Landmark Links November 14th – Disincentives


Lead Story….. This is the final post of a three part series that I’m writing about “the middle class,” tax reform and why it is so difficult to achieve in today’s environment.

Primum non nocere is a Latin phrase that means “first, do no harm.”  It is often incorrectly attributed to the Hippocratic Oath which many medical school students take before they become doctors.  Unfortunately politicians, in addition to doctors, are not required to take such an oath before taking office.  If they did, perhaps some of our laws would be more beneficial to society as a whole.  Take for example the latest tax reform proposal and the impact that it would have on high cost housing markets.  Virtually every high priced housing market in the US (certainly on the west coast) has a problem – too little inventory is driving prices up to the moon.  Not enough new, desirable product is being constructed to entice move-up buyers to sell their house and upgrade.  As a result, spending on renovations is through the roof (it’s a great time to be a Home Depot stockholder!) and resale inventory is at historically low levels.  Given the above, and it’s impact on an affordability crisis and growing homeless population, one would think any new tax proposal should have incentives to increase inventory of both rental and for-sale housing – or at the very least not contain provisions that would explicitly create incentives to drive resale inventory even lower.  Sadly, one would be wrong.

Merrill Lynch came out with a timely research note a couple of weeks back about the concept of tax cuts “paying for themselves.”  It’s important commentary because it focuses on the notion of incentives and how they determine the effectiveness (or lack of effectiveness) in tax policy achieving it’s stated objectives.  From Merrill Lynch (emphasis mine):

“President Clinton worked with Republicans and cut the capital-gains tax rate from 28% to 20% in 1997. Capital-gains tax cuts are among the most likely to generate greater revenues because taking a capital gain is optional. If the tax on the gain is 20%, you are more likely to realize the gain and pay taxes than if the tax rate is 90%. If you don’t take the gain, there are no tax revenues. The booming stock market in the late 1990s generated a wealth of potential gains, and more were realized at lower tax rates. While it is common to hear pundits in the financial media say something to the effect that “no respectable economist believes that tax cuts can pay for themselves,” the late-1990s experience is a case study in why “respectable” economists are so often wrong. Indeed, that was the last time that the U.S. government ran a fiscal surplus and the bounty of capital-gains revenues was a major factor behind the budget surpluses of the late 1990s.”

When taking a look at the current bill as proposed, ask yourself: what type of behavior does it encourage and what do it discourage?  When it comes to housing policy, the answer should be obvious.  The tax bill as proposed by House Republicans would be an absolute catastrophe for housing, especially in high priced markets where it would undoubtedly hurt the so-called “middle class” that politicians of all stripes profess to want to help (side note – this post is only addressing market rate for sale housing – but things do not look positive or subsidized affordable development either).

The provisions that would most impact housing affordability in high cost markets are:

  1. Property tax deductions will be capped at $10,000
  2. The $500k capital gains exemption currently available to those who sell a house that they have lived in for 2 of the last 5 years will now only be available to those who have lived in their house for 5 of the last 8 years.
  3. The mortgage interest deduction will be lowered from interest deductability on a home loan of up to $1 million to interest deductability on a home loan of up to $500k

Point one above would make owning a home less affordable in high cost (ie California) or high tax (ie New Jersey) markets.  However, since there is no grandfather clause for existing owners, it is unlikely to have a material impact on the housing shortage, IMO.  I wish that I could say the same for the other two provisions.

The supply problem that we face today is brought on by two factors that are limiting mobility: 1) There aren’t very many units being built; and 2) People don’t move as frequently as they used to.  As recently as the mid-2000s, Americans moved every 6 years on average.  Today, that average has increased to nearly 10 years.  When people move, they tend to make other large purchases which act to stimulate the economy, while opening up entry-level units for others.  Having good housing mobility is generally good for the economy – not just realtors and home builders – which is part of the reason that it’s been incentive in the tax code.  However, extending the capital gains exemption time-frame and reducing the mortgage deduction as noted in points 2 and 3 above would reduce, not increase mobility.

First, let’s look at the capital gains exemption.  The new provision of requiring people to live in their house for 5 of the last 8 years before being eligible explicitly incentivizes home owners not to move as frequently.  However, as stated above, mobility has been falling for the past decade.  This provision will simply give would-be movers a reason to hold on for a few more years in order to take advantage of the tax break rather than selling today.

Second, let’s look at the consequences of lowering the mortgage interest deduction.  It may be hard to believe for those who live in other parts of the country, but it’s nearly impossible to find a home that’s more than a studio for $500k in many high priced coastal regions.  The immediate impact is simply that this provision would negatively impact the affordability of a house in a high priced area and make renting more attractive on a dollar-for-dollar basis.  However, that’s not the aspect of this provision that I think will lead to reduced inventory.  The mortgage write off reduction comes with a grandfather clause that keeps the deduction at a $1MM cap for those who already own a home.  Homeowners who are grandfathered in will be able to keep the cap until they either sell and buy a new home or refinance their existing home.  It’s already expensive enough in many markets to sell a home and trade up.  Typically that move comes with a increased basis, higher mortgage payment and a new higher tax bill (especially with Prop 13).  This is yet another reason to do nothing and stay put.  Laura Kusisto, Christina Rexrode and Chris Kirkham addressed the likely fallout recently in the Wall Street Journal (emphasis mine):

Economists said the changes come at a sensitive time for the housing industry.

