April 8, 2008

SENATE HOUSING LEGISLATION HIGHLY DISAPPOINTING:
Three-Fifths of Cost of Senate Bill Goes For Tax Cuts
That Will Do Little or Nothing to Address the Foreclosure Crisis
by Aviva Aron-Dine, Barbara Sard and Chad Stone

As early as April 8, 2008, the Senate is expected to pass housing legislation that its supporters say will help struggling families hold onto their homes and assist the communities hardest hit by the foreclosure crisis.  But while some components of the package are aimed at achieving these laudable goals, about three-fifths of the bill’s cost reflects tax-cut provisions that will do little or nothing to help either homeowners or hard-hit communities and that in one case will actually worsen the problems facing local governments.

Meanwhile, in order to avert a Republican filibuster, Senate negotiators agreed to omit the most crucial housing provision from the bill.  That measure, which would provide a mechanism for large numbers of homeowners at risk of foreclosure to work out new mortgage arrangements, would likely do more than any other to help families remain in their homes and could ultimately benefit both homeowners and the holders of at-risk mortgages.  Notably, the reported cost of this measure is about equal to what the Senate bill spends on tax cuts that will do little or nothing to help address the foreclosure crisis.[1]

As the House develops its own version of the housing legislation, it should drop the Senate’s ineffectual tax provisions and replace them with measures that advance the bill’s core objectives.

Tax Cuts in Package Mostly Fail to Advance Bill’s Avowed Goals

According to estimates by the Joint Committee on Taxation and the Congressional Budget Office, the total cost of the Senate housing legislation is $14.9 billion over ten years.[2]  When he introduced the tax package on the Senate floor, Finance Committee Chair Max Baucus declared, “simply put, we are here today to help families to keep their homes.”[3]  Unfortunately, of the bill’s $10.8 billion in tax cuts, only $1.7 billion is devoted to a provision that would help alleviate the foreclosure crisis.[4]  The other three tax measures — which make up $9.2 billion, or three fifths, of the bill’s total cost — would do little or nothing to help families remain in their homes or to assist communities especially hard-hit by foreclosures.  (See Figure 1.  For a summary of the three provisions, see Table 1.)

The Net Operating Loss Carry-Back Provision

The largest provision in the Senate bill deals with business net operating losses.  A business experiences a “net operating loss” when its tax deductions exceed its income.  Under current law, businesses may use their net operating losses to reduce their previous two years’ taxable income, in which case they receive refunds of taxes paid in those years.  Businesses may also use these losses to reduce their taxable income in any of the next 20 years.[5]

The Senate housing legislation would extend the “carryback” period from two years to four years for net operating losses incurred in 2008 or 2009.  The cost of the provision is $6.1 billion over the next decade (2008-2018).  While the benefits provided to businesses up front would be much larger (about $25 billion), revenue would be recouped in later years because some of the losses that would be claimed as carrybacks would otherwise have been claimed later as carryforwards.

Supporters of the provision assert that it addresses the housing crisis by helping the homebuilding industry.  According to a Finance Committee press release, “homebuilders and other housing sector businesses particularly need cash to prevent layoffs, to avoid selling land and houses at distressed prices, and simply to shore up their lagging bottom lines.”  The press release also implies that the net operating loss (NOL) provision will encourage homebuilders to undertake new investments.[6]

Providing Businesses With More Cash
Generally Will Not Change Their Business Decisions

Generally speaking, homebuilders (and other businesses) will retain workers if they believe that the value of what the workers can produce exceeds their wages.  They will invest in new construction if they anticipate adequate demand for new houses.  And they will avoid selling houses at “firesale” prices if they expect to be able to sell them at higher values in the not-too-distant future.

None of these calculations is influenced significantly by a tax break like the NOL provision, which provides businesses with more cash whether or not they avoid layoffs and firesales or increase investment.  Simply put, a no-strings-attached cash infusion will not prevent businesses from making profit-maximizing choices about hiring, investment, and sales. 

