The Problem With US Housing Policy Is That It’s Not About Housing

Last time, in this series on political strategies for winning abundant housing, I wrote about preventing displacement. Here, I sketch the hidden reality of federal US housing policies: they are about real estate appreciation, not housing. And I spell out how they polarize wealth, exacerbate racial inequality, cut productivity and job creation, speed climate change, and exaggerate the ups and the downs of the business cycle. Next time, I will return to the series’ explicit focus on political strategy and how we might assemble an unusual left-right coalition to shift national policy.

For generations, the prime movers of federal housing policy in the United States—the biggest budgets, the rules that most profoundly shape the nation’s dwelling arrangements—have operated from agencies without the word “housing” in their name. The Internal Revenue Service, for example, is the premier source of housing assistance. Mortgage and securities regulators at various agencies have similarly outsized influence. The US Department of Housing and Urban Development (HUD), in contrast, is only a bit player.

Tax code and mortgage rules indirectly lavish hundreds of billions of dollars a year on homeowners, many multiples of HUD’s $48-billion budget.

Tax code and mortgage rules indirectly lavish hundreds of billions of dollars a year on homeowners, many multiples of HUD’s $48-billion budget. And for all the nattering of US leaders about expanding homeownership and providing affordable housing, these federal policies’ actual effects have included neither increased homeownership nor more-affordable dwellings.

Instead, US tax and mortgage rules turbocharge speculation in residential real estate, exacerbating the damage caused by the overly restrictive local zoning Sightline’s green urbanism and abundant housing team regularly endeavors to reverse. These federal policies polarize wealth, exacerbate racial inequality, cut productivity and job creation, speed climate change, and exaggerate both the ups and the downs of the business cycle. They are about real estate appreciation, not housing.

US tax and mortgage rules turbocharge speculation in residential real estate, exacerbating the damage caused by the overly restrictive local zoning.

Fortunately, the incentives these rules create for speculating in residential real estate peaked a decade ago and have since ebbed modestly. In 2017, the Republican Congress took a surprising step in the right direction by reducing the mortgage interest deduction and related tax benefits. Further progress in the years ahead might be within reach.

Feed the horses to feed the sparrows

The prime movers of housing—tax breaks and mortgage finance policy—operate according to what John Kenneth Galbraith called horse-and-sparrow economics: “If you feed the horse enough oats, some will pass through to the road for the sparrows.”

The horses, in this manure-pecking analogy, are the cluster of powerful industries involved in building, selling, and financing homes. The oats are tax breaks and federal promises of bailouts should the mortgage industry overextend. And the sparrows who get the digested oats? They would be ordinary American households.

Horse-and-sparrow economics can be good politics: unlike sparrows, horses are big, powerful, and well represented by lobbyists and political action committees. The bipartisan practice in Washington, DC, has consequently long been to give the mortgage and real-estate industries generous support, hoping that the result will be homebuying by millions of sparrows. But aside from fattening the horses, this approach has largely failed.

From lend-and-hold to shadow banking

US government interventions in the mortgage business started modestly.  During the Great Depression, the government invented the 30-year mortgage and created Fannie Mae to guarantee low-interest mortgages and stimulate the economy. The mortgage was elegant: a way to pay for homes with future earnings. The system was progressive, but only if you were a working class white person. Loaning practices were racially exclusionary from the beginning, the very genesis of redlining.

The mortgage business evolved over time from a boring but reliable lend-and-hold operation for local banks, credit unions, and savings and loan associations into an ever-accelerating binge that culminated in the collateralized debt obligations, mortgage-backed securities, and other bundled and securitized easy-money loans that collapsed in 2008, precipitating that year’s devastating financial crisis. The whole multi-decade spree was rationalized, when anyone bothered, as a way to extend opportunity and housing to more families: horses and sparrows.

The federal role has rarely been to provide public money up front. Instead, the US government regulates mortgage lending lightly, allowing the mortgage industry to take on enormous risks that can trigger recessions, while also implicitly guaranteeing its solvency. The mortgage industry includes not only quasi-public entities, such as Fannie Mae and Freddie Mac, but also their private, “shadow banking” counterparts, such as hedge funds, insurers, and the rest of the too-big-to-fail menagerie.

Government mortgage policy works in much the same way as a rich relative cosigning a young person’s loan. If all goes well, the relative never pays; if all does not, the cost to the relative can be large. In the case of government mortgage policy, though, the guarantee is not for individuals’ mortgages. It’s for the whole industry.

