The Phase-in of the Phase-out of the Phase-out

There is a provision of the Bush tax cuts that is an excellent example of the types of economic phenomenon we aim to illustrate on this blog where the valuation of wealth can be affected by a number of factors, in this case tax policy.  As such, you will note that such blog posts can be readily identified as a “wealth downdraft” or “wealth updraft” based on their category listing.  This is both a wealth-updraft and wealth-downdraft blog.

The tax provision in question is often referred to as “PEP and Pease,” see here for a history and details of the provisions. PEP stands for the Personal Exemption Phase-out while Pease refers to the Congressman responsible for the Itemized-Deduction Phase-out.  Thus, PEP and Pease are the first phase-out in the title.

The Bush tax cuts phased-out PEP and Pease, hence the second phase-out in the title.  However, rather than doing it all at once, the phase-out was done over the ten year life of the Bush tax cuts.  Taxpayer in 2006 and 2007 would get back 33 percent of the lost deductions while in 2008 and 2009 they would get back 66 percent and in 2010 they would get 100 percent.  This time-line was the phase-in portion in the title.

So how does this affect American’s wealth?  The most critical element in the PEP and Pease is how it affects the home mortgage interest deduction and, to a lesser degree, the deduction for local property taxes.  By themselves, these two deductions increase the after-tax return on housing because they lower your income taxes.  So PEP and Pease, by virtue of limiting these deductions, increases your income taxes thus lowering the after-tax return on housing.  In the end, PEP and Pease causes the value of certain homes to fall.

However, between 2006 and 2010, as PEP and Pease were slowly being eliminated, the after-tax return increased for those homeowners which led to price appreciation.  Ironically, this phase-in was adding fuel to the housing bubble fire.  Now, in 2010, for one-year only, PEP and Pease do not exist creating the most updraft for housing prices, especially upper-end, owner-occupied homes.

In 2011, that support for home prices will get yanked out from under the housing market in full.  This fact alone should make you wary of any talk of a housing recovery next year.  If policymakers are serious about helping home prices, this provision of the Bush tax cuts should be extended.  But, since it only affects higher-income taxpayers, the political chance of it being extended seem fairly slim at the moment.  If you are in the market to buy a house, you might want to double-check your 1040 under the 2011 tax code before taking the plunge.

Addendum:  Please note that I’m not talking about what makes for good income tax policy where eliminating deductions and lowering tax rates are good.  That being said, pulling the tax rug out from housing while still in the deflationary phase of the post-housing bubble economy is not the wisest of moves.