In determining how homes will appreciate going forward, income is likely a factor. As Americans grow wealthier, more can afford to buy and at higher prices, so homes appreciate. That was the logic explored Wednesday in a piece by David Leonhardt. I responded with a pessimistic view -- that even once employment recovers taxes will likely rise to combat the deficit. That will reduce after-tax income and limit the price of a home Americans can afford. I concluded that strong rates of appreciation aren't likely for at least a decade or two. But reflecting on this theory, it also depends on how tax hikes are designed.

If the U.S. increases taxes by raising the income tax rates, then homeownership would actually be even more attractive. But if it turns to a value-added tax (VAT) for additional revenue, then owning a home would be neither more nor less attractive. Let's think about a few scenarios:

Method 1: Increasing Income Tax Rates

This will likely be the route chosen by policymakers, since tinkering with income tax rates has been the method of major tax increases and reductions favored by Washington over the past several decades. So imagine, for example, what happens if a guy making $100,000 has his bracket rate raised from 28% to 33%. He should find homeownership more attractive.

Imagine, for example, that this individual pays $15,000 in mortgage interest during the year (with an average mortgage balance of $250,000 at 6%). As a result, he can deduct that interest expense from pre-tax income. This will allow him to escape $4,950 of taxes when facing a new rate of 33%. At his old rate, that same interest deduction would only have saved him from paying $4,200 in taxes.

Of course, his overall after-tax income is still lower through the higher tax rate. That's true of any increase in taxes. But being taxed at a higher rate provides him even more incentive to buy, to the tune of $750 for the year in this scenario.

Method 2: Instituting a National Value-Added Tax

Imagine now, instead of a 5% income tax rate hike, the U.S. government creates an 8% VAT to collect the same amount of revenue. (The rate would likely have to be higher to collect as much revenue as an income tax, since only a subset of all purchases would be hit, instead of gross income.) Let's continue using the example above. How does the homeowner feel about the new VAT?

Suddenly, his interest tax deduction doesn't look as sweet. Since his income tax rate stays at 28%, his tax savings from the interest tax deduction are only $4,200. That other $750 he would have saved will be paid to the government through the VAT, if the additional amount of pre-deduction gross taxes are assumed to be the same through either taxation method. Owning a home no longer allows someone to escape a portion of the additional taxes.

Blame the Mortgage Interest Deduction

Of course, all of this analysis assumes that the mortgage interest deduction will survive any tax reform effort. But that's a pretty safe assumption for now. The cult of homeownership is a very strong a force in contemporary politics. Yet without the deduction, one taxation method would probably not encourage homeownership more than the other, unless special provisions were specifically included to do so. But with the deduction in place, you will likely see the political viability of a VAT further diminished. Raising income taxes instead makes owning a home even more attractive, which is a win-win in Washington's eyes.

Where Does That Leave Home Prices?

If income taxes rise and mortgage interest deductions persist, will home prices still appreciate slowly over the next decade or two, as I previously hypothesized? Probably. Remember, after-tax incomes will still be smaller, overall, so purchasing power will be reduced. In the above example, the person's income would be $4,250 lower at the higher tax rate, even taking into account the mortgage interest deduction tax savings. Americans might feel even more urgency to buy a home at higher income tax rates, but will have less of their income to spend than they would have before the rate hike. So this strategy of raising taxes won't stifle appreciation as much as a VAT would, but it would still likely prevent prices from rising aggressively over the next few decades.

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