Monday, February 4, 2013

His Days May Be Numbered

Nearly one year later, I'm trying to crank up the blog again.

Michael Danilack, deputy commissioner (international), IRS Large Business and International Division, today called out politicians for their ignorance and pandering.  See 2013 TNT 23-4.  Anybody watch the presidential debates?  Remember how the President kept talking about "tax deductions for moving plants overseas"?

Discussing the OECD's base erosion and profit shifting (BEPS) initiative, Danilack commented that: "[P]oliticians may not understand [international tax] issues and may sometimes try "to paint international taxation with the broad brush of evasion and avoidance."
Speaking at a conference hosted by the Pacific Rim Tax Institute in Palo Alto, Calif., Danilack ... acknowledged that disputes occur and that difficult issues involving intangibles have yet to be addressed, but he said officials shouldn't "throw the baby out with the bathwater and talk about how the whole system doesn't work." The current regime should work, he said, adding, "There's nothing wrong with it aside from these areas where there are some really important questions that really need to be addressed.... The vast majority of what's going on internationally doesn't involve evasion or even avoidance.... The vast majority of what's going on is companies are trying to get it right."
Pssst, Mr. Danilack.  We agree with the sentiment, but don't mention it to your Boss!  Taxpayers are best served with a voice of reason in your position.

Monday, February 27, 2012

Brown's Taxing Headace

California Governor Jerry Brown is dealing with a "taxing" headache these days. Within the last week, Brown has taken a jarring one-two punch.

[1] The state is projected to run budget deficits for years to come. Despite rosy economic assumptions, Brown's 2012-13 budget was expected to result in a $9.2 billion deficit. A report issued today by the nonpartisan Legislative Analyst's Office concludes that Brown's forecast is overstated by approximately $6.5 billion.

Brown was looking at roughly a $9 billion budget gap. Now he's looking at $15 billion. To quote another governor wunderkind: "Oops"!

Silicon Valley is experiencing a "mini-bubble," and Facebook's pending IPO is expected to create hundreds of new millionaires. Brown's revenue estimate assumes that "social networking" entrepreneurs and investors will pay billions in state taxes on capital gain income. The LAO report emphasizes that capital gain income is highly variable and notoriously difficult to project. California has been down this road before. Those who cannot remember the past are doomed to repeat it.

California is lurching down a path towards Greek-style insolvency. Here's the basic formula. Politicians create an expansive state bureaucracy. The state employees organize into dues-paying members of public employee unions. The unions funnel dues into political elections to support candidates who promise to keep the gravy train running. The politicians become pawns of union bosses. They borrow money to cover budget deficits as state employees become increasingly detached from the public sector.

In the long run, the cycle is unsustainable and doomed to implode. California cannot afford to pay its recurring bills and satisfy its health and pension commitments to retired state employees. However, that's a problem for the next generation. Brown is a political careerist, and he has no interest in disrupting the cozy relationship between Democratic politicians and public employee unions in California.

[2] Brown wants to solve the $9.2 billion budget gap with a two-pronged tax increase. He wants state voters to approve an initiative to raise tax revenue. The "Brown Tax Initiative" would raise the sales tax by half a cent and raise tax rates on families who earn more than $250,000. In a savvy -- but disgusting -- political move, Brown would link a failure of his initiative to automatic cuts in the K-12 education budget.

Does the income threshold sound familiar? Yes, another Democratic politician defines a working family with $250,000 in income as nouveau riche. To give Brown some credit, his initiative would at least "spread the pain around." Everybody pays sales taxes; a vote to increase the sales tax is a vote to tax me and the "man behind the tree." I'm more disgusted by Brown's decision to hold K-12 teachers and students ransom for his tax increase proposal. (Full disclosure: my wife is an elementary-school teacher.)

The LAO report complicates Brown's overall strategy. The Brown Tax Initiative will not cover the LAO's projected revenue shortfall. Brown will have to go back to the drawing board. Or play games with the numbers, which is usually the "solution" to problems in Sacramento.

[3] Meanwhile, recent poll data suggests that the Brown Tax Initiative may be caught in the crossfire among competing initiatives. Someone pass the Tylenol!

Brown is not the only advocate for higher taxes on the "wealthy." Public employee unions are pushing a "Millionaire Tax Initiative." They want to increase tax rates by 3% for incomes over $1 million, and by 5% for incomes over $2 million.