The NOL provision could potentially affect the decisions of one group of businesses:  companies that would like to retain workers, undertake new construction, or keep their newly-built homes off the market but that are constrained by low cash flow and borrowing constraints.  Given the current economic and housing market situation, however, it is unlikely that many homebuilders believe it would be profitable to scale up production and would do so if only they had more cash on hand. 

It is conceivable that a cash infusion could increase the willingness of some homebuilders to hold onto newly-built homes, since some businesses may be selling those assets just to avoid bankruptcy.  On the other hand, the NOL provision could also make firesales more attractive, since it would make it easier for them to take immediate tax write-offs for the resulting losses.[7] 

Moreover, even if the NOL provision could accomplish the goals laid out in the Finance Committee press release, it is not clear that all of these goals are desirable ones.  In particular, additional new housing construction would add to the glut in the housing market, depressing home values further and likely prolonging the crisis.  And “shor[ing] up [failing businesses’] lagging bottom lines” is not generally considered a federal responsibility.

Most of the Benefits from the NOL Provision Would Accrue to Businesses
Outside the Housing Sector, and the Measure Would Provide
Little or No Boost to the Overall Economy

Even during an economic expansion, many businesses experience net operating losses, and some of them exhaust the standard two-year NOL carryback period.  During an economic downturn or recession, more businesses throughout the economy suffer losses that exceed what they can carry back against the previous two years’ taxable income. 

Internal Revenue Service data show that, during the last economic downturn, the biggest users of net operating loss deductions (among C-corporations) were the manufacturing, information, and finance and insurance sectors.  Together, these three sectors claimed more than half of all such deductions in 2002, or about $30 billion worth.  These data strongly suggest that the claim that the NOL provision is a targeted subsidy to the homebuilding industry is incorrect.

This might not be a problem if the NOL provision were likely to help the overall economy by providing high bang-for-the-buck economic stimulus.  But in its recent report on economic stimulus options, the Congressional Budget Office gave an extended loss carryback period its lowest cost effectiveness rating (out of three possible ratings), explaining that “by themselves, carryback and carryover effects are unlikely to generate substantial changes in investment in the short run.”[8]

This is because the same points made above with respect to the homebuilding industry also apply to businesses more broadly.  As a Goldman Sachs analysis noted, “companies don’t spend money just because it’s there to spend.  To justify outlays for new projects, the expected returns have to exceed the cost, and that usually requires growth in demand strong enough to put pressure on existing resources.”[9]  The more promising strategy for boosting business production and investment during an economic downturn is to take measures to boost consumer demand, rather than to raise business cash flow.

The Credit for Purchases of Foreclosed Homes

Under the Senate bill, purchasers of foreclosed homes who intend to occupy these homes as their primary residences would be able to claim a tax credit worth $7,000, spread over two years.  The theory appears to be that the tax credit would greatly increase demand for foreclosed homes, which would help struggling homeowners by raising prices and thereby facilitating refinancing.  Supporters also argue that the tax credit would help neighborhoods suffering from an epidemic of foreclosures by making it more likely that foreclosed homes would be sold to new owner-occupants.[10]

Credit Unlikely to Help Current Homeowners

In fact, this strategy is unlikely to provide meaningful help to current homeowners.  According to estimates by Moody’s Economy.com, about 4 million first mortgages were delinquent or in foreclosure at the end of last year, and another 3.5 million homeowners are expected to default on their first mortgages this year and next.[11]  To address the glut in the housing market, the boost to demand from the tax credit would have to be swift and massive — far larger than is plausible.[12]

Instead, the tax credit is likely to provide a windfall to purchasers who would have bought foreclosed homes even without the extra tax incentive, in order to benefit from unusually low prices.  To the extent that the credit did draw new buyers into the housing market to purchase foreclosed homes, the benefits would accrue mostly to banks and other lenders who are struggling to get foreclosed properties off their hands, not to homeowners suffering from declining equity values.

