Early last month, Congress passed what is commonly referred to as the "bailout" legislation. Officially titled the Emergency Economic Stabilization Act of 2008, it was actually just division A of a three-part bill. Division B is the "Energy Improvement and Extension Act of 2008", containing various measures (mostly tax credits) to encourage alternative energy use. Division C is the "Tax Extenders and Alternative Minimum Tax Relief Act of 2008", containing various changes to tax law. A few other miscellaneous measures that didn't fit into any of the three categories is also tacked on to division C.

Most of the tax measures in division C are to extend various deductions and credits which were originally passed as "temporary" measures. This is a legislative gimmick, perfected under the Bush administration, designed to let tax cutters have it both ways. The rules require that when taxes are lowered (ie, new deductions and credits introduced), they must make a reasonable calculation of what it will cost the Treasury so that it can be budgeted accordingly.

To get around this, the tax cut is proposed as a "temporary" measure, lasting only a year or two, and they report only what the cost will be for that small period. Later, when the "temporary" tax cut is about to run out, they propose an extension of it. They now argue that they aren't really cutting taxes, just "keeping taxes exactly how they already are". If other more scrupulous legislators dare to oppose the extension, they gather the TV cameras and accuse those legislators of wanting to "raise taxes". This, of course, is completely inconsistent with how they characterized it when it was first proposed, but the gimmick is nevertheless highly successful, politics being what it is. That's why all the supposedly temporary tax cuts have never run out, and probably never will.

(Actually, that's not quite true. One specific tax credit was extended for 2009 but not for 2008. It's the one that gives an individual homeowner a tax credit for installing qualified energy-efficient doors, windows, insulation, furnace, water heater, etc. If you made your improvement in 2007 or 2009, you get a small tax credit; if you did it in 2008, you're out of luck. I have no idea why they did it this way. Everyone in our office is baffled by the one-year gap. But if you look at the legislative language it was clearly intentional, not just an oversight.)

The entire legislation is on WikiSource, so wonks like me can skim through it and read the interesting bits. (If any of you claim to have read the whole thing, I don't believe you.)

There are also tax measures in division A, the bailout portion. In theory, these belong in division A rather than division C because they are related to the emergency stabilization of the economy, though in practice the claim is dubious. Prominent among these is a extension of the "temporary" tax break for forgiven mortgage debt. That tax break was passed just a year earlier, in September 2007, and is called the Mortgage Forgiveness Debt Relief Act of 2007.

The fundamental logic of the income tax is that you should pay tax on any income you receive, regardless of the nature and source, unless it is specifically excluded for some reason. Debt forgiveness counts as income. This makes sense: if the bank loans you $5,000, and then after repaying $3,000 of it you say "oh, sorry, I'm broke, I can't pay anymore" and the bank is somehow persuaded to forgive the remaining $2,000, you have thereby received $2,000 from the bank. That's income, so you pay income tax on it.

What the Mortgage Forgiveness Debt Relief Act did was specify that if that forgiven debt was for the mortgage on your primary residence, you don't have to count it as income, and thus you don't have to pay tax on it. If it's credit card debt or some other sort of loan, it still counts, but if you're a homeowner who defaulted on the mortgage, we sympathize with your plight and we'll give you a break and not ask you to pay income tax on it as well.

I'm not sure I agree with that sentiment — in fact, I'm pretty sure I don't — but for now let's set aside the general philosophy and just look at the specifics. I have two problems with this legislation.

First is the timing. This extension was put in the 2008 "bailout" bill because bailing out homeowners who have defaulted on their mortgage is supposedly part and parcel of bailing out the economy generally. So far, so good. But look at the applicable years. The original bill gave tax relief to any debts discharge in tax years 2007 through 2009. If you are someone who got whacked by the housing crash and had to default on your mortgage, chances are you've either already defaulted, or you're going to do so by the end of 2009. In other words, these victims have already been bailed out.

The new legislation passed just last month extends the tax break another three years, so that it now applies to mortgage debt that is discharged in tax years 2010 through 2012. Who is going to default on their mortgage in 2010? Not the current victims. This new tax break will affect people who are taking out their loan right now.

One of the problems with bailing out people who got into financial trouble is that you create a moral hazard: people are less likely to make prudent financial decisions if they feel they can count on being bailed out if things go wrong. Typically, the two must be balanced against one another: you want to provide relief to those in trouble, but at the same time you don't want to encourage the activity that led to the trouble in the first place. But in this case, there's no balancing act at all. The people who need relief already have it; extending the tax break another three years is all moral hazard and no relief. It's stupid.

My other problem with this legislation is the cap. According to the political argument, we're bailing out homeowners who defaulted on their mortgage because it's not right to only help rich investment bankers. We must help ordinary middle-class folk, too. Therefore, there should be a cap on how much forgiven mortgage debt can be excluded from tax. And indeed there is. The tax break only counts for the first $2 million.

Two million dollars?? Who the hell has a house worth $2 million? Certainly not the ordinary middle-class folk this measure is supposed to protect. But it's worse than that. The cap is not on the price of the house. It affects you only if $2 million is the portion of that price that you financed with a mortgage. But it's worse than that. The cap is not on your total mortgage. It affects you only if $2 million is the balance of your mortgage still unpaid. But it's worse than that. The cap it not on the remainder of your mortgage still unpaid. It's on the amount that the bank chooses to forgive. (And remember, by "forgive" we mean that the bank actually gave you that much money to spend on a house and has now decided to let you keep it rather than pay it back.)

Your mortgage is, by definition, secured by the house. The bank isn't going to forgive any of it unless they've already repossessed the house and you're still short. So in the final analysis, the amount that we're capping here is how much your house decreased in value minus how much equity you have in the house. So even supposing that you bought a multi-million-dollar mansion with no money down and you've made no principal payments at all since the loan ... what sort of house decreases $2 million in value? I realize housing prices have crashed, but they haven't crashed that much. At the very least we're looking at a house that was $5 million and has fallen to $3 million.

Remind me again why we're giving a tax break to someone who buys a house worth $5 million and then defaults on the loan. Because he's a suffering victim who needs help from the government? In the form of an additional $300,000 tax break? That's insane.

10:38:52 PM  [permalink]  comment []