Tuesday, May 9, 2017

Tax Reform and the Middle Class

When you are in the 15% tax bracket, things like home mortgage interest deduction and IRA deduction make less and less sense.

I have written about taxes before and noted that it is somewhat "unfair" that our tax code has so many incentives that benefit the middle-class and upper middle-class.  Of course, I wasn't complaining when I was in that bracket, now, was I?

The problem with tax incentives, as economists will tell you, is that they can produce unintended consequences in the marketplace as people chase tax deductions and tax credits instead of doing useful things with their money.   If taxes are high enough and loopholes abound, people will spend a lot of time and energy on things that are not productive to the economy.

A New York Times article (now a division of Pravda!) argues that "home ownership" (which many falsely think is "The American Dream") has created income inequality.  I am not so sure if I would go that far, but tax credits and tax deductions have altered the marketplace in a manner that does benefit the middle-class.   Moral:  Be middle-class, and stop wasting your money on crap that causes the middle-class to slide down the economic scale.

I say this because it is doubtful the tax code will be "overhauled" even under Trump (a man who keeps his promises!TM).   And as I keep harping on (a lot) in this blog, basing your personal life plan predicated on radical social changes taking place is not a very safe bet.   Better off to take action in your own life and work with the system you have (and likely will have to work with in any event) than hope for "change" that likely will never come (and even if it did, still would not work to your advantage without action on your part).

But getting back to home ownership, the tax code has created interesting anomalies in the market, and has skewed pricing to the point where the very poor have little hope of buying a home these days.   Simply stated, people like me end up buying the home and renting it to them.   How does this work?

Well, as a former "middle-class" person with a six-figure income (which put me in the slightly upper middle-class for a while) I did get a home mortgage interest deduction.   This did not really make me richer, though, as the New York Times would argue.   Since I was paying in the higher brackets (25% and up) my tax bill was much higher.  Having the home mortgage interest deduction - and the ability to itemize my deductions - offset this tax burden to the point where I was probably paying the same 15% I am paying today and that most of the lower-middle-class pays.  It is a wash.

However, the home mortgage interest deduction did do one thing - it drove up home prices.   And this is the same deal as with student loans and grants.  When there is more "funny money" for college, college tuition goes up.   You may think colleges add up their costs and then divide it by the number of students and then charge that number as tuition.  You would be terribly naive.   The reality is, they charge what the market will bear and like the car dealer, no two "customers" pay the same price for the product.   If there are empty seats in the lecture hall, they provide scholarships and other price breaks to students who could otherwise not afford to go, until there is a warm butt in every seat.

Economists would be proud.   It is the perfect pricing scheme where everyone pays what they can afford to pay - the most efficient market imaginable.    So each student goes off to college with a price in mind as to what they can "afford."  This may be what their parents saved for college, what they get in scholarships, and how much they think they can safely borrow.  They shop around based on what colleges will accept them and on price.   Or at least they should do the latter.  Some students, even though college-bound, are not terribly bright (were you at that age?) and assume that huge student loans will be repaid "somehow" later on.   However, this represents the small minority of students - the minority the press loves to harp on.  Average student loan debt is actually about $25K to $35K as I noted before, which is about what you pay for a car these days - hardly the "crippling lifetime debt" the media (and the Left - or am I being redundant?) loves to tout.

UPDATE:  A reader notes that the median student loan debt is even lower, and that the average is skewed by graduate students borrowing over a hundred grand - which is often an even more foolish choice.  And yes, it is a choice.

Similarly with houses, people have a budget in mind when they go house-hunting.  And like with poor car-buying decisions, many people shop on monthly cost.  When we bought our first house together in Alexandria, we compared the monthly mortgage payment to our existing rent payment.   When it seemed "affordable" (with a 3-2-1 buydown funny-money mortgage no less, at 11-5/8% interest!) we bought.   Most people have to think this way, as they only have so much money to spend per month based on their annual income.

And part of the "math" in this is the home mortgage interest deduction.  Since I was in the 25% or higher bracket, and since the first few years of mortgage payments are almost all interest, if I could deduct those interest payments, I could save about 25% of that amount off my taxes (the math is a little more complicated than that - you have to factor in the difference between standard deduction and itemizing as well).   But the net effect is, I could afford to pay more in monthly payments for the house, because I got a tax subsidy.

And since I was competing with a million other Washingtonians who wanted to buy this house, I made an offer at the highest price I was comfortable paying.   In major markets where housing is in short supply, that's how it works, period.   The cost of housing isn't based on the cost of construction plus "a reasonable profit" - it is based on the laws of supply and demand.

So the home mortgage interest deduction, which was designed (allegedly) to make homes "more affordable" really had the opposite effect - it raised home prices while lowering monthly payments.  This means that people in the higher tax brackets get a bigger tax break than people in the lower brackets, and thus can afford higher monthly payments, which in turn equates to higher home prices, which means the poorer folks are shut out.

