real estate markets since 1980: what role have tax ... - CiteSeerX

National Tax Journal, Vol. 45, no. 3, (September, 1992), pp. 253-66

REAL ESTATE

MARKETS SINCE 1980: WHAT ROLE HAVE TAX CHANGES PLAYED?

JAMES R. FOLLAIN*,

PATRIC H. HENDERSHOTT**,

HORTLY after passage of the 1986 Tax S Act, we wrote a two-part paper on tax reform (Follain, Hendershott, and Ling, 1987). In the first part, we developed a "theory" of tax law changes that interpreted the lengthened tax depreciation schedules and increased capital gains tax rate as a rational response to a decrease in the inflation rate. In the second part, we forecast the long-run impact of the 1986 tax act on real estate, assuming no future tax changes. In an exercise in accountability, we now evaluate the accuracy of our theory and forecasts. The theory and its implied forecast can be summarized briefly. Under U.S. tax law, tax depreciation allowances are based on historic cost and nominal capital gains are taxed. Arguably, allowances and gains should be indexed for inflation (depreciafion should be based on replacement cost and only real gains should be taxed). In the absence of formal indexation, depreciation allowances should be shortened and capital gains tax rates cut when inflation rises, and historically this has been the case. Thus we forecast that a significant cut in the capital gains tax rate and shortening of tax depreciation schedules would come only if inflation accelerated.' Inflation has not accelerated, and the cut and shortening have not occurred. Forecasting is a dangerous business as the cardinal rule for forecasters suggests: give them a number or give them a date, but never give them both. While we gave several numerical long-run forecasts five years ago, we contend that five years isn't the long-run and for some real estate nwkets we should not yet expect to see any of the forecasted impacts. Tax law changes are just one of many possible distwi)ances to real estate markets, and only in the absence of other major distur-

bances will the impact of tax changes be clearly revealed .2 Real estate markets in the early 1990s differ markedly from the 1980 market in at least two important respects. First, although 1990 real interest rates are about equal to 1980 values, the combination of cuts in regular income tax rates and equal reductions in both nominal interest rates and expected inflation has doubled real after-tax interest rates. As a result, 1990 investment hurdles rates or user costs for all real estate (and non-real estate) investments are substantially higher. Second, a "lending frenzy" has produced a glut of commercial real estate in most regions of the country, and a substantial excess of multifamily residential units in some regions. Moreover, this glut (excess) was produced during the 1983-86 period and thus has already existed for over five years. Two of our 1987 forecasts appear off the mark, one by a wide margin. We predicted small increases in real rents and decreases in real values for income-producing real estate. For apartments, real rents have been flat and real values have declined, although the evidence is mixed and varies by region. For commercial properties, both real rents and real values have plunged. The poorer-than-expected value performances are obviously caused by the lower-than-expected rental income streams.3 Below expected rental income is attributable, we contend, to the overbuilding in the middle 1980s, not to a misunderstanding of the 1986 tax provisions or their ceteris paribus impacts. While one might think that ample time has passed for us to be seeing the longrun economic impacts of the 1986 tax act, and that may be true for impacts in some markets, it is decidedly not true for income-producing real estate. Overbuilding in the middle 1980s has simply swamped the long-run effects of the 1986 tax act. Regarding owner-occupied housing, the forecasted economic impacts of the 1986

'Syracuse University, Syracuse, NY 13244-1090. *wMeOhio State University, Columbus, OH 43210. '$*University

of Florida,

Gainesville,

AND DAVID C. LING***

FL 32611.

253


254

NATIONAL TAX JOURNAL

tax act might be expected to be seen by now because widespread overbuilding has not occurred. Because after-tax real interest rates increased sharply and real rents moved little, we would expect substantial declines in homeownership and a slowdown in the rate of increase, if not an absolute decline, in real house prices throughout the decade. These have, in fact, been observed. Further, the 1986 tax act provides some predictions about the use of mortgage debt, which seem to be occurring. Our paper is divided into three sections and a conclusion. We begin with a further elaboration of the major disturbances to income-producing real estate markets in the 1980s and then describe a simple model that can be used to illustrate the effects of such disturbances. Section two interprets developments in the multifamily and office markets, and section three considers the owner-occupied housing market. Shocks to Commercial Markets in the 1980s

Real Estate

The 1980s and 1990s both began with substantial economic weakness. The 198082 period had two relatively short recessions, the second being quite deep; the 1990-92 period has been marked by a single long, double-dip recession. The early recessions were caused by the first serious period of monetary restraint in half a century. The restraint was successful in reducing the expected inflation rate from nearly ten percent to four percent. Nominal interest rates fell much less rapidly during the first half of the 1980s, and thus real interest rates averaged over 3 percentage points above the 1978-80 levels (nearly 5 percentage points above the 1975-78 levels) during the 1981-84 period (Hendershott and Peek, 1992). Real after-tax interest rates increased even further because tax rates were lowered. The 1981 and 1986 tax acts changed the provisions affecting income-producing real estate in opposite directions (Follain, Hendershott, and Ling, 1987). The 1981 act increased the tax saving from tax depreciation deductions by 40 percent and lowered the capital gains tax rate by 30

