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Edward L. Glaeser

A tax break that is breaking us

Mortgage deductions lure buyers to big, expensive, energy-wasting homes

By Edward L. Glaeser
May 7, 2010

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THE LATEST Case-Shiller housing data suggest that housing markets have now stabilized. Prices were higher in February 2010 than they were in February 2009, both for Boston and for Case-Shiller’s 20-city index. This stability makes it possible to move beyond stop-gap measures and to envision fundamental reforms that will make the next housing crisis less damaging. Lowering the $1 million cap on the home mortgage interest deduction is a good place to start.

The Case-Shiller index increased by 74 percent in real terms between 2000 and 2006, and then declined by more than a third. For every 10 percent that a city’s housing prices rose during the boom, the city’s prices fell by 7.6 percent during the bust. The astonishing 24.9 percent unemployment rate in the construction sector seems almost mild given that the country went from building more than 1.9 million new housing units in 2005 and 2006 to building fewer than 800,000 units in 2009. The great lesson from this episode is that prices go down as well as up and it is foolish to encourage excessive betting on housing.

I’m not claiming that government policies, like the mortgage interest deduction, caused the bubble. The deduction is an old policy that has remained a constant in good times and bad. Moreover, the bubble can’t be explained by low interest rates or easy mortgage approvals or high loan-to-value ratios. The historical relationship between these variables and housing prices is just not large enough to explain either the boom or bust. America’s great housing convulsion is best seen as an enormous, almost inexplicable whirlwind that was created by ebullient, but incorrect, beliefs about never-ending home price appreciation.

But while government policies cannot be blamed for the bubble, they did exacerbate its damage. For decades, the home mortgage interest deduction and government-subsidized institutions like Fannie Mae and Freddie Mac have made mortgages artificially inexpensive. This subsidy encouraged homebuyers to borrow like mad and tie their fortunes to the housing market.

During the boom, these policies were thought to lead Americans to accumulate housing wealth and create an “ownership society.’’ We now know that encouraging people to borrow to buy homes can just as easily lead towards a “foreclosure society,’’ where millions owe far more than their homes are worth.

The home mortgage interest deduction also subsidizes Americans to buy bigger homes, and there is little reason to like that. Americans, even poor Americans, have almost twice as much living space as the average resident of France or Germany. According to the Residential Energy Consumption Survey, homes with between 2,500 and 3,000 square feet of heated living space use 41 percent more electricity than homes with between 1,500 and 2,000 square feet of space. In an age of global warming, why should we subsidize the greater energy use inherent in larger homes?

There is a powerful connection between structure type and ownership, which means that encouraging homeownership implicitly encourages sprawl. More than 85 percent of people in single-family detached dwellings own; more than 85 percent of people in dwellings with more than five units rent. When we push people to own, we push them to choose suburban McMansions over urban apartments, which is bad for cities, bad for traffic congestion and bad for carbon emissions.

The mortgage interest deduction is also extremely regressive. Economists James Poterba and Todd Sinai estimate that the deduction typically saves $523 per year in taxes for home-owning families earning between $40,000 and $75,000, and $5,459 per year for families earning more than $250,000.

Now that prices have stabilized, we can imagine slowly leading this political sacred cow towards a good stockyard. The interest deduction currently has an upper limit of $1 million. That limit could be reduced by $100,000 per year over the next seven years, which would lead to a less regressive $300,000 cap. After that point, we could consider replacing the interest deduction altogether with a flat homeowner’s tax credit that would encourage homeownership without encouraging borrowing or big houses.

The pain of the great housing convulsion has demonstrated the folly of encouraging everyone to bet everything on housing. Let’s not let this hard-won knowledge go to waste.

Edward L. Glaeser, a professor of economics at Harvard University, is director of the Rappaport Institute for Greater Boston.

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