Of course, so many people are leveraged into their houses that if you took away this tax credit it would bankrupt them or cause them to lose their houses.  Worse yet, it could cost Republican Congressmen their seats!   Presuming you could get tax reform to eliminate the home mortgage interest deduction, you would have to phase it out over at least 15 years (the part of the mortgage where interest is highest) and thus prevent wholesale slaughter of the middle class.

The problem is, of course, is that the home mortgage interest deduction wasn't designed to help homeowners afford houses, it was designed to help builders ask higher prices for houses and help real estate agents sell houses and bankers to mortgage houses.   Do you really think the party of "Big Business" is going to take a piss on these three huge businesses?   Again, people would lose their seats in Congress and we don't want that to happen, right?   I mean, when Trump says "drain the swamp" he doesn't mean drain it of entrenched Republican Congressmen, of course!

So Mr. and Mrs. Middle-class gets this home mortgage interest deduction and it makes houses harder to afford for the poor.  But wait, it gets worse - a whole lot worse.  And then it gets worse, still.   The "whole lot worse" part is that Mr. and Mrs. Middle-class now have a tax-deductible means of borrowing money - a mechanism that the poor do not have access to.   Of course, this is a double-edged sword as we saw in the last decade, where people (including myself) kept refinancing and "taking out" money from their house (hint:  You can't "take out" that which you did not put in in the first place).  So the allure of easy mortgage money turned out to be as toxic as this opioid epidemic - a lot of fun at first, until it kills you later on.

But that is not the "gets worse, still" part.   Since mortgage interest on investment properties is deductible (naturally - it is an expense!) and you can depreciate the properties for additional tax deductions, you can convert ordinary income into capital gains by buying a rental property, depreciating it over, say, 10 years (consult your tax advisor for actual numbers) and cut your tax bill accordingly.  During my peak earning years when I was in the higher brackets, this technique cut my tax bills considerably.

This does mean, of course, that people like me start going out and buying investment properties to rent out.  So now in the lower income market, there is more competition for home buyers.  The $99,000 duplex I bought, for example, wouldn't have generated much of a tax benefit to a buyer in the neighborhood in the 15% bracket.   But for me, it meant not only a modest income every month, but  a tidy depreciation deduction every year - in the 25% plus bracket.   Undoubtedly this meant that the duplex was worth more to me than someone who wanted to buy it and live in it.

Of course, at the time, I didn't think of myself as snatching the house out of the hands of some deserving homeowner, but rather being smart by investing in Real Estate.  And I was, too.   It wouldn't have changed much if I had decided to not buy the property on some political grounds - someone else would have bought it in my stead.   Investing based on politics is usually stupid investing.

It is hard to say, however, whether eliminating the home mortgage interest deductions or the depreciation deduction would change much.  The very poor often have bad credit and of course, low incomes, which means they likely won't qualify for mortgages, or if they did, only on onerous terms or at rates they couldn't afford.  During the last real estate meltdown, the folks who jumped in at the very end - when prices were highest and mortgages were flakiest - were some of the most unsophisticated buyers.  When the "liar's loans" came due, they defaulted in droves, and demand for housing collapsed, and the overbuilt condos and houses sat unsold, which in turn screwed all those middle-class "buy and flip" people who thought they were going to make a mint.  So home buying screws the poor that way as well - they often are unsophisticated and get shitty deals.   Few "poor" people could even read the preceding paragraphs and understand what I was saying.  So maybe it is better off that they rent.  Or at least the government thinks so, with subsidized rental housing and section-8 and so forth.

And maybe the government is right.  Not a day goes by without some media rat reporting on some poor person living in Flint, Michigan, who refuses to leave that impoverished no-hope city for better opportunities because they own a house there and don't want to "give up" on that.   It was reported recently that one reason unemployment is down is that many people are migrating away from dead-end high-tax rust-belt communities and taking jobs in low-tax, low-cost-of-living, non-union Southern States where industries are locating these days.   One reason for the delay was given that during the recession many could not afford to move as they were trapped in upside-down real estate.   Karl Marx was right (about one thing) owning land ties the worker to one location, and mobility of the workforce is essential in a modern industrial economy.

Hey, my "middle class" parents moved several times during their marriage - including overseas - to take advantage of job opportunities.  Myself, I have moved six times.   Maybe owning a home is not necessarily all it is cracked up to be.

But the inequality of tax deductions goes beyond that.   As I noted before, I no longer contribute to my IRA as my tax deduction is basically zero.  I don't itemize anymore (no mortgage) and I am in the 15% bracket - well, actually the 0% bracket, as I only pay self-employment tax on a decreasing amount of money every year at this point.   The big middle-class deductions mean nothing to me now, which is a good thing at this stage in my life.  Debt and retirement, for the 401(k) generation, is a toxic mix.  Sure there is a tax credit for low-income investors, but in the lower brackets, you really have little money left over to invest, and even if you could put away some money, it would be a paltry amount compared to your retirement needs.

