At the end of 2012, a number of tax and spending policies are scheduled to change. Taken together, these changes may exert a strong fiscal drag on an already fragile macroeconomic environment depending on the actions of Congress. Federal Reserve Chairman Ben Bernanke calls this the “fiscal cliff.” Tax policy analysts call it “taxageddon” or “taxmageddon.”

Regardless of its name, it represents the next dramatic policy deadline in Washington. Under present law, in 2013 the 2001/2003 tax cuts expire, the payroll tax cut expires, extended unemployment benefits end, and federal government spending levels decline due to last summer’s Budget Control Act.

If implemented, these changes would have large consequences for housing and home builders.

First, at the macro level, the fate of the ongoing recovery in housing is dependent on economic growth, job creation and household balance sheet repair. If all of the scheduled tax hikes and spending cuts go into force, the Congressional Budget Office (CBO) estimates that the total 2013 fiscal drag on the economy will be $560 billion. The chart below illustrates the CBO budget projections by fiscal year. Notice the jump in revenues in 2013, as well as the decline in outlays from 2011 to 2014.

As a result of the scheduled 2013 policies, the CBO forecast for GDP growth in 2013 falls from 4.4% to 0.5%. NAHB is currently forecasting 2.8% growth, but that is because our forecast assumes that the fiscal cliff is for the most part avoided (producing only a 1 to 1.5 percentage point drag on GDP, compared to the 3.9 percentage point drag estimated by CBO).

However, if the full fiscal drag is inflicted on the economy it would clearly be harmful to GDP growth. Negative or virtually flat GDP growth would obviously be harmful for housing, as it would cause more job loss, set back household balance sheet repair, and depress the already weakened housing market.

Besides the macro impact, certain individual policies will have a direct negative impact on housing and home building.

For home builders, the expiration of the 2001/2003 tax cuts would represent a business tax hike for a majority of the industry. According to NAHB census of membership data, 80% of NAHB members are organized as pass-thru entities, such as S Corporations or LLCs. For pass-thru entities, individual income tax rates are business tax rates. And if the 2001/2003 tax cuts expire, all the rates will increase – from the bottom rate of 10% increasing to 15% to the top rate of 35% increasing to 39.6%.

Taxes would rise for capital income as well. Capital gains tax rates, important for multifamily developers and C Corporations, would increase from 15% to 20%. Dividends rates, important for some S Corporations and C Corporations, would increase from 15% to ordinary income tax rates up to 39.6%.

Expiration of the 2001/2003 tax cuts would also mean an end to the Alternative Minimum Tax (AMT) patch. Absent an AMT patch, the number of AMT payers for 2012 would grow from somewhat less than 5 million to more than 30 million. If the other tax cuts expire, this 30 million number would be significantly lower (10 million), but the AMT patch remains important nonetheless given the number of home builders organized as pass-thrus, who tend to get hit with the AMT. Typically the AMT is a concern for taxpayers reporting $200,000 to $500,000 in income, particularly those with large numbers of dependents or who live in high cost areas.

Finally, the top estate tax rate would increase to 55% and the exemption amount would fall to $1 million. For the nation’s family-owned home builders, the estate tax is a threat to keeping an multigenerational enterprise alive.

For housing demand, a number of expiring tax law provisions would reduce after-tax income and homebuyer and rental demand. For example, if the 2001/2003 tax cuts expire, the marriage penalty returns for a significant number of taxpayers. The child tax credit falls from $1000 to $500 per child.

And a direct negative effect on housing demand would come from the return of the Pease limitations, which would reduce the value of the mortgage interest deduction (MID) for taxpayers in high cost areas. The Pease rule phases out itemized deductions for taxpayers above and below the commonly cited middle class threshold of $250,000, thereby weakening the benefit of the MID.

Finally, while already in the baseline, there is also the issue of the “tax extenders.” For housing, important tax extenders needing approval include the 9 percent credit fix for the Low-Income Housing Tax Credit, the 25C energy-efficient remodeling credit and the 45L new energy-efficient home tax credit.

So what do we expect to happen? While a lot rides on the results of the 2012 presidential and congressional elections, the best guess is that Congress manages to avoid the fiscal cliff, but as usual, runs close to the effective deadline. Thus, most, if not all, of the 2001/2003 tax cuts will be extended, perhaps for just a year or two. The payroll tax cut and extended unemployment benefits will likely lapse, but we expect the net spending cuts from the Budget Control Act to stand, even if there is some shifting or postponement among certain programs.

It is worth noting that there is a long-run fiscal challenge. Current budget deficits are unsustainable year after year if present policy is extended. Hard choices are going to have to be made regarding government spending – particularly entitlements – and tax revenues. But those choices do not have to be enacted in 2013, and given the weakness in the economy, they should not be.

While our expectations are that an economic crisis is averted, how the fiscal cliff problem is solved in 2012 will shape the tax reform debate in 2013. And given then importance of the MID and other housing tax rules, the importance of the short-term political challenge should  be apparent.

Tags: economics, home building, housing, policy, tax