[Vol. XLV

percent; the 1986 act halved the tax sav. ings and doubled the capital gains tax ratp. Thus, the 1981 tax act should have in. creased investment, lowered rents, and raised asset values, and the 1986 act should have done the reverse. The in. crease in real after-tax interest rates would act to dampen the impact of the 1981 Ad and to reinforce that of the 1986 Act. The last, and almost certainly greatesk disturbance to commercial real estate markets in the 1980s is a phenomenon Hendershott and Kane (1992a) term a "lending frenzy." By this they refer to the financing of income-producing real estate construction to the point of extraordinary excess supply in the middle of the decade and the continuing financing of it to maintain this excess supply throughout the remainder of the decade. Apartment (over 4 unit buildings) vacancy rates, which varied between 6 and 8 percent during the 1970-84 period, exceeded 9 percent in late 1986 and averaged 9.5 percent throughout the rest of the decadc Between 1968 and 1983, downtown office market vacancy rates were above 11 per. cent only in 1975 and 1976; since 1985, they have exceeded 16 percent continuously and averaged 17.5 (suburban vacancy rates have averaged 22 percent). Substantial excess supply also existed in the second half of the 19808 for most of the rest of the commercial real estate market. Overall, Hendershott and Kane estimate that $80 to $100 billion in excess commercial real estate was constructed. Using a much different method, Giliberto (1991) derives a lower $50 to $70 billion estimate of excess construction. Many lending institutions have con. tributed to this frenzy. Probably the first, and certainly the easiest to document, were the savings and loans (S&Ls). Between the end of 1981 and the end of 1985, the pro. portion of S&L assets in home mortgages, which had varied within the tight 0.72 to 0.74 range throughout the 1965-81 period, plunged to 0.57. These institutions had been encouraged/required to borrow short and lend long (federally-chartered institutions were not allowed to originate adjustable-rate mortgages until 1981). When interest rates rose sharply in the


No.31

JAMES FOLLAIN,PATRICHENDERSHOTT,DAVID LING

late 1970s and early 1980s, the enterprise-contributed equity (as opposed to deposit-insurance-generated equity) of the institutions became negative. Mistakenly left operating with government deposit guarantees and given new powers to fund construction loans and to wt as real estate equity investors through their real estate service corporations, as well as a 150 percent increase in deposit insurance coverage, S&Ls increased their investments in nonhome mortgage loans at a 30 percent annual rate throughout the 1982-84 period. After that the growth in these loans returned, until the 1989 FIRREA legislation, to the normal 10 percent per annum rate, but was applied to a base that had doubled in the 198284 period. Supervision of commercial bank risktaking and capital adequacy was only Oightly better. Banks pursued risky concentrations of lending both to less-developed countries and in local real estate markets. Developers were no longer required to secure "take-out" financing as a site to obtaining a construction oranr7FUiinally,foreign (especially Japaam) investors, pension funds, and life insurance companies poured money into commercial real estate after 1986, even though vacancy rates were at extraordiuq levels. Our framework for thinking about how these shocks should have affected incomeproducing real estate markets consists of five relationships describing: (1) the adjutment of real rents to differences between the natural and actual vacancy rates, (2) an identity relating the current vacancy rate to last periods rate, the net (of discards) construction rate, and the 6wrption rate, (3) a Tobin-q like relaWn between the construction rate and the price-replacement cost ratio (P/RC) less unity, (4) an identity relating the differow between P/RC and unity to the present value of all future differences between the expected and equilibrium (user cost) rental rates, and (5) the dependency of the user cost on the real after-tax inWmt rate, the economic depreciation rate, oW the tax saving on the present value of tax depreciation.

255

Tax law changes alter the user cost, but so do changes in real after-tax interest rates. This user cost (relative to market rents) affects the price/replacement-cost ratio, the force driving construction. Construction, in turn, attects the vacancy rate and thus real rents. The long-run equilibrium in an income-producing property market is characterized by P = RC, user cost equal to rents, and a vacancy rate equal to the natural rate. In such a market, an unfavorable tax law change (e.g., the 1986 Tax Act) increases the user cost above rents and lowers prices below replacement cost. This, in turn, should halt construction and, with normal discards and absorption, drive vacancy rates below the natural level. Only then will the t'ax change be reflected in higher real rents.' A lending frenzy acts as an ad hoc addon to the construction relationship. That is, the frenzy can stimulate construction (and thus depress rents) even when replacement cost seems to exceed market value (and user cost to exceed net rents). In fact, the frenzy pushed an "effective" user cost well below the "efficient market" user cost we have computed. When lenders become equity participants and do not require a fair risk premium or when developers do not have to put up any equity or obtain permanent financing prior to getting a construction loan, efficient market user costs become irrelevant to the determination of construction and thus real rents. Income-Producing Real Estate The tax acts of 1981 (ERTA) and 1986 (TRA) were predicted to have different economic effects. ERTA was expected to encourage construction and thereby reduce rents (Hendershott and Ling, 1984), while TRA was anticipated to do the reverse (Hendershott, Follain, and Ling, 1987). The primary sources of these predictions were changes in the tax saving from tax depreciation writeoffs, although capital gains changes reinforced the impact of the tax depreciation changes. Figure 1 (right axis) illustrates both the increase in this tax saving in 1982 and the plunge in 1987.5