A wealthy lawyer (Molly Munger) and the state PTA is pushing the "Munger Tax Initiative." The Munger Tax Initiative would progressively raise taxes on all taxpayers, and would funnel the revenue into education.

According to the recent poll, likely voters express support for the Millionaire Tax Initiative (63%) and the Brown Tax Initiative (58%). More likely voters oppose (48%) than support (45%) the Munger Tax Initiative. No big surprise. The first initiative provides a "free lunch" courtesy of the highest-income taxpayers. The second initiative echoes Team Obama's drumbeat to raise taxes on the top 3%. The third initiative would require increased taxes for everybody, which triggers some soul-searching among voters.

If you need to guard the entrance to Hades, I'd recommend a three-headed monster named Cerberus. However, a three-headed tax initiative may confuse and fatigue California voters. Team Brown conducted an unofficial poll suggesting that voters will play "knock out" and select one plan while rejecting the others. If so, voters may fragment their support for the initiatives and tank the entire process. (Team Munger disputes Brown's logic.)

A final remark on the California initiative process. Why exactly do we elect state politicians, when they put any tough decision on the ballot?

Friday, February 24, 2012

Obama Woos the Corporate 1%

[1] You really can't make this stuff up. On February 11th, the Wall Street Journal reported that (sub. required):
The Obama administration is attempting to persuade U.S. corporations about the benefits of investing in renewable energy, in an effort to help the industry after a government grant program expired.

The Energy Department-led effort includes a planned March 13 meeting at which senior financial-firm executives and Energy Secretary Steven Chu would speak, documents viewed by The Wall Street Journal show. The 79 invitees include some of the largest companies in the U.S., from Exxon Mobil Corp. to Walt Disney Co., according to the documents.
Yes, crony capitalism at its best. Team Obama sings a populist tune for its cheerleaders on the political left. Most of the time, someone needs to stand up for the "99%" against the big, bad "1%". But, ahem, there are some exceptions. A big exception involves the much touted "green jobs agenda." Guess what? The "green jobs agenda" can really use some help from the Corporate 1%.

The existing tax subsidy regime for renewable energy development is dysfunctional. Team Obama needs cash from big U.S. businesses with big U.S. tax bills. Without cash from the Corporate 1%, renewable energy development will continue to limp along. Hopefully, the "most transparent administration" in history will release a transcript of the March 13 meeting. But we can be assured that the real "action" will occur behind the scenes. Crony capitalism at its best.

[2] Back in August 2011, I wrote a series of posts describing the relationship between tax subsidies and renewable energy development. See Part 1, Part 2, Part 3, Part 4. The political left wants to subsidize renewable energy through federal spending. The political right favors the magic of "tax expenditures" over direct outlays. Together, they devised a laughably flawed regime that provides tax credits for certain types of renewable energy.

Why is the regime laughably flawed? A quick summary of my August posts. I'm focused on wind and solar development, although the same principles apply in other contexts.

Congress wants more development of wind and solar projects. But generating electricity from wind and solar resources costs more than generating electricity from coal and natural gas ("bad" fossil fuels). Because wind and solar are "uneconomic," no rational actor would develop wind or solar projects without some kind of subsidy regime. Put another way, a rational consumer would not choose to purchase expensive, unsubsidized electricity from wind and solar projects.

There are various ways to subsidize energy development. For example, Congress could have passed a direct subsidy for electricity produced by wind and solar projects. The direct subsidy would have been, say, 1.0 cent per kilowatt hours of electricity produced by a "qualified" energy facility for a given number of years. The entire program could have been administered by the Energy Department ... which is, after all, responsible for our national energy policy. Under a direct subsidy regime, a wind or solar project would merit development if (a) sales of electricity to utilities or other unrelated customers, plus (b) the 1.0 cent/KwH subsidy from the Energy Department, exceeded the cost of debt and equity required to finance development. Nice and easy.

Instead of a direct subsidy, Congress enacted a complicated tax subsidy. Actually, a series of slightly different, complicated tax subsidies. For wind, Congress enacted a "production tax credit" or "PTC." For solar, Congress enacted an "investment tax credit" or "ITC." In addition, wind and solar property qualifies for accelerated tax depreciation. Suffice to say, a taxpayer must have positive income tax liability to use PTCs, ITCs and accelerated depreciation. (Unless extended, the PTC regime will expire on December 31, 2012, adding more complexity and uncertainty into the mix.)