Single-family home prices rose on an annual basis in 92% of 177 U.S. metropolitan areas in the third quarter, according to a Thursday report from the NAR. That was the largest share of metros notching price gains in more than two years.

But the gains were driven by a shortage of homes for sale. At the end of the third quarter, there were 1.9 million homes on the market, 6.4% fewer than the same period last year. The average supply during the third quarter was 4.2 months, down from 4.6 months a year earlier. Economists say six months is typical of a balanced market.

“We have affordability issues as it is. If you make it more difficult for people to put money toward the house, or take away the economic benefits of them owning a house, it really, really could be a major problem,” said Rick Sharga, executive vice president of Ten-X, an online marketplace for real estate.

Mr. Howard of the NAHB said the tax overhaul could cause a housing recession because of a potential drop in home values. States with high housing costs, including California, where more than a third of homes are valued above $500,000, would be particularly hard hit, he said.

“Republicans have always claimed that they don’t want to pick winners and losers in the economy,” he said. “They are clearly picking large corporations over small businesses, and they are clearly picking wealthy Americans over the middle class.”

To be sure, the $500,000 cap on the mortgage interest deduction would apply only to loans made after Nov. 2, which protects existing homeowners. But experts said that is likely to exacerbate the current stagnation in the housing market.

Homeowners in high-cost cities like New York, Boston, Los Angeles, San Francisco and parts of Miami are less likely to trade up to larger, more expensive homes if they know that means losing the protection on the mortgage interest deduction, which in turn makes it difficult for younger buyers to enter the market.

“In those expensive markets that already have an inventory crunch it’s probably going to make the situation worse,” said Ralph McLaughlin, chief economist at Trulia. He said this is likely to drive up prices.

I tend to think that the initial response, should this be signed into law may be a relatively small decline in prices.  However, I would also guess that the intermediate to long term consequences are less inventory, lower affordability and ultimately higher housing costs.  To be 100% clear, we do indeed over-incentivize home ownership in many ways under the current tax code.  In fact, I would propose that if we were starting the tax code from scratch there are elements of the new proposal that make more sense than what is currently in place.  However, politicians have to deal with conditions in the real world, not an idealized version.  As such, making these sort of sweeping tax reforms at a time when we are already facing an unprecedented housing affordability crisis is just bad policy.  And, damn I wish that I owned stock in Home Depot right now.


Push and Pull: The US unemployment rate fell to 4.1% in October, marking a new cycle low.  Inflation has been tame though which has kept the Fed from being too aggressive in hiking rates and leading to speculation about the reliability of the Phillips Curve (the relationship between unemployment and inflation).  However, look for more aggressive rate hikes if unemployment falls much below 4%.

Area of Concern: Overnight index swaps suggest the economy will be weak enough a year from now to warrant rate cuts.

Playing Catch Up: Wage growth is subdued in the US due to deceleration at the top end masking acceleration at the bottom end of the scale.


Office Space: The personal computer was supposed to kill the office and liberate us from hellish commutes to the city. But the average American commute has only increased since then.  Could virtual reality reverse this trend?

Breaking Up is Hard to Do: The bat-shit crazy and incredibly expensive Harry and Linda Maclowe divorce proceedings are a reminder that there ain’t no divorce like a billionaire developer divorce.


Out on Their Own: New data shows that the trend of Millennials leaving their parents basements to buy homes of their own shows no sign of abating.

Dragged Down: Job growth is continuing to slow in the most expensive residential markets in the US.  Turns out it’s hard to work where you can’t afford to live.  Who knew?


Oops: $300 million in cryptocurrency was accidentally lost forever thanks to a bug.  Fear not though, this is a stable asset class that will prove to be a tremendous store of value in the long run.

Race to the Bottom: Researchers at the Cleveland Fed think that peer-to-peer loans have deteriorated to the point that they are starting to resemble subprime loans during the mortgage crisis.

Where in the World? Jet-set debt collectors join a lucrative game – hunting the super rich who owe millions.

All the Cool Kids: The retail worker of the future will be cool, charismatic and better paid as successful retailers emphasize in-store experience.

Chart of the Day

How Many Hours Americans Need to Work to Pay Their Mortgage

Source: Visual Capitalist


Hot Boxed: A Kansas City man facing federal gun and drug charges ended a police interview by ripping massive farts. I have no clue whether he’s innocent or guilty but this epic:

According to the Kansas City Star newspaper, a detective’s report said Mr Sykes “leaned to one side of his chair and released a loud fart” when asked for his address by police while being interviewed in September.

“Mr Sykes continued to be flatulent and I ended the interview,” the detective wrote after recovering.

Night Out on the Town: A group of naked people rampaged through Missouri town, breaking into buildings, barking and showering in soda water because, drugs.

Gotta Hear Both Sides: An Oklahoma man who taped adult magazines to his body for protection was arrested for trying to stab an ex-neighbor. (h/t Ty Reed)

Landmark Links – A candid look at the economy, real estate, and other things sometimes related.

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