NATIONAL

256

TAX JOURNAL

[Vol. XLY

FIGURE 1 USER COST AND ITS COMPONENTS

0.15

a3O

0.10 -

a25

ao5

OL20

0.00

0.15

-0.05 0.10 1975197619771978197919801981198219831984198519861987198819891990 Rental

6

User Cost

Tax Savings of Depreciation

Discount

Rate

Allowance

Figure 1 also reveals that the impact of the favorable tax changes in 1981 on the user cost was overwhelmed by the increase in real after-tax interest rates, part of which has been attributed to the investment incentives provided by ERTA (Hendershott and Peek, 1992). The user cost (left axis) was clearly higher after 1981 than before, and especially higher relative to the 1975-79 period .6 As a result, we should find real rent increases, not decreases, during the first half of the decade. During the second half of the decade, the user cost is roughly constant. In the remainder of this section, we discuss developments in the rental housing 7 We use and office markets in the 1980s. the office market as illustrative of commercial real estate generally. Rental

Real After-Tax

Housing

Figure 2 plots three series from the multifamily market: real rents, vacancy rates, and housing starts.3 The vacancy

rate is on the right axis, and indices, waled to unity in 1980, for the other two series are on the left axis. As can be seen, real rents rose by 12 percent between 1981 am 1986. The rent increase was more directly in response to a surge in the number of renting households (during the 1982-85 period, renter households increased at twice the 1978-81 rate) combined with a low initial vacancy rate (see figure) than to a higher user cost. While the surge in starts in the 198386 period is consistent with a naive a& sessment of the 1981 tax act (tax advan. tages increased), it is not consistent with the observed jump in user cost owing to higher real after-tax interest rates. It @ certainly consistent, though, with a lending frenzy, especially when combined with an initially low vacancy rate and a bulp in the number of renter households. This surge in starts led to a glut of rental housing by 1987. Returning to Figure 1, the negative tu 'changes in TRA translated into a higher


JAMES FOLLAIN,

No. 31

PATRIC HENDERSH07r,

DAVID LING

257

FIGURE 2 RENT, MULTI-FAMILY STARTS, AND VACANCIES

0.095

L6 LS -

- 0.08

L4 -

- 0.075

L3 -

- 0. 07

Ll Li

- 0.065 - 0.06

a9 ag

- 0.055

a7 - 0.05 a6 0.045

as

197519761977 1978 1979 1980 19811982 1983 1984 1985 1986

1987

1988 1989 1990

-.0- Real Rent Index -.*- MF Starts Index --*- Vacancy Rate wr cost and thus might reasonably be expected to reduce multifamily construedon and increase real rents.9 Starts did fall substantially in 1987, but real rents have remained largely unchanged. The failure of rents to rise seems to be a direct result of the high vacancy rate, which has continued, in spite of reduced starts, beesta the rate of increase in renter households has returned to its low 1978-81 level. While the passage of TRA in late 1986 reduced the incentive to construct new rental housing, TRA should not be viewed n the sole cause of the construction colkpw. As a consequence of the excess supOy and slowed absorption of rental units, rental housing construction was destined for several years of low production with or without TRA. Further, the final end to the lending frenzy caused by the passage ofFIMA and comparable tightening of capital requirements on commercial banks has certainly played a major role in the continued decline of rental housing con-

struction 1990s. Office

during the late 1980s and early

Markets

Indices of office market vacancies, real effective rents, and the real value of construction for the 1972-90 time period are presented in Figure 3.'o Hendershott and Kane (1992a) describe the 1970s as a prototypical real estate cycle: overbuilding late in the 1971-73 boom, leading to a cutback in production, decreases in vacancy rates, and eventually another boom. In fact, office vacancies had fallen below 4 percent by the beginning of the 1980s, production had already rebounded to its 1971-73 levels, and the offilee market was ready for another "normal" spurt of overbuilding. Post-1981 increases in construction and declines in real rents are not consistent with the increase in the user cost. They are, however, consistent with a lending frenzy. The surge in construction peaked