Importantly, a taxpayer with positive tax liability cannot simply "purchase" tax credits. On the flip side, a developer without tax liability cannot "sell" tax credits or excess depreciation. Instead, taxpayers with cash and tax liability must invest cash (so-called "tax equity") into qualifying wind and solar projects.

In exchange for its financing commitment, a tax equity investor receives tax credits, accelerated depreciation and some cash until the project satisfies an agreed IRR "hurdle." After the IRR hurdle is satisfied, somewhere down the road, the tax equity or common equity/sponsor exercises a put or call to close the transaction. Under the put/call arrangement, the common equity/sponsor purchases the tax equity investor's position based on its residual value.

[3] And that's why the regime is laughably flawed. It is complex and impenetrable for most taxpayers and most tax advisors. Plus, the commitment of cash to a renewable energy development project is absolutely "non-core" to most corporate treasurers and CFOs. Meanwhile, administering the subsidy regime falls into the lap of the IRS. Why not administer energy subsidies through the Energy Department?

In practice, there are only 15-20 active participants in the tax equity market. The market is dominated by large national banks, some regional banks, and a few other taxpayers in the financial services business (GE; insurance companies).

Before the financial meltdown in 2008, tax equity yields ranged from 6-8% on an after-tax basis (10-12% on a pre-tax basis). Then the financial system flirted with Armageddon. All of a sudden, market facilitators (the banks and insurance companies and GE) began running tax losses. Without taxable income, facilitators didn't need tax credits, so the market effectively froze up. This didn't bode well for Team Obama's "green jobs agenda." So the administration's Congressional allies quietly created a program to bail out the developers. During 2010 and 2011, qualifying projects could elect to receive Treasury grants (so-called "1603 grants") in lieu of tax credits. The 1603 grant program permitted the industry to survive the turbulence of the Great Recession.

Time flies, and we're in 2012. The Treasury grant program has expired, and Congress recently declined to renew it. Renewable energy development again hinges on 15-20 banks and insurance companies. Because there is a massive supply/demand imbalance (more renewable energy developers than tax equity), tax equity yields have skyrocketed. Yields for reputable developers have jumped from the 6% range to the 12% range. Yields for marginal developers are in the 15-20% range.

[4] Now we come full circle. The tax equity market is dysfunctional, and would make an interesting study for an economics PhD dissertation. Plenty of corporate taxpayers outside the financial services business (think retail, domestic services) have (a) large U.S. tax bills, and (b) stockpiles of cash earning 1% or less in ultra-secure investments. But tax equity yields are running 12-20% after-tax.

As evidenced by Team Obama's pending meet-and-greet, many of those large corporate taxpayers are probably put off by the complexity of the tax subsidy regime. But many of them routinely invest in other tax credit schemes, including low-income housing tax credits. Team Obama loves to demonize big business and large corporate taxpayers. Can it persuade those "big bad corporations" to commit cash in support of Obama's "green jobs agenda"?

In the world of crony capitalism, anything can happen. It's always a good time when you're rolling in the Corporate 1%.

Wednesday, February 22, 2012

Obama's Dividend Assault: Silver Lining for Private Equity?

[1] Among the proposals in the 2013 budget, Team Obama wants to increase the tax rates on dividends received by the "rich." Obama defines "rich" to include families that earn $250,000 annually (and single individuals that earn $200,000).

(Any higher thresholds would substantially reduce the amount of taxes raised from increased taxes on the "rich." As government's thirst for revenue intensifies, expect the threshold to drop. It's all relative. A family that earns $150,000 is living large compared to a family that earns $50,000. And an individual that earns $75,000 is sampling the good life compared to an individual that earns $25,000.)

[2] In today's Wall Street Journal, the editors took aim at President Obama's "assault" on dividends. (Sub. required; thanks to Paul Caron for the link.)
Mr. Obama is proposing to raise the dividend tax rate to the higher personal income tax rate of 39.6% that will kick in next year. Add in the planned phase-out of deductions and exemptions, and the rate hits 41%. Then add the 3.8% investment tax surcharge in ObamaCare, and the new dividend tax rate in 2013 would be 44.8%—nearly three times today's 15% rate.

