To Spur Homeownership, Stop Subsidizing It
Tax reform could make housing more affordable. Done correctly, it could increase the supply of homes by reducing federal tax subsidies for homeownership. The House’s Tax Cuts and Jobs Act furthers this aim in several ways—by raising the standard deduction, capping new loans qualifying for the mortgage-interest deduction at $500,000, eliminating the deduction on loans for second homes and the deduction on cashing out home equity, and capping the property-tax deduction at $10,000.
The Senate’s version contains some of these provisions, but it leaves the mortgage-interest deduction intact at $1 million and retains tax deductibility for mortgages on second homes. In conference, House negotiators should push their Senate counterparts to adopt the lower threshold.
How would the House’s approach affect the housing supply? In three ways. First, the stock of second homes totals some six million units; eliminating the interest subsidy on second homes would cause demand for the existing stock to decrease. Most second homes could also be used as a primary residence, either for a new buyer or as a primary home for the current owner after retirement. A conservative estimate is that over 10 years 600,000 second homes, or 10% of this stock, will convert to use by a primary resident.
Second, demand for newly built second homes would decrease. I estimate that second homes constitute about 62,000 units annually, or 10% of new-home construction. If demand were reduced by 25%, or 15,000 units, builders, in an effort to maintain volume, would choose instead to build more homes targeted for primary occupancy. That represents another 150,000 units added to supply over 10 years.
Third, the demand for newly built homes costing between $625,000 and $1.25 million would go down, since mortgage interest would no longer be fully deductible (assuming the standard 20% down payment). In the past year an estimated 50,000 such homes have been built. If annual demand were reduced by 25%, or 12,000 units, builders would likely choose to replace these with less expensive homes, adding another 120,000 lower-cost units to the housing supply over 10 years.
In total, it is reasonable to forecast that the House tax bill would create about 870,000 additional available units over 10 years. This represents a boost of 14% (the current build rate will yield about 6.2 million units over 10 years).
Cutting homeowner subsidies out of the tax code provides other important benefits. The percentage of mortgage holders who itemize would drop from about 60% to 12%. This would free nearly half of mortgaged homeowners from a massive federal tax incentive hanging over their financial decisions, thereby greatly reducing the market-distorting impact produced by the interest deduction.
Moreover, the cost per square foot of financing expensive houses would rise as big mortgages lose their tax subsidy. Some households that might otherwise buy such homes will buy cheaper or smaller homes instead, thereby reducing the capital allocation distortion of the subsidy. Others will borrow less to buy their home, reducing the inflationary impact of leverage on home prices.
The doubling of the standard deduction (this is in the Senate bill, too) will have a similar effect on financing homes in the $150,000 to $400,000 range. More buyers in this price range will take the larger standard deduction instead of deducting their mortgage interest. The reduction in the tax subsidy for these homes will once again lead some households to consider smaller or cheaper options, or else borrow less, with the same benefits noted above.
Lower prices due to loss of subsidies will ultimately allow more low-wealth Americans to become homeowners, since less cash will be needed to close a purchase. Rents will remain roughly constant as house prices decline, thus reducing the cost of homeownership compared with renting—another positive outcome. Recent research by economists from the Federal Reserve and American University found that the combined impact of these effects would cause prices to fall and homeownership rates to rise.
As an added bonus, reducing the subsidization of mortgage debt would reduce the need for taxpayer-backed mortgage debt. In 2016 about one-third of Fannie and Freddie’s business involved mortgages greater than $500,000, second homes, or cashing out home equity. The same is true of one-sixth of the Federal Housing Administration’s business. These activities could likely be scaled back.
Importantly, the resulting shrinkage in the $6.7 trillion pool of outstanding government-guaranteed mortgage debt will lead to lower Treasury rates as competition with Treasury debt is reduced. Mortgage interest rates will also go down, as Treasury rates and mortgage rates are highly correlated.
Finally, the reduction in subsidies could result in lower overall mortgage leverage and slower growth in home prices and therefore result in greater financial stability. Now is a particularly good time to make this change. According to the National Association of Realtors, existing home sales have been in a seller’s market for 62 straight months. This is true even at the higher price end of the home market.
It is time to put the interests of taxpayers and aspiring homeowners ahead of the interests of the housing lobby. Tax reform—especially if the final bill fully implements the House’s subsidy cuts—will improve the housing market and make homeownership more accessible to all.
Mr. Pinto is a co-director of the American Enterprise Institute’s Center on Housing Markets and Finance.