258


[Vol. XLV

FIGURE 3 OFFICE MARKET: 1972-1990 REAL CONSTRUCTION VALUE, RENTS, AND VACANCIES

c 1

2.60-

19%

2.40-

-17%

2.20w

2.00-

0 z

1.80

-13%

11.60:-

-11%

1.40-

9%

z

1.201.00-5%

0.800,60-

. 72

. 74 73

. 76 75

i8 77

REAL VALUE CONS

in 1985 at a level two-and-a-half

. 82

iO 79

81

83

REAL RENTS

times that

achieved in the late 1970s. Downtown vacancy rates exceeded 17 percent by 1986, and real rents had fallen 25 percent from their 1982 high." While TRA increased user costs marginally, the massive excess office capacity that existed just prior to TRA would have been sufficient to keep real rents from rising for an extended period of time, even if new construction had plunged in response to TRA. Because construction during the remainder of the 1980s never fell below twice the average of the 1970s, vacancy rates remained at 18 (downtown) to 22 (suburban) percent and, faced with this persistent oversupply, real office rents continued to decline, being only half their 1982 level in 1992. Owing to the unprecedented overbuilding, the expected increase in real rents is unlikely to develop for the better part of a decade. In fact, given the numerous tax changes of the last decade, a more generous tax act could be enacted before any increase in real rents is evidenced, negating any impetus for the increase.

. 84

i6 85

8'8 87

9'0'

3%

89

)K VACANCY

Owner-Occupied

Housing

The average cost or annual "price" of owner-occupied housing influences the tenure (or buy-versus-rent) decision of households, and the marginal cost affects the quantity demanded by households that choose to own. Both costs likely affect the real asset price of owner-occupied hou& . ing. These costs depend upon the required returns on owner equity and debt, prop erty taxes, economic depreciation, expected appreciation in house values and rents, and homeowner tax benefits. The benefits relevant to the two costs can change differentially, as we shall show. The tax benefits to homeowners are the nontaxation of imputed rental income and the "light" taxation of capital gains owing to deferral and the $125,000 one-time ex. clusion. Deductibility of home mortgage interest ensures that itemizing households with mortgages also benefit from the nontaxation of owner-occupied housing. The higher the tax rate of the individual, the larger the tax benefit and the lower the after-tax cost of owner-occupied hous-


No.31

JAMES FOLLAIN,PATRICHENDERSHOTT,DAVID LING

ing, TRA lowered the tax benefits of owner-occupied housing by reducing the marginal tax rates at which higher income households deduct housing Co$tS.12 Allelse equal, these reductions increased the after4ax cost of owner-occupied housmg and would be consistent with a decline in ownership, reduced quantity demanded, and a softening of house prices at the higher end of the market. A more subtle but potentially more impdrtant effect of TRA follows from its substantial increase in standard deductions and decrease in the amount of nonhousing expenses that can be claimed as itemited (Schedule A) deductions. 13 These provisions have had a combined effect comparable to elimination of the mortpge interest deduction for many households, which sharply raises the costs relevant to their tenure and quantity decisions. For other households that confinue to itemize under TRA, the cost relevant to the quantity-demanded decision is not affected (beyond the direct cut in marginal tax rates), but the average value of mortgage interest deductions is reduced if their total nonhousing deduefions are less than the standard deducfion. Thus, the average after-tax cost of debt for these households is greater than the average risk-adjusted after-tax cost of equity, even if the two costs are equated at the margin. Ling (1992) calculates marginal and tenure-choice owner income tax rates (including state taxes) for nineteen income groups and for each of three household types on a quarterly basis from 1973 through 1989. Overall weighted average tax rates in each quarter are based on the actual distribution of households among de three household types and across the nineteen income classes. Annual averMo of these weighted-averages are shown in Figure 4. 14 If there were no excess nonhousing deductions, the tenure choice tax rate would always exceed the marginal rate in a progressive tax system because dw tenure choice rate would simply be an average of the marginal and higher tax rates. , This is the general pattern with two exceptions, 1977-79 and 1987-89. Not sur-

259

prisingly, both of these followed substantial increases in excess nonhousing expenses, the first caused by the tax reform act of 1976, which raised the standard deductions of married couples from $1000 to $3200 and of singles from $500 to $2200. The 1986 Act raised the deduc tion for married couples from $3964 in 1986 to $5000 in 1988 and for household heads from $2578 to $4000, and lowered nonhousing expenses (see note 13). The remainder of this section is divided into two parts. First, the effect of TRA on the amount of wasted housing deductions (excess of standard deduction over nonhousing deductions) is computed and evidence on changes in the relative use of debt financing among owners is presented. Second, trends in ownership rates of younger, more mobile households since 1973 are compared with estimates of the cost of owning housing relative to the cost of renting, and the real asset price of owner-occupied housing during the 1970s and 1980s is compared with marginal user costs and real income per household. Changes in Wasted Housing Deductions and the Use of Mortgage Debt Because itemization requires giving up the standard deduction, housing deductions equal to the standard deduction (SD) less deductible nonhousing expenses (NHE) are "wasted" in that this amount does not reduce taxable income below what it would be if the household retained its renter status. In the language of user cost, the average after-tax cost of housing under TRA for households with nonhousing deductions below their standard deduction depends on the loan-to-value ratio. This TRA-induced anti-debt bias would be consistent with a subsequent decline in ownership rates among younger, less wealthy households because such households are less able to substitute equity for debt financing. Those households that did choose to own would be expected to make relatively less use of mortgage debt (Follain and Ling, 1991). On the other hand, TRA also elimiiiated the deduction for consumer interest.'5 For households without wasted


