Wednesday, October 19, 2005

Tax Reform - III

An article in today’s New York Times outlined more features of plans for tax reform being considered by the President’s Advisory Panel on Tax Reform. As previously noted, putting caps on the deductibility of mortgage interest was floated as one approach to reducing the tax advantages of home ownership. Paradoxically, the panel is suggesting another change that will enhance that benefit: raising the exclusion from capital gains on the sale of a principal residence from $500K to $600K for married couples.

This one perplexes me. The panel is charged with the following tasks:
"(a) simplify Federal tax laws to reduce the costs and administrative burdens of compliance with such laws; (b) share the burdens and benefits of the Federal tax structure in an appropriately progressive manner while recognizing the importance of homeownership and charity in American society; and (c) promote long-run economic growth and job creation, and better encourage work effort, saving, and investment, so as to strengthen the competitiveness of the United States in the global marketplace." (This is from the Executive Order on the Advisory Panel Website.)

It does seem that (b) is stacking the deck a little in favor of home ownership. From a political perspective, there are reasons to favor a social structure in which individuals own their own homes. The self-interest of home ownership presumably works in favor of better neighborhoods, where people care enough to beautify and improve their own surroundings because those efforts inure not only to their benefit in the form of aesthetics, but also in the form of increased valuation for their property.

The success of the Home Depot and Lowes of the world are testaments to the interest that people have in doing home improvements -- often working for themselves after inspiration from This Old House. (I like that show - even with the slightly goofy new guy who replaced Steve Thomas. ) Landlords also have incentives to improve property values, but they are unlikely to benefit from the out-of-pocket cost savings from doing the work themselves. Thus, the marginal cost of improvements in the hands of landlords are likely to be greater, and the marginal benefits are likely to be lower because they lack the psychic income from the satisfaction of enjoying their own home improvement project. (Even with flaws and all, it is still nice to enjoy one's work.)

The exclusion for capital gains from the sale of one’s principal residence sweetens the deal somewhat, as it makes the increased valuation a tax-free gain. Of course, you can also get this tax-free gain by dying in possession of the home. (I call this the “cheat the government and die” rule – which my colleague Dr. Goss seems to hold in high esteem based on a previous post. I am not so enamored of this provision.) Or, under a provision existing since 1997, you can simply live in it for two years (or perhaps less in some exceptional cases) and get up to half a million in appreciation tax free.

True, this means that people who sell their homes and move into a bigger one have the capital to improve their lives. Having no taxes on the sale does prevent a “lock-in” effect and an alternative rule which might require reinvestment to avoid the tax would perhaps encourage unnecessary investment in housing in order to invoke the “cheat the government and die” rule at death. (For example, retired couple with grown children retains large home rather than buying the small condo in order to avoid tax consequences.)

While I recognize these problems, increasing the amount of this exemption seems to add little to the fundamental political value of home ownership. In an era when we are trying to do away with the AMT and other gnarly problems, it seems odd that the Commission wants to pile on still more benefits in favor of homeowners with large capital gains. I would prefer fewer specialized benefits like these and letting people make decisions about owning or renting based on other factors besides the tax-favored treatment of their investment.

1 comment:

Charles said...

One of the key elements missing in a lot of tax reform is simplification. I think most people are frustrated with the current set up. Thousands of pages of laws are added every year. Middle class families have fewer deductions and exemptions than companies or the elite wealthy, due to tax shelters etc.

Focusing on vast tax reform such as the Fair Tax initiative or a Flat tax plan would simplify the rules enough to create a national interest, one that has the attention of every person not just those that can take advantage of it.

The average home in the US is about 250-300 grand. What incentives are there to the average person if new benefits are being made from 500 to now a 600 G home. Its ridiculous.

The best plan is to tax what people spend not what they earn. Tax each dollar only once. Remove all deductions and exemptions to level the playing field for all people.

Streamline the government agencies charged with overseeing the process.

Finally, budget accordingly. There should be no projections on what will be spent. Money collected in 05 is the budget for 06, you can't spend anything more, not one dollar more! Of course this would require the government to accept that they are not responsible for every aspect of life. Some pet projects will have to be reduced and the states, counties or cities may have to take up some of the cost, but then the money will be funded on population and taxable income rather than who has better politicians.