Keep in mind that dividends are paid to shareholders only after the corporation pays taxes on its profits. So assuming a maximum 35% corporate tax rate and a 44.8% dividend tax, the total tax on corporate earnings passed through as dividends would be 64.1%.
The numbers are pretty shocking, but consistent with Obama's core philosophy. Obama is campaigning in 2012 as a populist Robin Hood. As many have noted, the 2013 budget is a political document at its core.

[3] I'm actually more interested in the "knock on" effects of the dividend tax increase. The WSJ editors argue that increased dividend tax rates will "make stocks less valuable." Maybe so, but probably not.

The WSJ article includes a graph that tracks reported dividend payments from 1990 through 2009. The graph suggests that corporations increased dividend pay outs in response to a dividend rate cut in 2003. Let's assume that the relationship is causal, i.e., the decrease in tax rate on dividends caused corporations to increase dividend pay outs.

What happens if tax policy changes, and dividend tax rates are increased (for those "rich" families that earn $250,000 annually and their distant cousins, the mega-millionaires and uber-billionaires)?

If there is a causal relationship between dividend tax rates and corporate distributions, we'd expect corporations to reduce distributions. However, corporations have two ways to return cash to shareholders. They can pay dividends, which is arguably good for retail investors on fixed incomes (traditionally, "widows and orphans"). And they can engage in stock repurchase transactions, which is arguably good for other investors who want capital appreciation without dividend income (and current tax leakage).

A dividend tax increase does not impact the cash from operations available for distribution to a corporation's shareholders. It simply impacts the form of distribution. Ironically, this flexibility at the corporate level makes static budget forecasts unreliable. A dividend tax rate increase may raise immaterial revenues if corporations shift gears and increase stock repurchase activity. So what's the point? Political distraction. And, if nothing else, President Obama gets to wear his Robin Hood tights and cape for his political admirers.

[4] Finally, let's assume that higher taxes on dividend income do, in fact, take some air out of the market for public equities. In other words, assume that Obama's assault on dividends "make stocks less valuable." Would this be bad for the "tens of millions" of Americans that own stock "through pension funds"?

In fact, lower equity valuations would probably benefit pension funds and their individual beneficiaries. Ironically, lower equity valuations may provide a silver lining for their private equity advisors.

I won't get into a full-blown discussion of the relationship between pension funds and private equity. Suffice to say, despite all the hype about private equity, a substantial majority of the capital for private equity managers is invested by pension funds.

Unlike high-income individuals, pension funds generally pay no income tax on dividend income (or interest income, or other forms of passive income). If increased dividend tax rates decrease equity valuations, private equity managers will have "cheaper" opportunities to deploy their investment capital. They can improve the performance of portfolio companies, strip out operating cash flows through tax-exempt interest and dividend payments, and flip investments at slightly lower earnings multiples.

Big pension funds win. Private equity fund managers win. Only small individual retail investors lose. But what else is new when government interferes with capital markets?

Back in Action

For readers that paid attention to this blog in the second half of 2011, I apologize. I intended to take a one-month hiatus in December. The one-month hiatus turned into two months and then three months.

Meanwhile, there has been no shortage of "tax news." Most of it is politically motivated rubbish. Team Obama continues to hype its class warfare fantasy that increased taxes on the "rich" will solve virtually every social, economic and environmental problem that has surfaced in the past decade. The political right has countered with its own policy lies and distortions. It's going to be a long year for us political independents.

I can't possibly "catch up" on the barrage of tax news clippings over the past 10 or 11 weeks. So I'll jump back into the fray as developments catch my eye.

* * * * *

As I've previously observed, Team Obama is completely incoherent when it comes to tax policy. Sometimes, Obama talks the talk of common sense tax reform. Mostly, Obama walks the walk of a populist Robin Hood. Sure, he wants tax simplification ... but he also wants to expand tax incentives for "favored" industries and activities. Sure, he wants to improve the competitiveness of U.S. businesses ... so long as the government can use tax policy to shape the winners and losers in the domestic business landscape.