260

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(Vol. XLV

FIGURE 4 MARGINAL AND TENURE CHOICE TAX RATES WEIGHTED AVERAGES ACROSS INCOME AND HOUSEHOLD

TYPES

0.220.210.200.19co w

0.180.170.160.150,140.130.12i3

75 74

77 76

MARGINAL

i9 78

@l 80

TAX RATES

housing deductions, we would expect increases in the use of mortgage debt because its deductibility (along with its favorable collateral value) makes it the cheapest source of consumer debt financing. Evidence regarding changes in household financing decisions after TRA have been obtained from the 1985 and 1989American Housing Surveys (AHS) conducted by the U.S. Department of Commerce. The AHS contains detailed micro data on households, including geographic location, number, age, and marital status of occupants, income type and level, tenure status, original and current home values, and property tax payments. Detailed mortgage information also is collected, including the number and amount of mortgages (including home equity loans), mortgage interest rates and payments, and original and remaining terms and balances. Each survey observation (household) is weighted so that national

@3 82 TENURE

i-5 84

i7 86

69 88

TAX RATES

estimates can be inferred.16 The left-hand portion of Table 1 shows that wasted housing deductions averaged $1,042 in 1985 and were not a serious problem for households with more than about $25,000 in adjusted gross income. However, average wasted housing deductions jumped more than 150 percent to $2,699 in 1989. In fact, typical households with adjusted gross income (AGI) between $30,000 and $35,000 (approximately the 1989 median) received no tax benefit in 1989 from their first $2,638 in mortgage interest and property tax ex. penses. Reductions in the use of mortgage debta by lower income households would b consistent with this surge in wasted housing deductions. The middle portion of Table 1 shows that the percent of houw holds with no mortgage debt increased, between 1985 and 1989, by 3 percentage points for those with AGI between $10,000 and $30,000. Similarly, the percent of


TABLE I WASTED HOUSING DEDUCTIONS AND HOUSEHOLD MORTGAGE DEBT: 1985 ALL HOUSEHOLDS FROM SUPPLEMENTED AHS DATA 198S Adjusted Gross Incomes

19as Wasted Housin ExpL-nseit

19a9 Wasted Housing Expense

Difference

1985 t of HHs With No mtg. Debt

1989 t of HHs With No Mtg. Debt

Difference

0-10 10-20 20-30 30-40 40-50 50-75 75-100 100+

2,116 1,878 861 16 0 0 0 0

4,504 4,369 3,226 2,020 877 28 0 0

2,388 2,491 2,365 2,004 877 28 0 0

73.8 52.4 32.5 2S.3 21.8 18.8 22.2 20.0

75.4 55.5 35.4 26.0 20.8 20.7 18.6 20.3

1.6 3.1 2.9 0.7 0 1.9 -3.6 0.3

Total

1,042

2,699

1,657

42.7

42.4

-0.3

19 HH Sec

is based on the AHS survey sample projected back to the popu are adjusted to reflect the amount of inflation between 1

a.

Number of households 1989 income brackets

b.

Wasted housing expense represents itemized deductions, i. e., the beyond simply using the standard

the difference between the amount of housing deductions deduction.

household*B stand that will be abso


262

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households with second mortgages declined by a point for those in this income range. In contrast, higher income households, presumably those that can make full use of their mortgage interest deductions, increased their use of mortgages in response to the elimination of the consumer interest deduction. For those in the $75,000 to $100,000 range, the percentage with no mortgage debt decreased by 3.6 percentage points (16 percent), and an additional 3 to 4 percent of those in the $50,000 to $100,000 range took on second mortgages (a 40 to 50 percent increase). 17 This type of financial adjustment, which dampened the potential negative impact of the tax act on homeownership and con. sumer durable demand, illustrates how financial behavior adjustments can make real responses to "prices" seem lower than they actually are (Slemrod, 1992). Effects on Ownership Prices

