This month, researchers Michael P. Keane of Johns Hopkins University and Xiangling Liu of Hunan University released a paper in the National Bureau of Economic Research’s working paper series on reforming taxation of housing.
This working paper revolves around a problem in housing economics called imputed rent.
Say you rent your home. That means you pay a landlord for the ability to live in your home. Since you are paying someone, they receive that payment as income. Like any other income, this income is subject to income taxes.
What if you live in your home? Well, you pay your mortgage, the same way a landlord does. But you don’t pay a landlord for rent. You “pay” yourself to live in the home that you own. You get the same good (housing) as any renter gets, but since you own the home, you pay yourself from it. But here’s the catch–that payment is tax free. Because no money changes hands, you are exempt from income taxes.
What this amounts to is an implicit subsidy to own a home rather than rent. This theoretically pushes people who would be renting to own due to the subsidy, in particular encouraging upper-income households to buy larger houses than they would otherwise. It also ties up capital in homeownership. Rather than investing in companies, individuals spend their incomes on homes, artificially inflating their value and decreasing the value of businesses.
These researchers investigated what would happen if an alternative tax system existed. Under this system, all homeowners would be treated as landlords and people who lived in their own homes would be required to report the imputed rent they paid and received by living in their own home as income. Just like landlords, homeowners would be allowed to deduct property taxes, maintenance, depreciation, and mortgage interest. After all this was deducted, however, they would have to pay taxes on the value of rent they are paying themselves.
This would mean a lot less money in the pockets of homeowners and a lot more money in the pockets of the government, right? Not necessarily. Keane and Liu model what would happen if this extra government revenue was used to finance an across-the-board income tax cut for all taxpayers. This tax cut would offset part of the new tax for homeowners.
…or rather, all of the new tax for homeowners. Keane and Liu simulate this policy change using data from the Panel Study of Income Dynamics. They estimate that this new tax would finance a 9.15% income tax cut across the board. This means every 11th dollar raised by income taxes would go back to households. It also leads to a rare policy change that would lead to a Pareto improvement, meaning no one will be left worse off by the policy and some (many in this case) will be left better off. Under their simulation, every homeowner paying taxes on their imputed rent will have their new taxes offset by the tax cut and the average household will see incomes raised by 0.79% after taxes. This means the average household will get an additional $610 every year under this policy.
Furthermore, housing prices would fall modestly under this policy due to a moderation in demand for housing. Keane and Liu estimate this would mean a 0.7% reduction in average housing price, which would amount to about $2,400 for the average U.S. home.
An interesting wrinkle to Keane and Liu’s simulation is that they actually don’t find that the homeownership rate would decrease, which on its face seems counterintuitive. Why would it depress prices on homes but not the homeownership rate?
Their simulation finds the answer for this: people would reduce the size of their homes. The current uneven playing field between owning and renting doesn’t actually get more people to own homes. It mainly incentivizes ownership of larger homes.
The researchers also use their model to estimate the impact of two proposals to eliminate the mortgage interest deduction.
How the mortgage interest deduction works is that a household can subtract the amount they pay in mortgage interest from their reported income. So this means a wealthy household paying $24,000 in interest and $9,000 in property taxes could effectively save $12,000 from the mortgage interest deduction.
The mortgage interest deduction is an unpopular policy among economists because it essentially functions as a subsidy to high-income households. Since low- and middle-income homeowners usually take the standard deduction, they do not benefit from this deduction. So this means the more wealthy you are and the larger your house is, the more you benefit from the mortgage interest deduction.
Keane and Liu estimate what would happen if the mortgage interest deduction were eliminated and replaced with an across-the-board income tax cut. According to their simulations, replacing the mortgage interest deduction with an income tax cut would drop income tax rates by 4.7%, housing prices by 1.66% (about $5,600 in 2023), and would discourage homeownership slightly, dropping homeownership rates from 64.9% to 64.3%. Incomes would rise by 0.76% (About $590 for the average household) and it would also be a Pareto improvement: all households would have more income under this policy. Benefits for this change would be highest for low- and middle-income households and higher-income households would purchase smaller homes under this scenario.
They also put forth an alternative: replacing the mortgage interest deduction with a revenue-neutral refundable tax credit. This means all homeowners could claim the credit and upper-income homeowners would not have higher benefits than lower-income homeowners. Under this scenario, ownership rates increase from 64.9% to 68.7%, home prices fall by 1.3% (about $4,400), average income rises by 0.58% (about $450 for an average household), and low- and middle-income households gain the most. High-income households end up worse off under this scenario due to not benefiting from the income tax cut in the other mortgage interest deduction elimination.
A lot of money is tied up in subsidies to high-income households to pay for larger homes. Eliminating these subsidies can lead to scenarios that make everyone better off, free up investment for more productive uses, and help low- and middle-income households. We’ll see if Congress pays attention to this well-known problem during its tax reform work this year.