more than necesary.
    With the rising cost of gas, home owners insurance,
    electricity, & water that you have to have to stay
    in a home adds to the help you need to get as much
    as your earned dollar to pay for these and all other
    rising expenses for people who make less than $75
    thousand dollars and especially those salaries that are frozen.

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