All has not gone well. In the Savings & Loan (S&L) crisis of the 1980s, one-third of US thrifts went bust, and the US Treasury bailed out their depositors at a cost of $130 billion. The fallout contributed to the early-nineties recession. But the S&L crisis was nothing compared with the 2008 housing bubble and the Great Recession it triggered. These calamities cost the United States many times as much in direct government bailouts to financial institutions. And they cost the world literally trillions of dollars in vanishing wealth and collapsing economies, to say nothing of human misery and ruined lives.

Financialization

Brink Lindsey of the center-right Niskanen Center in Washington, DC, and Steven Teles, a left-leaning professor of political science at Johns Hopkins University in Baltimore, document the saga of the US mortgage industry in their 2017 book The Captured Economy. They summarize:

The track record of US regulatory subsidies for mortgage credit is thus nothing short of abysmal. Instead of offering transparent, on-budget fiscal transfers, policymakers chose to promote homeownership by channeling subsidies through financial institutions, first with the savings-and-loan industry, next with securitization and shadow banking. Both of these models of mortgage finance, designed and propped up by public policy, ended in meltdown. Apart from the ruinous costs of financial crises, regulatory subsidies chronically misallocated resources by pushing financial institutions to direct resources toward household consumption (of housing) rather than productive business investment.

Indeed, the mortgage industry, once a cautious niche industry that generated modest profits and stable housing, has become a leading force of the financialization of the US economy. Securitized home mortgages—thousands of mortgages bundled together, sliced, and recombined—are a large share of the Wall Street capital pools that constitute the shadow banking sector. The finance industry and its implicit short-termism have become ascendant in the economy, shunting investment capital into real estate and other existing assets and away from the businesses whose innovations in products and services are the engines of prosperity. Write Lindsey and Teles:

the large and destabilizing subsidies that the government bestows on debt financing and mortgage lending. . . are a major root cause of both the financial sector’s excessive growth and its recurring instability. They are the source of massive rents for financial firms and a catalyst for the excessive risk-taking that misdirects capital and periodically convulses the larger economy.

Retrenching the mortgage industry—by regulating it more tightly and revoking its implicit government guarantee of bailouts—would be a healthy step toward a better-balanced economy. It would make mortgage loans a little harder to get, a little smaller, and a little more expensive in fees and interest rates. None of this is something that home buyers would like, but it would dramatically reduce the risk of financial crises and rightsize the returns on buying real estate.

Tax breaks for home-value speculation

Mortgage policy is only half of the problem with US federal housing policy. Four parts of the US tax code also encourage real-estate speculation. Between them, these tax rules showered perhaps $150 billion on homeowners in 2020. The handouts are not structured to encourage ownership as such, or to promote stable housing, but rather to reward homeownership as an investment strategy. Because the benefits grow with incomes and home prices, they operate like Robin Hood in reverse.

American families who earn more than $200,000 a year receive federal housing assistance worth about four times as much on average as do American families who earn less than $20,000 a year.

The four parts:

1. The mortgage interest deduction lets you subtract interest on your home loan (or loans, if you have two homes) from your income before you calculate your US personal income taxes. The more interest you pay, the bigger the tax break, which makes the policy steeply regressive. Reduced by Congress in 2017 (as I’ll discuss in my next article), it still cost the Treasury $26 billion in 2020.
2. The state and local tax deduction (SALT) lets you remove all the nonfederal taxes that you pay from your income before tallying your federal taxes, including state and local income, sales, and property taxes. This policy functionally gives homeowners a discount on their property taxes, and like the mortgage interest deduction, the benefit grows with your income and home price. The more property tax you pay—and the higher your income—the bigger the discount. Despite being trimmed in 2017 by Congress, in 2020, the property tax portion of SALT cost the Treasury $6 billion (assuming the same ratio of property to other taxes as in past years).
3. The capital gains exemption, which denies the Treasury some $35 billion a year, allows home sellers to pay no income tax on the first $250,000 of profit from selling their homes (or $500,000 for married couples). It’s a giant inducement to park your savings in home equity: neither stocks nor any other form of equity investment grows tax-free, unless it’s locked away in retirement or college-savings plans.
4. The imputed rent exemption is a more curious beast. It waives from taxation the in-kind income homeowners receive through use of their homes. You may be thinking, “Huh?! Pay tax to live in my own house? That’s nuts!” In the terms of economists and tax accountants, though, it’s reasonable. If you lease your house to someone, you’ll be taxed on the rent you get from your tenant. Just so, if you live in the house yourself, you should pay tax on the monthly value of the shelter. Like much of accounting, it’s counterintuitive but logical. The imputed rent exemption likely denies the Treasury of more than $80 billion a year. In contrast, Switzerland imposes taxes on imputed rent, which makes it one of the only countries where taxpayers have no monetary advantages from owning rather than renting their homes. The Swiss choose buying or renting based on nonfinancial considerations, and fewer than 40 percent of households buy, compared with 67 percent in the United States.

