Saturday, December 27, 2008

The Tax Laws and Housing Prices
Mike Rappaport

As I have been stressing lately, the financial crisis is an incredibly complicated matter, and part of the problem is that so many different government policies were involved.  Here is another aspect.

What caused the housing boom?  Russ Roberts writes:

There are four factors that helped drive up the price of real estate in the United States and create the housing bubble: The GSEs (Fannie and Freddie), the Community Reinvestment Act, expansionary monetary policy starting in 2001, and the 1997 Taxpayer Relief Act that for the first time let people avoid capital gains on home price appreciation without having to rollover the gains into a bigger house.

We have heard a great deal about the first three, but Russ makes a strong case that the tax change was far more important than people have realized.

But many economists say that the law had a noticeable impact, allowing home sales to become tax-free windfalls. A recent study of the provision by an economist at the Federal Reserve suggests that the number of homes sold was almost 17 percent higher over the last decade than it would have been without the law.

Vernon L. Smith, a Nobel laureate and economics professor at George Mason University, has said the tax law change was responsible for “fueling the mother of all housing bubbles.”

By favoring real estate, the tax code pushed many Americans to begin thinking of their houses more as an investment than as a place to live. It helped change the national conversation about housing. Not only did real estate look like a can’t-miss investment for much of the last decade, it was also a tax-free one.

The timing seems right on this.  Russ has a chart:

Just look at that picture. If it's accurate, something dramatic happened in 1997 that fueled an explosion in housing prices. I don't think it was irrational exuberance. I think it was a change in a tax policy that suddenly made houses dramatically more attractive as an investment vehicle.

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Mike Rappaport


Impossible - there was a Democratic President in 1997.

Posted by: dearieme | Dec 27, 2008 4:17:11 AM

This doesn't sound right to me at all. Most households didn't cash in on rising home prices by selling their homes and moving into cheaper ones--the only way the new tax law would have affected them. Moreover, encouaging people to do that during a hot real estate market would actually have reduced, not increased, the severity of the bubble, by increasing overall supply on the market, and thus exerting downward pressure on prices.

More typically, though, people cashed in via "cash out" refinancing--that is, using their newly acquired additional home equity as collateral on a home loan. Needless to say, that sort of activity was ultimately much more destructive, since it increased lenders' exposure to the risk of a home price decline.

Now, if the 1997 law applied to non-resident homeowners (i.e., speculators) as well as resident homeowners, then I could understand it feeding the speculative frenzy at the tail end of the bubble. But I'm guessing that it didn't, and in any event my understanding is that the speculators only jumped in en masse well after the bubble had already assumed dangerous proportions.

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