But could this scenario be changed?  And is it really the source of income inequality?   I pretty much think "NO" on both counts.   Eliminating these deductions would derail a 30-year long passenger train that most Americans are riding on - you would have revolution on your hands.   And the industries relying on these deductions would stop contributing millions to your re-election campaigns, so you couldn't even blame it on the Democrats as you could not afford the campaign ads!  (just kidding, no, on second thought, serious).

The problem is, of course, that the poor don't vote and when they do, they vote for the candidates who are contrary to their best interests.   Trump won the last election because poor rural whites voted for him and poor blacks stayed home.  And it wasn't that Hillary wasn't black or something - it was just that they failed to see the advantages bestowed upon them after eight years of Obama.  As one barber in Milwaukee put it in one article I read, "Obama didn't get me no 401(k) or anything!" - apparently missing the point about how a "self-funded" retirement actually works.   But again, it illustrates that the poor are unsophisticated (hence poor!) and just don't get this stuff.   Similarly, the poor rural whites voted for Trump to "get their union jobs back" but there is no indication than any such thing is happening or will happen.   Jobs are available, in the South where unions are not welcome.   And this is not by coincidence, either.  Unions kill jobs, period.

Similarly, proposals for "flat taxes" are really just huge tax breaks for the rich and huge hikes for the poor.  Like I said, I basically pay no income taxes right now, as I am living off savings, small amounts of taxable capital gains, some dividends, and a pathetically small amount of income from work.   If my taxes were raised to a "flat" 15%, that would be a 15% increase for me, not a cut - unless of course, they eliminated the social security and medicare taxes (self-employment tax) at the same time.

For someone in the 35%+ brackets, it would be a sweet deal, of course.   But again, such radical changes would upset the apple cart.   So many industries would lobby against it, particularly the home builders, mortgage companies, and real estate agents.   Yes, eventually the market would reach a new equilibrium in a post-deduction world.   Likely that would skew prices in other directions.

But getting back to the premise of the NYT article, I am not sure that "income inequality" is the result of home ownership.  Tax deductions do affect home prices.  But the real disparity in incomes isn't between the guy making $40,000 a year and the guy making $150,000 a year.  It is between the median income family of $55,000 a year and the investment guru pulling in $20 million.   Because as it turns out, the upper-middle-class family still pays a huge amount of their income in taxes - and is forced to chase deductions as a means of amelioration this.   The very rich - the Mitt Romneys, Warren Buffets, and yes, Donald Trumps, pay 15% capital gains rates, and avoid a lot of taxes though other mechanisms they can afford to set up.  And under Donald Trump's proposals, these very, very rich stand to gain a lot (particularly by cancelling the estate tax) while the middle-class and upper-middle-class would gain very little, if at all.

I also take issue with the idea that the NYT article promotes that a home is a big investment opportunity.  As I have noted time and time again, an investment property is a much better opportunity, whereas a home is just an expense.   While you might get back all the money you paid into a home, after decades of ownership, you don't get back more than you paid in over the years.   So buying more home isn't going to make you "rich" it is just creating a huge expense in your life that could come back to haunt you later on, if you lose your job or your income goes down.

But hey, we're talking The New York Times, here.  These are clueless liberal arts dweebs who think their overpriced row-house in Brooklyn is going to be their nest egg and is a great "investment."   These are the same people who tout home ownership as "The American Dream" which as I have emphasized again and again is an ersatz perversion of the real American Dream - the ability to succeed on your merits in an egalitarian society.  The American Dream is not about granite countertops and stainless steel appliances.  It is not about something as plebeian as possessions.  These are the same sorts of people who feel sorry for the poor and think they are better than the rest of us, because they gave some panhandler $10 on their way to work today.

Sorry, no sale.   While tax deductions alter market prices, they really do not provide much of an "advantage" to homeowners - it just allows them to pay more, in terms of retail price, for a home.   And while it may price houses out of reach of the poor, most of the poor are not in a situation where they can afford a home, and many simply shouldn't be buying homes in the first place, if their economic situation is perilous to begin with.

Writing an article that incites class-warfare or tries to make the middle-class feel guilty about itself isn't the answer to anything.   And this is exactly why I cancelled my subscription to the New York Times.   This isn't "journalism" - this is communism, cloaked in a journalistic wrapper.  So sad the "Grey Lady" has become so delusional these days.  Keep it up, kids!  Those protests will surely cause Trump to resign any day now!   After all, it worked for that pipleline deal, right?  Maybe if we could get Bernie Sanders to run in 2020, he'd defeat Trump, right?

Oh, I forgot, he owns four houses - three in Vermont and one in Washington, DC.   Part of the problem, not the solution, eh?