The credit could even have unintended adverse consequences for some homeowners.  While a $7,000 credit is probably not large enough to lead many people who were not otherwise planning to purchase a home to enter the market, it could sway someone’s decision about which home to buy.  If the credit induced homebuyers to purchase foreclosed homes instead of other homes, it would pump up demand and prices for foreclosed homes at the expense of other homes.  And to the extent this occurred, it would help banks and other lenders at the expense of other homeowners, many of whom have already been hurt by declining home values (even if they are not in danger of losing their homes).

Some have suggested that the proposed credit could even encourage foreclosures.[13]  If it made it easier for banks and other lenders to quickly sell foreclosed homes, they might be more eager to foreclose on properties and less willing to renegotiate mortgage terms. 

Credit Poorly Targeted for Helping Communities

The credit for foreclosed homes is also an inefficient approach to helping neighborhoods plagued by large numbers of foreclosures.  Because it is a generally available tax credit, it cannot be targeted to such neighborhoods.  In fact, since demand is probably stronger for foreclosed homes in areas with few foreclosures than in areas with many, most of the benefits of the credit are likely to go to purchasers of homes that are not in areas with a high concentration of foreclosures. 

(In contrast, funds provided for the Community Development Block Grant (CDBG) in the non-tax portion of the housing bill are targeted to areas that have been particularly hard-hit.  The $4 billion increase in CDBG funding would be distributed to states and localities based on actual foreclosures and the prevalence of sub-prime loans and mortgage defaults and delinquencies.[14])

The Non-Itemizer Property Tax Deduction

The third item in the Senate’s tax package is a new property tax deduction for non-itemizers (i.e. for taxpayers who claim the standard deduction rather than itemizing their deductions).  As noted, one of the main objectives of the Senate’s housing legislation is to help families that are struggling to keep their homes.  Because these families are homeowners and pay property taxes, they would receive at least some assistance from a property tax deduction for non-itemizers (at least, provided they do not itemize and their incomes are high enough for them to benefit from a tax deduction).  But many homeowners who own their homes outright or are not struggling with their mortgage payments also would benefit.  And because the benefits would be spread so widely, they would be very small.  The $1,000 per couple ($500 per individual) deduction in the Senate bill, which would cost $1.5 billion for one year, would provide a benefit worth only $100 to a couple in the 10 percent tax bracket and only $150 to a couple in the 15 percent bracket (and only $50 and $75 respectively to singles in these brackets).

The idea of a non-itemizer property tax deduction appears to have arisen during the period when housing values were appreciating rapidly, and property taxes were perceived to be a major burden on moderate-income homeowners.  In today’s housing market, however, where property values are falling, this issue is less important.  (Of course, for some homeowners, assessed property values may not have caught up with the drop in home values.  But where it has not yet happened, this “catch-up” is likely to occur soon.) 

Most Low- and Moderate-Income Seniors
Would Not Benefit from a Property Tax Deduction Anyway

Typically, much of the concern around property taxes centers on seniors, for whom these payments are perceived to constitute an especially onerous burden.  Yet low- and moderate-income seniors would receive little or no benefit from a property-tax deduction for non-itemizers.  Because Social Security benefits are not taxable for low- and moderate-income beneficiaries, seniors generally need substantial non-Social Security income to have enough taxable income to owe income tax and thus to benefit from a deduction.  As a result, Urban-Brookings Tax Policy Center estimates indicate that 61 percent of elderly households would not be able to benefit from any new tax deduction, simply because they do not have income tax liability.[15]

Thus, concerns about low- and moderate-income seniors are not a sound reason to establish a new deduction for property taxes, particularly since doing so would significantly reduce the amount of help that could be provided to the families more likely to be hard-hit by the current housing market problems

Senate Provision Would Worsen Problems Facing Local Governments

The Senate measure would deny the new property tax deduction to any resident of a locality that raised its property tax rate between April 2 and next January 1.  By effectively preventing localities from raising tax rates to help compensate for shrinking property tax revenues caused by falling home values, the provision could force many localities to cut police, firefighting, schools, and other vital public services.  It also would improperly pre-empt local taxing powers and pressure states to make up the lost local revenue even as many of them struggle with their own budget problems.  And it would place unprecedented demands on the IRS that would likely make it impossible to administer.  (At least 40,000 towns, counties, and school districts levy property taxes, and in many cases, their boundaries do not correspond to other boundary measures such as zip codes.)

