By Simon Johnson and James Kwak
Tuesday, October 27, 2009 12:20 AM
Congress and the administration seem likely to extend the first-time-home-buyer tax credit. Senate Majority Leader Harry M. Reid wants to extend it through December 2010 but phase out the amount over time; Republican Senator Johnny Isakson, a former real estate agent, wants to extend it through June but double the income limit and make it available to all home buyers.
This is a bad idea.
The main argument for the tax credit is that it stimulates the economy and stabilizes the housing market. Seen purely as a stimulus, the tax credit is highly inefficient. The National Association of Realtors claims that the credit created 350,000 new sales; the Calculated Risk blog calculates that this means the government is paying $43,000 for every extra house sold (since most sales would have happened anyway). According to the Wall Street Journal, Goldman Sachs estimates 200,000 new sales, implying a cost of $80,000 per marginal sale.
Even at a price of $43,000, what are we getting? Given that these are first-time home buyers, and given the glut of homes on the market, most of these are financial transactions where a house changes hands in exchange for cash (and additional transaction costs). The $43,000 is not being invested; it isn't buying anything for the public, like a new road. It's just cash going into people's pockets.
Putting cash in pockets does have a stimulative effect because some of that cash will turn into consumption. But as far as stimulus measures go, it has a low multiplier (the ratio of new economic activity to stimulus spending). By contrast, we could take the same cash and hire more teachers, police officers or soldiers to fight in Afghanistan. We would get more economic activity, and the government would get something for its money.
But the tax credit stabilizes the housing market, people say. What does this mean? It means that the credit keeps housing prices artificially high. But housing is something that all people need. Why do we want it to be expensive? Would we want government policies that artificially push up the price of food? (Wait, we have some of those already . . . but that's a matter for another column.)
As of July, the real price of housing, according to the Case-Shiller Composite 10 Index (adjusted using the consumer price index), was still 20 percent higher than in January 2000 and more than 30 percent higher than its average for the entire 1990s. Now, there is a risk that a weak economy can cause housing prices to fall well below their long-run average. However, housing prices appear to have stabilized, at least for now, and at too high a level. That is in part due to the tax credit, in part due to the partial economic recovery we are witnessing.
What happens when you artificially prop up housing prices? Imagine the credit were expanded to all home buyers and made permanent. This would simply boost housing prices at the low end of the market by close to $8,000, since all buyers would be willing to pay $8,000 more. (Prices would rise by a little less than $8,000 because at higher prices, more people would be willing to sell.) Whom does this benefit? Not first-time home buyers. It benefits people who already own houses (and their real estate agents) because it's a one-time boost in housing values. This would be just the latest chapter in a long history of government policies to boost housing prices -- the mortgage interest tax deduction, the capital gains exclusion on houses, the extension of the mortgage interest tax deduction to second houses, etc. Each of these policies pushes up prices just once; if you want to keep pushing up housing prices, you have to keep adding sweeteners.
A temporary tax credit has a similar effect, but for a shorter period of time. It boosts the price of a transaction that would have happened anyway. It may create additional transactions, but is that a good thing? If someone could not have afforded a house without the tax credit, then what is he or she going to do when the tax credit goes away and the price of the house falls? In effect, the tax credit is a way of making houses temporarily affordable that would not otherwise be affordable, and we know where that leads.
But doesn't the tax credit boost the value of securities backed by residential mortgages and therefore help bolster the financial system? Well, there are more direct ways of recapitalizing banks. In addition, a tax credit that shifts people from renting to owning pushes up the price of houses but pushes down the price of renting (by a smaller amount). By subsidizing home purchases, we are helping banks that own portfolios of foreclosed houses but hurting other banks with commercial real estate portfolios. Another argument for the tax credit is that it gets more people into foreclosed houses and reduces the number of vacancies, which have negative externalities (vandalism, crime, etc.). If that is true, then there are better ways to spend our money. One would be restricting the credit to people buying foreclosed houses. Another would be investing in programs to convert foreclosed properties into rentals. From 1998 to 2008, the homeownership rate grew from 66.4 percent to 67.5 percent (it peaked at 69 percent in 2003-06), while real median household income (in 2008 dollars) fell from $51,300 to $50,300. Propping up the homeownership rate in the face of declining incomes is possible only with financial engineering to inflate housing prices, which cannot be done forever.
But isn't it just better for more people to own their homes? The conventional wisdom is that homeownership has positive externalities: Homeowners are more likely to invest in their communities, and it is the best way to build household wealth. But the evidence for this is mixed. In "Our Lot," Alyssa Katz cites three academic studies and concludes: "Scholars found that once they set aside the various traits that tend to determine whether someone chooses to own or rent one's home, homeowners and tenants really aren't that different. . . . Often the new homebuyers were purchasing the worst housing in the worst neighborhoods with the worst schools -- hardly a solid investment."
Even if you want to encourage homeownership, it hardly follows that the solution is to make houses more expensive. Ultimately our housing "policy" suffers from the idea that changing the level of prices on existing housing can provide a net benefit to society; because sales of existing houses are essentially zero-sum transactions, changing the price level is purely redistributive.
Given the serious possibility that housing prices are currently being propped up by the tax credit -- Goldman estimates by 5 percent -- we can understand the argument for, at most, a gradual phase-out to smooth out the inevitable downward adjustment. But anything more would be throwing good money after bad.
Simon Johnson is a professor at MIT Sloan and senior fellow at the Peterson Institute. James Kwak is a Yale law student and former software entrepreneur. They blog about economics at The Baseline Scenario.