The President's fiscal 2013 budget proposal reflects his irreconcilable tax priorities: simplification; competitiveness; corporate welfare; income redistribution. The former two goals would be good for all of us. The latter two goals are good for politicians seeking annuities -- in the form of political donations -- from corporate lobbyists, unions, and other special interest groups. Martin Sullivan puts it this way:
As it is trying to promote tax reform [in its fiscal 2013 budget proposal], the Obama administration is defying the logic of real tax reform -- the economic logic that tax neutrality is best for growth and job creation except in extraordinary circumstances.

What administration incentives hinder true tax reform efforts? A conversion of the already complicated section 199 manufacturing deduction into a two-tiered incentive. A temporary incremental wage credit for small business. A tax credit for investment in communities that have experienced a job loss event. A tax credit for moving expenses when companies move jobs to the United States. New tax credits for alternative energy to replace the existing ineffective and outdated ones.

This is big government through tax policy. The complexity of these new tax breaks is extraordinary even by the standards of our tax code... And as for the coming corporate tax reform, there is no more place for them there than there is for a fox in the henhouse. (134 Tax Notes 922 (Feb. 20, 2012))
In his 2008 election campaign, President Obama vowed that he would renounce "politics as usual." That empty promise, like so many others, was simply "politics as usual." No surprise that, come 2012, we're getting more "politics as usual."

Team Obama is not interested in, nor committed to, fundamental tax reform. The existing system creates winners and losers, and the Obama administration believes that the government exists to create winners and losers. Team Obama is very comfortable with the status quo, so long as it can influence the choice of winners and losers.

The media and the blogosphere will spill much ink on the topic of "fundamental tax reform" this year. The Obama administration will give a wink to simplification and a nod to increased competitiveness. But it's all about distraction in 2012. Any debate about "tax reform" takes some of the focus off trillion dollar budget deficits as far as the eye can see. It's savvy "politics as usual" from a master of smoke and mirrors.

Friday, December 2, 2011

December Programming Note

I will be blogging infrequently for the month of December, due to work and holiday-related obligations.

Happy Holidays! See you in January (maybe late December)

Monday, November 28, 2011

Sheppard on Earnings Stripping

Our favorite tax fashionista, Lee Sheppard, has an interesting article out today. See "News Analysis: The Fashion in Interest Deduction Restrictions," Tax Notes, Nov. 28, 2011, p. 1061.

Earnings Stripping

What is earnings stripping? First, some background. Many jurisdictions, including the United States, permit taxpayers to deduct interest expense in computing net taxable income. Deductible interest reduces pre-tax income and taxes owed to the revenue authority. The deductibility of interest expense creates a difficult challenge for policy makers. The issue will be lurking below the surface as Congress begins wading into the waters of tax reform.

Deductible interest creates a "bias" for debt-heavy capital structures ("overleverage"). The deduction for interest expense artificially decreases the "real" cost of debt relative to the "real" cost of equity. Overleveraged capital structures are more likely to capsize during the "trough" of business cycles, creating turmoil and trauma for stakeholders of the overleveraged business (employees, customers, local communities, etc.).

Deductible interest also permits business owners to "strip" taxable income out of the the tax base. This "earnings stripping" or "base erosion" involves variations on a theme. Sheppard's article focuses on cross-border earnings stripping.

A corporate parent with a foreign subsidiary may be able to fund the subsidiary with "shareholder loan" capital that pays interest. With proper treaty planning, (i) the shareholder loan pays interest, (ii) the interest expense is deductible, reducing taxable income and tax liabilities in the subsidiary's jurisdiction, and (iii) low or no withholding taxes apply to the interest payment. This type of structure permits the parent to "strip" earnings out of a higher-tax jurisdiction into a lower-tax jurisdiction.

Designing an "interest strip" is not rocket science. Tax advisors can use the basic structure in domestic transactions. Assume a group of pension funds pools capital and purchases a U.S. business organized as a corporation. The pension funds capitalize an acquisition vehicle with a mix of equity capital and "shareholder loan" capital. The decision to capitalize with equity and debt is effectively "deemed" to have economic substance. The target business generates taxable income after the acquisition. But the acquisition vehicle pays deductible interest expense on its shareholder loans. The pension funds are tax-exempt entities, so pay no tax when they accrue or receive interest. Voila, an "interest strip" -- shifting tax revenue from the U.S. Treasury to the pension funds.