Rates and Asset

Homeownership depends on, among other things, the ratio of the average cost of owning (the tenure-choice user cost) to the cost of renting (the market rent series referred to earlier). The tenure-choice user cost is a weighted-average for median income owners of the three household types (Ling, 1992). Figure 5 plots the ratio of these costs. Because rents moved so little, the ratio is dominated by the sharp increase in after-tax interest rates from the late 1970s to the early 1980s. The high ratio of owner to renter costs in the 1980s should have caused declines in homeownership, particularly of younger households whose greater mobility causes them to be more sensitive to changes in costs. Declines have, in fact, occurred in the ownership rates for married households. The rate for households headed by an individual less than 25 years of age fell from 37.5 percent in 1979 to 27.3 percent in 1990. The corresponding declines for the 25-29 and 30-34 age groups, which are plotted in Figure 6, over the same years are from 58.1 percent down to 50.7 percent and from 74.5 down to 67.0. Even for the 35-44 group (not graphed) the rate

[Vol. XLV

dropped from 82.8 percent to 79.7 per. cent . 18 Homeownership rates for married cou. ples over the longer 1960-90 period clearly show that the surge to homeownership in the 1970s has been completely reversed for married couples under age 35 and Will probably shortly be reversed for those under age 44. The surge and its reversal an consistent with movements in tenure um costs, which were extraordinarily low in the 1970s as well as high in the 1980% but they may also reflect other phenom. ena. For example, recent distribution@ data suggest that higher income (likely older) households had substantially greater real income gains in the 1980s than lower income (likely younger) households. The observed reduced propensity to save could also have played a role, as could the in. crease in labor force participation rates. Because ownership requires saving prior to purchase and saving to repay the mor@ gage, a lower saving propensity could m duce ownership. Because two-earner fam. ilies have less aggregate nonwork time, their cost of home maintenance is greater than that of a one-eamer married couple. Research on the impact of the recent sharp decline in homeownership should be a high priority. If the observed decline is largely due to reduced desires to save or to spend time on home maintenance, we may not be concerned. But if the decline largely reflects higher housing costs caused by tax law changes or by real income declines, we might be concerned about the possible implications of a "forced" renter society. Changes in weighted-average marginal user costs are dominated by changes in the level of nominal interest rates and expected appreciation in house prices and implicit rents. Figure 6 shows that marginal user costs were high throughout the 1980s. Figure 6 also includes real income per household and real house prices, both indexed to one in 1973. Nominal house prices are measured by the Census Bureau's constant quality house price index and are deflated using the CPI net of shelter.' 9 Relatively low user costs in the middle and late 1970s appear to have stimulated real house prices, and high real user costs


No. 31

JAMES FOLLAIN,

PATRIC HENDERSHOTT,

DAVID LING

263

FIGURE 5 OWNERSHIP RATES OF YOUNG MARRIED HOUSEHOLDS VERSUS COST OF OWNING TO RENTING

750/o-

16% -15% -14% -13% 12%

70%650/oQ6

-11% -10%

60%-

0)

a: 46

(9 0

4

0 .2

-9%

c

550/0-

-7%

600/0

-6% 5%

0 0

i4

i6 75

1

i8 77

25-29 Yrs

@O 79

i2 81

@6 83

)K 30-34 yrs

85

@8 87

9'0 89

E3 Own/Rent Costs

inthe 1980s to have lowered real house s ightly in spite of rising real in,n'N come@'We say appears because all three seriesare subject to substantial measure-

So what can we say about taxes? Regarding the commercial market, probably not much. Because high construction levels continued long after passage of the

ment error. User cost depends on an expected appreciation series; alternative measures of constant-quality house prices

1986 tax act, it is hard to attribute the pre-1986 high levels to the earlier 1981 tax act. Moreover, the vacancy rate was

Conclusion Discerning the impact of tax changes on real estate in the 1980s is not as simplea matter as one might think. Two maOrdisturbances occurred in the decade in addition to the two major tax changes. First,inflation plummeted early in the

so high for so much of the decade, trying to discern a direct link from user costs to rents seems pretty hopeless. For apartments, the tax link seems clearer. Multifamily starts surged shortly after the 1981 tax act and plunged after the 1986 tax act. Is a stronger multifamily response to the 1986 tax act plausible? While tax depreciation for commercial properties is slightly less generous than for residential under post-TRA law, depreciation for the former was even less generous than for the latter

decade and real after-tax

under

differ;and the relevant real income per bdunhold series should be for owners only (theplotted series likely understates real imomegrowth of owners).

interest

rates

surged.By the end of the decade the latter were still high, although real pretax mteshad finally returned to more normal levels.Second, a lending frenzy funded an enormousglut of commercial real estate, n well as a few extra apartments.

pre-TRA

law. More specifically,

the

recapture provisions for commercial properties were such that if trading was expected before the tax life, straight-line depreciation was preferred to accelerated .21 Thus tax-oriented limited partnerships worked better with residential than


