Today the NCPA featured a report summary in its Daily Policy Digest on how taxing capital penalizes saving. The report, by Alan Viard of the American Enterprise Institute, provides a clear example of how even if the tax rates on labor income and saving are the same, the saver still pays a greater effective tax rate on a dollar earned and saved than the worker who earns her dollar and spends it.
But that comparison just scratches the surface. Not only does government penalize saving, it subsidizes consumption, especially for home purchases. For the sake of simplicity, suppose I earn $100, taxed at 25 percent, leaving me with $75 to spend. I go to the mall and purchase an item that is not taxed at the state and local rates for whatever reason (sales tax holiday or perhaps I live in a state with no sales tax). No consumption subsidy here.
But suppose I spend my $75 toward the purchase of a $200,000 home. I take out a 30-year fixed loan at 4.5 percent, and my total interest paid in the first year is $8,861 on a principal amount of $3,300. So for the first year, every $75 in principal carries an additional $201 in interest. But wait…that interest is tax deductible! At a 25 percent marginal tax rate, the first year tax savings on $75 is about $29. Thus, the buyer receives an additional $4 subsidy for the $75 spent on housing.
Some may argue that tax-deferred retirement accounts provide the same subsidy. But the difference is that savings in those accounts are limited to an annual contribution amount for all wavers each year. The mortgage interest deduction, on the other hand, is only limited for the highest income earners. Because of this the subsidy has a greater impact on middle-income earners, who may be more likely to purchase more house than they can afford.
Two years ago, I published the NCPA report, How Are Baby Boomers Spending Their Money?, that detailed how today’s 45- to 64- year olds are spending their money and why many of them are ill-prepared for retirement. Compared to the same age group 20 years ago, more of today’s pre-retirees are paying mortgages that will go well into their retirement years. This may very well be in part due to the fact that homeownership is an overemphasized public policy goal (compared to saving), and the tax system is none to happy to help those who want to buy.