Monday, October 30, 2017

Housing: Part 266 - Tax subsidies as annuities

Let's imagine a home purchase in an environment with no tax distortions.  Rental income taxed after expenses.  No mortgage interest deduction.  No capital gains exemption.

A house that rents for $20,000 (annually) might sell for $200,000.

Now, we add in these tax benefits that are only captured by owner-occupiers.  No tax paid on rental income.  Mortgage interest deducted when taxes filed.  No capital gains on most sales.  Now, the house might sell for $300,000.  (I am using round numbers for ease, so this might be a slight exaggeration of reality, but it probably isn't too far from the actual premium.  White House estimates put the value of these subsidies at about 25% of annual operating profits for owner operators, and those subsidies are focused at the top end of the market.)

I think it helps to look at property taxes as a silent partnership.  If property taxes amount to 20% of net rental income (either cash or imputed), then the government has become a 20% silent owner of the property.  This is not that different than having an adjustable rate, negative amortizing mortgage with an LTV (loan to value) of 20% with no prepayment option.

Likewise, we can think of tax subsidies as a sort of annuity.  When you buy the house, you are basically buying the future cash flows of a house with $20,000 annual rent.  But, tax subsidies mean that when you buy the house, you also are required to purchase a $100,000 annuity.  That annuity amounts to the forgiven taxes on the net tax income as they are earned, the tax deduction on mortgage interest when taxes are filed, and the forgiven capital gains tax from when the home is sold in the future.

Since the value of tax subsidies are capitalized into the price of the house, then it is best seen as a legal requirement that when you buy a home, you also must purchase an annuity.  The payment for the annuity goes to the previous homeowner, and the annuity income comes from the government, in the form of forgiven taxes.

So, the question about the effect of tax subsidies on homeowners really comes down to the price of the annuity compared to the value of the annuity.  If the price of the annuity is more than the value, then home buyers will decrease their investment.  If the price of the annuity is less than the value, then home buyers will increase their investment.  Of course, the value of the annuity is complicated, itself, since it is largely determined by discount rates on those future tax savings.  These are difficult, if not impossible, to quantify.

But, we can make some generalizations.  And, instead of thinking about how this affects "the housing market", there is probably a lot more going on in the differences between sub-markets.  Low priced homes or homes owned by households with low incomes would not have very valuable annuities, because those owners would not capture many tax benefits.  But, in neighborhoods that would be dominated by those owners, prices are much lower (in price/rent terms).  The prices of the annuities are low, too.  The distortions in those markets are probably not great.

I think one of the things that happened in the Closed Access cities during the boom was that home prices in low-tier neighborhoods were rising high enough to make those annuities valuable, and the in-migration of high income buyers to the Closed Access cities also might have made the marginal new buyer also more sensitive to the tax advantages.  So, in Closed Access cities, during the boom, low tier Price/Rent levels rose up to nearly the same level as high tier Price/Rent levels.

At the other end of the spectrum, in the highest tier neighborhoods, households would value the untaxed rental income, but those neighborhoods tend to be less leveraged.  Another mitigating factor here is that at the top tier, rent tends to take a lower percentage of household income.  In order to capture the annuity, the household must purchase a more valuable home.  They may simply not demand more shelter, so even if the annuity has value, it may not have enough value to induce them to consume more housing than they already care to consume.

So, as in the low tier, the annuity may not have much of an effect on owner-occupier demand.  This may be why Price/Rent ratios level out in zip codes above $400,000 or so (plus or minus, depending on local conditions).

In the middle, households would value untaxed rental income and capital gains exemptions.  Here, there would be a lot of variation.  In a single neighborhood with a single price point, there would be less leveraged older families who would value that benefit less, and younger, leveraged families who would value it more.  So, if there is a section of the market that might value the annuity the most, it is young households with above-average incomes.  They would react by increasing their demand for housing because housing would be a complementary good with the annuity that legally comes attached to it.

But, these families are probably among the most credit constrained households.  In other words, they may be in a position to gain the value of ownership (in and of itself, before any value from the annuity), but their limit to gaining that value may be limited by their access to mortgage credit.  So, their demand for housing may be very elastic at the limit of mortgage payments they can qualify for.

This means that the households who might be most likely to increase their housing consumption because of the tax subsidies may be least able to pay for the annuity.

Consider: without the subsidies, those households would be provided with the opportunity to purchase $20,000 in rental value for $200,000.  With the subsidies, those households would be provide with the opportunity to purchase $20,000 in rental value for $300,000.  What if their credit constraints mean that they are basically willing and able to purchase a house with a price of $200,000.  Mortgage constraints are based on price, not rental value.

That would mean that, without the subsidies, they would purchase a home with $20,000 in rental value, but with the subsidies, they would only be able to purchase a home with $13,333 in rental value.  For households with high incomes but with credit constraints, the subsidies might reduce their housing consumption, and it is those households who would most value the subsidies.  This seems like it would especially be a factor in Closed Access cities, where higher rents mean that potential homeowners have both higher incomes and more credit constraints.

Where new homes are built, the important margin is the comparison between price and the cost of a new home.  The payment for the annuity goes to the homebuilder, and the builder doesn't care if you're paying for the home itself or for the legal annuity attached to it.  It's all profit to them.  So, we should expect new residential investment to decline if subsidies are removed.  Price/Rent of existing homes would decline.

But, the important margin for housing consumption is nominal rent expense as a proportion of incomes.  Households would be willing to spend a similar amount of income on rent, but with less supply coming online, the normal increase in demand (expressed as total rent paid) would continue to rise.  There would be rent inflation, which would cause home prices to increase somewhat, mitigating the decline in value because of the withdrawal of subsidies.  In other words, over time, households would tend to live in homes with lower cost of construction (smaller, etc.) but with no change in rental value.  This would mainly happen in the mid- to upper-tier markets where the subsidies had been the most valuable.  (This would not be the case in the Closed Access cities, because cost of structures is not particularly relevant to home values there.  In Closed Access cities, values would fall and rents would be generally unaffected by this effect.)

Now, we need to think again about those credit constrained buyers.  Without the subsidies, their demand for housing (in terms of rental value) might actually rise.  This would put more upward pressure on rents, and probably upward pressure on residential investment and housing starts.

There are many studies that seem to suggest that tax credits get capitalized into home prices, so that they make homes more expensive, but they don't lead to an increase in homeownership.  That is not surprising to me.

In the end, under certain circumstances, I wonder if eliminating homeowner tax benefits might simultaneously be associated with strong residential investment while at the same time creating some negative wealth shocks among the households who would lose the annuities which they had paid for when they had purchased their homes under the tax-preferred regime.  These effects would probably not be significant in low tier markets, where the price and value of the annuities is low.  It would be significant in the high tier markets.

This seems counterintuitive, because we generally think of tax subsidies as a handout.  But, if tax subsidies are capitalized into home values, which they clearly are to some extent, then they could be conceived of as a regulatory burden.  New home buyers are required to purchase an annuity, frequently entirely with borrowed money, which would rarely be considered a wise investment strategy.  And, their buying decision is partly based on the effective value of that mandated annuity to them.


  1. The interplay you describe is why a plan like makes sense.

    1. Thanks for the link. Some interesting points.

  2. End the mortgage interest tax deduction and property zoning.