In dealing with the current economic problems, a first principle should be “do no harm.”  This provision fails that minimal test, since it would further worsen the serious difficulties the housing crisis is causing for local governments.[16] 

What Would a Better Housing Tax Package Look Like?

In general, expenditure programs are likely to work better than tax cuts in addressing the foreclosure crisis.  Such programs can better target assistance to the families and, especially, communities that actually need it.  (For a few examples of worthwhile programs the Senate could have funded, see the box above.)

However, Ways and Means Committee Chair Charles Rangel has announced his intention to mark up his own housing tax package shortly.[17]  Thus, it is worth considering what a better housing-related tax provision might look like. 

One better use of the funds that the Senate would spend on the NOL provision, the foreclosed-home buyer credit, and the non-itemizer deduction would be a non-itemizer tax credit for mortgage interest.  Unlike a credit restricted to home purchases, a non-itemizer mortgage interest credit would help those families that have already bought homes and are now struggling to keep them.  Such a credit could provide meaningful assistance to low- and moderate-income homeowners, especially if it were made refundable so that families with incomes too low to owe taxes could benefit.  Unlike a non-itemizer deduction for property taxes, such a credit would help only homeowners with mortgages (rather than also providing assistance to those who already own their homes outright).  By targeting assistance more narrowly, it could provide larger tax benefits for the homeowners more likely to be struggling in the current environment.

Based on data from the 2006 American Community Survey, we estimate that, for the $9.2 billion the Senate bill spends on tax provisions that do little or nothing to address the current crisis, it could instead have provided a $500 refundable non-itemizer credit for home mortgage interest payments.[18]

Rest of Bill Disappointing for What It Omits

The Senate housing bill does not include Senator Chris Dodd’s proposal to have the Federal Housing Administration guarantee restructuring of mortgages on certain properties that are at risk of foreclosure.  This is a crucial omission, because many experts believe such a measure affords the best available opportunity to limit the number of foreclosures and to allow more homeowners in danger of defaulting on their mortgages to stay in their homes.[19]

Because of the enormous changes over the past several years in the way mortgages are marketed and securitized, opportunities for face-to-face negotiations between the homeowner and the mortgage holder are much rarer than they were in the days when the local bank held and serviced the mortgage.  Indeed, many mortgages are now in effect owned by investors in various types of commercial instruments, rather than lenders.  In many cases there is no entity with the power to decide to “make a deal” to write down the value of the mortgage or restructure interest payments in order to avoid the substantial costs of foreclosure and enable homeowners to stay in their home under restructured arrangements.

The Dodd proposal, like a similar measure being crafted in the House by Representative Barney Frank, provides a mechanism for achieving mutually beneficial restructuring.  Essentially, the Federal government would buy up existing mortgages at below face value (reflecting the new reality of home prices) and the Federal Housing Administration would guarantee new mortgages issued to these homeowners.  While the provision would need to be carefully crafted to prevent abuses and guard against risks, many view it as the best available option for addressing the foreclosure problem.

Conclusion:  The House Bill Needs to Do Better

As the House of Representatives formulates its own housing legislation this week, it should focus on targeting resources toward measures that advance the legislation’s avowed goals:  helping struggling homeowners and communities hard-hit by foreclosures.  For starters, it should include the important housing measure that the Senate omitted, and it should drop the Senate’s ineffectual tax cuts.

End Notes:

[1] The New York Times reports that the cost of the proposal would be about $10 billion.  David M. Herszenhorn and Vikas Bajaj, “Tricky Task of Offering Aid to Homeowners,” New York Times, April 6, 2008.

[2] Estimates reflect the Senate package as introduced.  This analysis will be updated when cost estimates for the final bill become available.

[3] “Floor Statement of Senator Max Baucus Regarding Housing Tax Provisions, April 3, 2008, http://finance.senate.gov/press/Bpress/2008press/prb040308.pdf.