(In the long run, query whether foreign and domestic pension funds will be able to use their tax-advantaged status to purchase every commercial enterprise on Earth. Marx would be vindicated. The working class -- through pension funds and their investment managers -- would control the means of production.)

U.S. Rules

Congress understands that earnings stripping can be a big problem. It enacted Code section 163(j) to address the issue. Sheppard snorts at the U.S. rules: "[I]t remains ridiculously easy to strip [income out of the United States] using interest deductions, despite a statute squarely aimed at foreign-parented groups."

I won't go into section 163(j) in detail. It limits a corporation's related-party interest deductions if the corporation has too much leverage and too much interest expense. It works in some cases, but has a couple obvious shortcomings. First, it doesn't apply to my domestic example above (where a group of pension funds acquire a U.S. business and use shareholder loans to interest strip). The statute only bites if the shareholder loan capital is provided by a "related" person.

Second, the U.S. limitation does not expressly contain any transfer pricing limitation. Take a technology business. Many technology businesses are capitalized with low ratios of third-party debt to equity ("leverage ratios"). But let's assume that a foreign parent corporation purchases a U.S. target corporation and injects leverage (a shareholder loan) into the target's capital structure. Assume that external leverage ratios in the industry are very low (10% or lower). But the foreign parent capitalizes its new subsidiary with $20x of equity capital and $80x of shareholder loan capital (an 80% leverage ratio).

The U.S. earnings stripping rules do not prohibit the legal structure. And while the U.S. transfer pricing rules impose "arm's length" pricing requirements on intercompany transactions, IRS agents do no commonly focus on shareholder loans (in my experience). Unlike Sheppard, I don't fault section 163(j), so much as lax or unsophisticated U.S. tax administration.

German Rules (and Copyists)

Historically, the U.S. has exported principles of tax law and administration. But the rest of the world has caught up. Sheppard summarizes discussion at a recent International Bar Association annual meeting in Dubai. Tax professionals explored various European earnings stripping limitations. At some point, U.S. policymakers will start paying attention.

According to Sheppard, Germany was the first country to revise its earnings stripping rules. The German rules have serious teeth. The rules apply to all debt of a German affiliated group (an organschaft). The deduction for net interest expense is limited to 30 percent of EBITDA, regardless of whether the payer is related to the lender. EBITDA for this purpose is capped by the group's taxable income. (This effectively limits the benefit of timing or temporary differences to an organschaft with external or internal leverage.)

Practitioners apparently regard the limitation as "stingy." In my view, this is another example of German sensibility and efficiency. The rule is simple to describe and understand. It keys off EBITDA of a business; the financial metric that lenders and equity investors care about when financing an enterprise. The limitation may get low marks on "elegance," but it gets high marks from an administrative perspective. From a tax compliance perspective, policymakers should balance ease of administration against "technical perfection."

Italy has adopted a close variation of the German rule. The French legislature is considering a similar regime to address perceived abuse of French thin cap rules. The Dutch, Irish and Swedish are openly struggling with excessive leverage in domestic capital structures due to cross-border private equity transactions.

If you work in the international tax space or the domestic M&A space, Sheppard's article is definitely worth a quick read.

Friday, November 25, 2011

Hypocrisy and McMansions

Happy Thanksgiving Weekend!

With the national economy sputtering and unemployment around 9%, many Americans will need to tighten their belts this holiday season. Meanwhile, Democrats and Republicans in Washington teamed up to serve up a big order of Hypocrisy on a silver platter.

On November 18, President Obama signed into law a bill that reinstates higher conforming loan limits for the Federal Housing Administration through 2013.

In plain English, home purchasers can now receive cheaper financing on home loans up to $729,750. The financing is "cheaper" because it's effectively guaranteed by the federal government (i.e., taxpayers). The interest rate on non-conforming jumbo loans is roughly 0.75% higher that the interest rate on conforming loans.


Gee, isn't this a sign of progress? Team Obama was finally able to hammer out a bipartisan consensus with Republicans. The House passed the bill with a healthy 298-121 majority. Of the dissenters, 101 were Republicans and 20 were Democrats.

The main progress here was the blatant display of hypocrisy. Politicians didn't hold their noses against the stench and enact this bill in the dead of night. They transparently abandoned their "core principles" in broad daylight.