264

NATIONAL TAX JOURNAL HOUSE PRICES,

[Vol. XLV

FIGURE 6 USER COSTS, AND HOUSEHOLD

INCOME

1.20-

16%

1.16-

-14%

1.10- 1 20/c x ,a C

1.05-io% 1.00-8% 0.95-

6%

0.90--7---r-

73

75 74

77 76

-0- REAL HOUSE PRICE

i9 78

@3

di 80

82

65 84

67 86

69 88

-+- MARGINALUSERCOST -)K- REALlNcz7m@

with commercial properties, and when the tax law was changed to curtail limited partnership deals, residential investments were more adversely affected. The impact of relative prices, and thus of the taxes that affect these prices, on owner-occupied housing decisions seems clear. Real house prices rose sharply in the late 1970s, when the cost of owning was relatively low, and then fell in the 1980s when the cost was high. Similarly, homeownership grew sharply in the 1970s, when the relative cost of owning was low, and reversed itself in the 1980s, when the relative cost of owning was high. The sharp decline (10 percentage points for married couples under age 25 and 7.5 percentage points for married couples age 26 to 35) may be a major social concern, and identifying the cause of the decline is certainly an important topic for future research. A possibly unintended effect of the 1986

tax act is the sharp reduction in the ef. fective home mortgage interest deduction for low and moderate income households. The combination of large increases in the standard deduction and decreases in nonhousing deductions effectively eliminates or almost eliminates the home mortgage interest deduction. This makes debt financing relatively more expensive than equity financing and leads to lower debt usage by such households. ENDNOTES 'Note the adjective "significant." In the earlier paper we stated that the 1986 act had "overshoe'the theory-tax depreciation had been lengthened more and the tax rate raised higher than the cut in the inflation rate warranted. Thus, a small reduction in the capital gains tax rate would not be inconsistent with the theory. 'This is in the spirit of Hendershott (1987), who, in his attempt to assess whether or not events between 1981 and 1985 were consistent with the 1981 Tax Act simulated both the tax change and a three pereentap


No. 31

JAMES

FOLLAIN,

PATRIC

HENDERSHOTT,

pointdecline in the inflation rate, recognizing that tWlatter was potentially as important a disturbance n the tax law change. 'rhe appreciation components of the RussellNCREIF indexes suggest substantial declines in real mutant-quality prices in recent years. For office buildings, the decline is 30 percent since the end of 10, a third of this coming in 1991, and for apartments16 percent since the end of 1987, with half the &din coming in 1991. Hendershott and Kane (1992b) &W that office building market-value prices should have risen far less than appraisal prices did prior to 1986and should not have fallen so drastically since. 'As we stressed in Follain, Hendershott, and Ling, 1987,the timing of the increase in real rents caused bythe 1986 tax act would depend on local market conditions.local markets that were overbuilt prior to pmge of the act would not experience real rent inaeam until discards and absorption depleted the exem supply. Absorption, of course, would depend on therate of economic growth in the local market. 'The tax saving depends on the tax depreciation "ule, the after-tax discount rate, and the tax rate at which the deductions are taxed. The decrease in thetax saving in 1980-81 is due to a sharp increase in the discount rate. 'Me derivation of the user cost of capital is based uponthe concepts and methods discussed in Follain, 16ndershott, and Ling (1987). The series relies upon an expected inflation series generated by a distributed lag of past inflation rates. The series also asP=s a tax rate for investors equal to 50 percent for the period prior to ERTA, 45 percent for the period IN2 to 1986, and a 36 percent rate since the passage d TRA.The specific rental user cost series plotted here mbeing used in ongoing work by Dixie Blackley and Jow Follain. 'These discussions draw on Follain, Leavens, and Volt (1992) and Hendershott and Kane (1992a) who, roqwtively, discuss developments in the rental hous14 and office markets in the 1980s. ,me real rent series is the residential rent compment of the CPI with two modifications. First, the rut component is adjusted upward beginning in 1964 by0.5 percent annually to correct what many believe to be a downward bias in the residential rent component.Second, the series is converted into real terms bydividing by the CPI-Iess-shelter series. 'Poterba (1990) attributes the decrease in starts to the 1986 tax act. "rhe series are described more fully in Hendershott and Kane (1992a). "While office markets represent the best measured &Wprobably the most dramatic example of overbuilding in the 1980s, they are hardly the only.one. To industrial vacancy rate moved similarly, rising hom 3.5 percent in 1980 to over 5.5 percent in 1986 ad staying above that level for the rest of the deeWo.While harder to document, the hotel/motel and shopping-center markets showed major weakness as oil]. '4U also limited the deductibility of mortgage intsrnt expense to that on mortgages of $1 million plus 6100,000 of home equity debt. 'More specifically, consumer (non-inortgage) interad has been phased out, sales taxes are no longer de"ble, miscellaneous deductions are now subject to