[4] The $1.7 billion provision provides state (and in some cases local) governments with a one-time increase in mortgage revenue bond authority.  It also allows them to use mortgage revenue bonds to help homeowners refinance existing mortgages and to finance multi-family rental housing, as well as to help homebuyers take out new mortgages.  Mortgages financed by mortgage revenue bonds typically are more affordable than other mortgages due to lower interest rates and fees.  Default rates for these mortgages remain low, and the availability of additional mortgage credit would provide some much-needed liquidity.

[5] Loss “carrybacks” have a higher value than “carryforwards” because they are paid out immediately, instead of years in the future.  In addition, companies cannot be certain they will have the opportunity to use all of their loss carryforwards.

[6] “Tax Relief for American Homebuilders:  Baucus-Grassley Business Tax Provision Saves Jobs, Helps Struggling Companies Survive,” Committee on Finance News Release, http://finance.senate.gov/press/Bpress/2008press/prb040208b.pdf.

[7] See Citizens for Tax Justice, “The Senate’s Foreclosure Prevention Act Unfairly Rewards Big Business Over Middle-Class Americans,” http://www.ctj.org/pdf/foreclosurepreventionact.pdf.

[8] Congressional Budget Office, “Options for Responding to Short-Term Economic Weakness,” January 2008, http://cbo.gov/ftpdocs/89xx/doc8916/01-15-Econ_Stimulus.pdf.

[9] GS Weekly, September 21, 2007.

[10] “Tax Relief for American Homebuyers:  $7,000 Credit for Purchases of Foreclosed Homes Will Aid Responsible Buyers, Raise Property Values,” Committee on Finance News Release, http://www.senate.gov/~finance/press/Bpress/2008press/prb040208d.pdf.

[11] David M. Herszenhorn and Vikas Bajaj, “Tricky Task of Offering Aid to Homeowners,” New York Times, April 6, 2008.

[12] The Joint Committee on Taxation estimates that the cost of the $7,000 credit (which would be in effect for one year) is $1.6 billion.  This suggests that the Joint Tax Committee expects 200,000-250,000 people to claim the credit.  Even if all of these people were buyers who entered the housing market because of the credit, the boost to housing demand would still represent a small fraction of the projected number of foreclosures.  In reality, most of these individuals are probably people who would have purchased homes anyway, meaning that the true boost to housing demand is much smaller.

[13] See for example, The Washington Post, “A Pro-Foreclosure Bill,” April 7, 2008.

[14] The funds must be used within 18 months primarily to purchase and redevelop foreclosed or abandoned properties for resale or rental.  Sale proceeds must be used for the same purposes.  These funds also are more tightly income-targeted than any of the other provisions of the bill.  At least 25 percent of funds must be used for properties that will house families with incomes at or below 50 percent of the area median income (nationally, 50 percent of median income equals $30,750 for a family of four), and the remaining funds must be used for housing for households with incomes at or below 120 percent of area median income (nationally, $73,800 for a family of four).

[15] See Tax Policy Center Table T08-0012.

[16] For more discussion of this provision, see “Statement by Iris Lav, Deputy Director, on Provision in Bipartisan Senate Housing Package Affecting Local Property Taxes,” Center on Budget and Policy Priorities, April 3, 2008, http://www.cbpp.org/4-3-08sfp-stmt.htm.

[17] Lori Montgomery, “House to Offer Plan on Housing,” Washington Post, April 8, 2008.

[18] These estimates are based on the number of households with home mortgages that have incomes below $50,000.  Our assumption is that the number of households with incomes below $50,000 with mortgages provides a good approximation of the number of non-itemizers with mortgages.  (Most households with mortgages that have incomes above $50,000, as well as some with incomes below $50,000, itemize.)  To the extent that the credit induced some of the households who currently itemize to instead claim the standard deduction, the cost would be higher; on the other hand, take-up of the credit would certainly be less than 100 percent, which would lower the cost.

[19] See, for example, Alan Blinder, “How to Cast a Mortgage Lifeline,” New York Times, March 30, 2008.