Mortgaging the Economy

Marc Comtois highlights another fascinating glimpse into the reasoning behind policy ideas that he and I agree are, well, in error. I’m speaking of this paragraph from Slate’s Matthew Yglesias:

… I’m especially enthusiastic about the mortgage part. Suppose homeowners in expensive coastal cities couldn’t deduct their mortgage interest, what would happen? Well, what would happen is that prices would fall. But nothing more dramatic than that. All the deduction does is encourage further bidding up of the price. In a normal market, that bidding up of the price might lead to additional construction. But the main reason those blue metro areas have such expensive houses is that zoning doesn’t allow demand to be matched with supply. No matter how expensive Georgetown or Harvard Square or Park Avenue gets they’re not demolishing the existing structures and replacing them with much larger ones. So you’d get some extra tax revenue this way with no real change in the amount of underlying economic activity.

Look, I’ve been known to make statements about the effects of policies that are arguably over-confident, but at this level of detail, human behavior has a definite x-factor of which policymakers (and policy-propounders) should beware. Prices ultimately reflect the willingness of buyers to pay for something at the expense of other things on which they might spend their money.  Consumer competition is hardly the only factor in setting that rate.

For one thing, it would take more than an assertion to prove that the real discount that buyers receive on the cost of housing through the tax deduction will ultimately come out of housing and not (say) dining out or charity. Money is fungible, so the dynamics of a particular area may overwhelm the influence of a mortgage deduction on real estate prices. That there are only four potential buyers for a house, rather than eight won’t affect the price if those four are still willing to bid it up.

Real estate also isn’t a smooth spectrum of assets that can be multiplied, so changing the economics could cause prices to bubble up in unexpected places. Even if the prices drop in a town’s most desirable neighborhood, the next-best-option may not drop by just the amount of the mortgage deduction, pushing wealthier families into competition with less wealthy families.  With “affordable housing” taking up some of the available real estate on the low-end of the market, the overall effect may be to focus the buying public on a narrower range of the market, driving up prices there.

But whatever the case, the price of real estate isn’t some abstract quality of nature with no beneficiary. Rather, it determines the value of the homes that actual people own and, therefore, how much they have to spend on other activities. In other words, one way or another, withdrawing more federal tax will remove money from the local economy.

According to tax data available from the IRS for 2010, a total of 151,266 Rhode Island taxpayers reported mortgage interest of $1.5 billion.  This isn’t an area that I’ve studied in depth, so there may be significant nuances that I’m missing, but breaking out that total across the appropriate income brackets and applying the progressive tax rates (very roughly) suggests that Rhode Islanders would pay somewhere around $375 million more to the federal government.

That’s about three-quarters of a percent of the state GDP that would just disappear out of the local economy.

Frankly, I’m sympathetic to the argument that Rhode Islanders deserve as much, for the governments that they’ve helped to elect at every level, but the idea that a tax increase of this amount is akin to an intangible adjustment of accounting — shifting money from the “real estate” column to the “government” column with “no real change in the amount of underlying economic activity” — strikes me as absurd.