US housing bubble stoked by ‘97 tax cut

Source : Business Times - 22 Dec 2008

Ryan Wampler had never made much money selling his own homes.

Starting in 1999, however, he began to do very well. Three times in eight years, Mr Wampler - himself a home builder and developer - sold his home in the Phoenix area, always for a nice profit. With prices in Phoenix soaring, he made almost US$700,000 on the three sales.

And thanks to a tax break proposed by then-President Bill Clinton and approved by Congress in 1997, he did not have to pay tax on most of that profit. It was a break that had not been available to generations of Americans before him. The benefits also did not apply to other investments, be they stocks, bonds or stakes in a small business.

Those gains were all taxed at rates of up to 20 per cent.

The different tax treatments gave people a new incentive to plough ever more money into real estate, and they did so. ‘When you give that big an incentive for people to buy and sell homes,’ said Mr Wampler, ‘they are going to buy and sell homes.’

By itself, the change in the tax law did not cause the housing bubble, economists say. Several other factors - a relaxation of lending standards, a failure by regulators to intervene, a sharp decline in interest rates and a collective belief that house prices could never fall - probably played larger roles.

But many economists say that the law had a noticeable impact, allowing home sales to become tax-free windfalls. A recent study of the provision by an economist at the Federal Reserve suggests that the number of homes sold was almost 17 per cent higher over the last decade than it would have been without the law.

Vernon Smith, a Nobel laureate and economics professor at George Mason University, has said that the tax law change was responsible for ‘fuelling the mother of all housing bubbles’.

The provision - part of a sprawling Bill called the Taxpayer Relief Act of 1997 - exempted most home sales from capital gains tax. The first US$500,000 in gains from any single-home sale was exempt from tax for a married couple, as long as they had lived in the home for at least two of the previous five years. (For singles, the first US$250,000 was exempt.)

Mr Wampler said that he never sold a home simply because of the law’s existence, but it played a role in his decisions and also became part of his stock pitch to potential customers who were considering buying the homes he was building in the desert. He would point out that the tax benefits would increase their returns on a house, relative to stocks.

During the boom years, he prospered. But today he owns 32 hectares of land on the outskirts of Phoenix that he cannot sell. He owes US$8 million to his banks, which may soon foreclose on his land.

The change in the tax law had its roots in a Chicago speech that Bob Dole, Mr Clinton’s Republican opponent in the 1996 presidential election, gave on Aug 5 of that year. Trailing Mr Clinton in the polls, he came out for an enormous tax cut, including an across-the-board reduction in the capital gains tax.

The proposal made Mr Clinton’s political advisers more nervous than almost anything else during the campaign. The campaign’s chief spokesman, Joe Lockhart, travelled to Chicago to stand outside the ballroom where Mr Dole was speaking and make the case that the Dole tax cut would cause the deficit to soar. At the same time, Mr Clinton’s aides began scrambling to come up with their own tax proposal. Getting rid of capital gains on most home sales seemed like the perfect idea.

Treasury officials had become interested in that provision earlier in Mr Clinton’s term after Jane Gravelle, an economist at the Congressional Research Service, had called it to their attention, according to Eric Toder, an official in the tax policy office at the time. He and his colleagues were looking for ways to simplify the tax code, and Ms Gravelle told them that eliminating capital gains taxes on houses was an excellent candidate.

Three weeks after Mr Dole’s speech, with support from top Treasury officials, the proposal had made it into Mr Clinton’s speech at the Democratic convention. During the presidential debates that followed, he used it to parry Mr Dole’s calls for a big tax cut. The following summer, he signed the provision into law.