Let's start with the Democrats. The Obama administration and Congressional Democrats have relentlessly spun the following narrative:
The Great Recession was brutally difficult for lower- and middle-income Americans. But upper-income Americans emerged largely unscathed. And many of them actually profited from the economic downturn. The top 1-2% have "unclean hands" because they have not suffered the harshest effects of the economic downturn. And it is time to "spread around" some of their wealth by creating or expanding government programs funded by increased taxes on the top 1-2%.
Rhetoric aside, these tireless advocates for the middle class understand where their bread is buttered. The most expensive real estate in the United States is concentrated in Democratic strongholds on the East and West Coasts. Wealthy liberal enclaves provide enormous financial support to Democratic politicians. Note that House Democrats overwhelmingly supported the legislation.

A middle-class American cannot afford a million-dollar McMansion. She does not need a $700,000 jumbo loan, conforming or non-conforming. This legislation was nominally intended to keep an ailing real estate market on life support. But the main people hurt by a softer real estate market are the affluent real estate brokers and financial institutions that service upscale local markets. To quote tax blogger James Maule, "boo hoo" for affluent real estate brokers. Democrats howl about cuts to services for the "most vulnerable" Americans. Yet when push comes to shove, they prioritize subsidies to affluent real estate brokers by propping up home values in the wealthiest communities.

How about the Republicans? Most Republicans argue that free markets work, and that government intervention tends to cause more problems than it solves. Many Republicans have criticized government policy for exacerbating the housing bubble that burst in 2007 with such a devastating effect.

But Democrats do not have a monopoly on wealthy political donors in expensive homes. The "crony capitalism" that riled up the Occupy Wall Street crowd has deep roots on both sides of the political aisle. The main Republican advocate of the bill was John Campbell (R-Calif), whose constituents in Orange County have taken large haircuts on million-dollar homes. Republicans lose all credibility when they argue that certain sectors of the economy should remain on taxpayer-funded life support.

Republican also like to play the "certainty" card. They frequently argue that the economy is sputtering because individuals and businesses are uncertain about the future of government policy. But in this case, Republicans reversed course on a prior aspiration to scale back the federal government's role in residential housing finance. The acting director of the Federal Housing Authority bluntly criticized the legislation as "sending the wrong signal."

...and McMansions

The federal government (i.e., you and me as taxpayers) provide two main subsidies to the residential housing market. The first involves federal loan guarantees, which shift risk from private lenders to the government and, ultimately, taxpayers. Federal loan guarantees make it cheaper for homeowner to borrow money, which means that they can bid more for homes.

The second involves the deduction for home mortgage interest. Effectively, the mortgage interest deduction is a tax subsidy for home owners. Although the mortgage interest deduction is capped, it has the same overall effect as the federal loan guarantees. By reducing tax liabilities, the mortgage interest deduction frees up cash to service home mortgage principal and interest payments.

Here's the funny thing about the federal subsidies. They are nominally intended to make home ownership more accessible. But they don't make housing more affordable. On the contrary, the subsidies make housing less affordable, because they permit home buyers to qualify for bigger mortgages and pay for more expensive homes than would be possible without the subsidies.

Okay, if homes aren't more affordable, then who benefits from the subsidies? In other words, who benefits from government policies that increase the cost of housing above market rates?

Primarily the housing lobby, comprised of home builders and real estate agents. The former group (home builders) employs large numbers of union and other blue-collar workers in the construction industry. No surprise that Congress might want to direct economic subsidies to this group. In addition, local governments benefit from higher real estate prices, which translates into higher property tax revenues. Many local governments jumped on the bandwagon during the bubble years, assuming that real estate prices and property taxes would increase in perpetuity. They developed long-term budgets and entered into contractual obligations with service providers (teachers, police officers, bureaucrats) that have become unsustainable after the bubble popped.

The deduction for mortgage interest is second largest tax expenditure (estimated to cost $99 billion in 2012). Eliminating it would tend to make housing more affordable over time (by reducing the inflation-adjusted value of residential real estate). That's a bad result for many existing homeowners, but a good result for new homeowners. If political actions mirrored rhetoric, we would expect that Democrats and Republicans could agree on a plan to phase out the deduction over time. Home prices would become more affordable for the 99%. And individuals would re-allocate capital away from (subsidized) housing into more productive activities.

But political hypocrisy is just as certain as death and taxes.