DAVID LING

265

a 2 percent floor, and the floor for medical deductions has been increased to 7.5 percent of AGI from 5.0 percent. Thus for many households, charitable contributions and state income tax liabilities are the only personal nonhousing deductions that remain. 14The constancy of the marginal rate in the figure (compare 1979-80 with 1988-89) in the face of sharp cuts in marginal income tax rates reflects the substantial decline in homeownership of younger, lower income households. This decline is discussed below. l5Skinner and Feenberg (1990) emphasize the impact of this change on the composition of household debt. 16Calculation of 1985 and 1989 federal income tax liabilities is accomplished for each household by applying the applicable federal income tax structure to an enhanced AHS database. Although the AHS data do not contain income tax liability information, most of the raw data required for estimating income tax liabilities are present. Ling and McGill (1992) provide a detailed discussion of the calculations and the enhancement of the AHS data base with supplemental information from the Internal Revenue Service's individual tax return data. 17Most notable, though, was the 17 percentage point increase (32 percent to 49 percent) in the total mortgage-debt-to-value ratio of households with AGI greater than $120,000. (The aggregate mortgage-loanto-market-value ratio increased slightly from 31.2 percent in 1985 to 32.8 percent in 1989.) "We thank David Crowe for supplying us with these numbers. 19Numerous alternatives to the Census Bureau's constant quality house price index have been put forward. The differences in these house price series highlight the difficulty associated with the construction of house price indexes. A recent special issue of the Journal of the American Real Estate & Urban Economics Association (Fall, 1991) contains numerous papers that address this topic. '-'OFora general analysis of many factors affecting real house prices, see Peek and Wilcox (1992) 21 If accelerated depreciation were taken, all depreciation would be recaptured at ordinary income tax rates; if straight-line depreciation were taken, it would be effectively recaptured at the capital gains tax rate. (For residential, the excess of accelerated over straightline was recaptured at ordinary rates, and the straightline was recaptured at the capital gains tax rate.) REFERENCES Follain, James R., Patric H. Hendershott, and David C. Ling, "Understanding the Real Estate Provisions of Tax Reform: Motivation and Impact," National Tax Journal, 1987, pp. 363-72. F,Ilain, James R. and David C. Ling, "The Federal Tax Subsidy to Housing and the Reduced Value of the Mortgage Interest Deduction," National Tax Journal, June 1991, pp, 147-68. Follain, James R, Donald Leavens, and Orawin Velz, "Identifying the l@,ffectsof Tax Reform on Multifamily Rental Housing," March 1992, National Association of REALTORS Research Paper (revision forthcoming in Journal of Urban Economics). Giliberto, S. Michael, "The Real Estate Bubble," Sal-


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omon Brothers, October 8, 1991. Hendershott, Patric H., "Tax Changes and Capital Allocation in the 1980s," in Feldstein (ed.), The Effects of Taxation on Capital Formation, University of Chicago Press, 1987, pp- 259-290. Hendershott, Patric H., James R. Follain, and David C, Ling, "Effects on Real Fstate," in Pechman (ed.), Tax Reform and the U S Economy, The Brookings Institution, 1987, pp. 71-102. Hendershott, Patric H. and Edward J. Kane, "Causes and Consequences of the 1980s Commercial Construction Boom," Journal of Applied Corporate Finance, May 1992a, pp. 61-70. -, "Office Market Values During the Past Decade: How Distorted Have Appraisals Been?," May 1992b. Hendershott, Patric H. and Joe Peek, "Treasury Bill Rates in the 1970s and 1980s," Journal of Money, Credit and Banking, May 1992, pp 195 - 214. Ling, David C., "The Price of Owner-Occupied Housing Services: 1973-1989," in Sa-Aadu (ed.), Re-

search in Real Es&zte.- Volume IV, forthcoming 1991 Ling, David C. and Gary A. Mc(;ill, "Measuring the Size and Distributional Effects of Home Owner Ta Preferences," Journal of Housing Research, for& coming 1992. Peek, Joe, and Wilcox, "The Measurement and De. terminants of Single-Family House Prices," Jour. nal of the American Real Estate & Urban Econom. ics Association, Fall 1991, pp. 353-82. Poterba, James M., "Taxation and Housing Marka Preliminary Evidence on the Effects of Recent Tu Reforms," in Slemrod (ed.), Do Taxes Matter? Tk Impact of the Tax Reform Act of 1986, Cambridgr. The MIT Press, 1990, pp. 141-160. Skinner, Jonathan and Daniel Feenberg, "The I* pact of the 1986 Tax Reform on Personal Saving,* in Slemrod, (ed.), Do Taxes Matter? The Impact 4 the Tax Reform Act of 1986, Cambridge: The MIT Press, 1990, pp. 50-79. Slemrod, Joel, "Do Taxes Matter? Lessons from the 1980s,- NBER Working Paper No. 4008, March 1991