The effects

Two recent summaries by prominent housing researchers synthesize the findings of a generation of scholars about the harms these policies cause.

In brief, tax breaks and hidden loan subsidies encourage speculation in home values. They cause buyers to put more money into their homes and less into other, productivity-enhancing investments. They bid up home prices in zoning-constrained high-price markets and escalate house and lot sizes at the top end of the market in more sprawling, less-expensive markets. For example, US housing policy boosts the prices of multi-million-dollar Victorians in San Francisco and speeds McMansion sprawl around Houston. It also exacerbates inequality. Because the tax breaks are much more valuable to households in high tax brackets, they skew the housing market away from first-time and entry-level buyers, who are mostly in lower tax brackets.

Because people of color were long prevented from owning homes by law and policy, this process of exclusionary price escalation reinforces wealth disparities by race and ethnicity.

Tax breaks and easier loans inflate prices across the entire real-estate market, driving up sticker prices and making it harder to break in. Ever more precariously leveraged borrowing was rampant in the run-up to the 2008 financial crisis and persists. Because people of color were long prevented from owning homes by law and policy, this process of exclusionary price escalation reinforces wealth disparities by race and ethnicity. It concentrated mortgage foreclosures among people of color during the financial crisis and continues to do so today.

Easier loans plus tax breaks have damaged the economy overall and the environment as well. The diversion of capital into mortgage lending (a type of consumption) squeezes out investment in businesses (production). The net effect is slower productivity growth and job creation. Bigger houses use more energy and materials and typically spread over more land, augmenting sprawl and increasing climate-disrupting emissions both from the homes and the driving their locations necessitate.

In the end, the tax breaks for homeowners—not speaking of the mortgage system in this case—do not even increase homeownership. Because they elevate prices, they hurt first-time buyers and keep them out of the market. Homeownership is less common in the United States than in countries that provide no similar tax subsidies, such as Australia, Canada, and the United Kingdom.

Peak horse-and-sparrow

Federal underregulation of mortgage finance peaked before the 2008 financial crisis; since then, a tightening of rules has somewhat dampened the systemic risk to the economy and reduced the chances of more bailouts. Still, securitization of mortgage loans remains a principal function of Fannie Mae and Freddie Mac. Investors keep buying these risky instruments partly because they know the US government will not let the mortgage industry collapse. And mortgage loans are easier to get and at greater risk of default because of these policies.

Tax loopholes for homeowners, meanwhile, peaked before the 2017 tax reform. In 2015, these home-owner tax benefits arguably amounted to more than $240 billion, which is about five times as much as the United States provided in housing-related assistance to renters and low-income households that year. Another estimate placed the total closer to $210 billion. Either way, the 2017 reform trimmed the total to about $150 billion, a giant step in the right direction.

Further restraints on federal policies would ease the flow of money into home-value speculation and soften home prices. It would also dampen all the harms chronicled above.

Next time, I will turn to the politics of making that happen. For now, a glimpse at another model.

A different model?

What might a housing economy look like that no longer feeds the horses to feed the sparrows?

It might look something like the housing economies of German-speaking nations in Europe. The German mortgage industry, for example, is stodgy and closely regulated. Homeownership is less common in Germany than in North America, but it’s still widespread, with much lower home prices and more abundant housing. German renters, though, enjoy a level of security in their homes that would be unfamiliar to North Americans, because abundant apartment supply and German law both ensure a renter’s market and strong tenant rights in most cities.

Next door, Austria too gives no special favors to home buyers in tax law or banking regulations. Indeed, Austria subsidizes not mortgage lending but the production of thousands of ordinary urban apartments. The policy yields affordable, abundant housing; stable, long-term leases, as in Germany; and a real-estate economy far less driven by speculation.

In Switzerland, meanwhile, taxation of imputed rents means policy is neutral between buying and renting. Fewer people choose to buy there than almost anywhere in Europe, and housing is among the most affordable in Europe.

In these countries, housing policy is about housing, not real estate, so homeownership is a good way to live but a bad way to make money. And that’s as it should be. Could that be our future in North America as well?