Houses and taxes

Aug. 1, 2005
The Federal deficit is declining at a faster rate than had been expected and the reasons are rather complex. While some analysts attribute the decline to the tax cuts put in place early in President Bush's first term, others point to an increase in capital gains (and thus tax revenues) on housing sales. Both camps are correct. Let's start with the impact of the tax cuts. I have suggested that tax

The Federal deficit is declining at a faster rate than had been expected and the reasons are rather complex. While some analysts attribute the decline to the tax cuts put in place early in President Bush's first term, others point to an increase in capital gains (and thus tax revenues) on housing sales. Both camps are correct.

Let's start with the impact of the tax cuts. I have suggested that tax cuts that resulted in an increase in consumer consumption would help stimulate the economy. Sure enough, people spent nearly every dollar they saved in taxes in ways that allowed the recovery to take place. I have no reservation in stating that if the tax cut were not in place, the GDP would be lower than it is today. It didn't happen overnight, however. In fact, it took about two years for consumer dollars to overcome the adjustment that manufacturing had to make to get costs reduced and capacity aligned with demand. But the result is a stronger and more competitive business environment.

However, we paid a price for the economy's turnaround in terms of the budget deficit, which reached nominal heights that some consider dangerously high. But since interest rates have fallen to historically low levels, either the markets are not all that concerned, or there are fewer alternatives for invested funds.

The interest rate is really no more than the price of capital, as set by the marketplace in much the same way as any other broadly consumed good. If demand is strong, the price can favor the seller and vice-versa. In this case, the demand for U.S.-backed securities was the best alternative available; we saw a rather remarkable demand for Treasury debt.

At the same time, the expectation that inflation had become more manageable than in the past led to a much lower spread between long-term debt and short-term debt. This allowed companies to readjust balance sheets to bring the overall cost of capital to historic lows. Businesses have done a great deal to manage costs, and should be applauded for their effort. Mergers, acquisitions, plant closings and product-line rationalization have all led to a leaner and more productive goods-producing sector. This positions us well ahead of most other industrialized economies in terms of meeting the demands of the next decade.

The increase in housing prices is a reflection of lower interest rates, more liberal borrowing criteria and the imagination of financial institutions to take advantage of less expensive long-term capital. Recently, about 10% of the demand for housing has been speculative; but most of the increase has been due to upgrading and second-home buying.

Some would point to the capital gains of the speculators as a source for significant tax revenues that helped reduce the deficit. While there's no question that this had an impact, it didn't happen in a vacuum. Were it not for our sustained economic growth, the attractiveness of the U.S. market relative to others and the lower cost of borrowed funds, we would not have seen the movement in house prices that we did. The fact that we had mortgage instruments that attracted first-time buyers, as well as a large segment of the population looking for second-home opportunities, certainly helped the demand for housing.

In fact, the next capital gains opportunity appears ready to present itself as the equity markets are finally realizing the earnings potential of all the hard work put in place by for-profit firms over the past two years. But then again, I should know better than to predict the direction of the stock market.

The upshot of all this is that if we eliminate the tax break, we will reverse the improvements that are currently in place.

About the Author

MARTIN LABBE

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