Did the 1997 change in the tax law for home sales launch the bubble?

Remember back in 1997 when the tax law was changed so people selling their principal residences would never have to pay capital gains taxes on certain amounts ($250,000 for singles, $500,000 for couples?). That was also about the same time that the housing bust here in Southern California of the early 1990s finally began to show some real bounce. A story in the New York Times investigates:

By itself, the change in the tax law did not cause the housing bubble, economists say. Several other factors — a relaxation of lending standards, a failure by regulators to intervene, a sharp decline in interest rates and a collective belief that house prices could never fall — probably played larger roles.

But many economists say that the law had a noticeable impact, allowing home sales to become tax-free windfalls. A recent study of the provision by an economist at the Federal Reserve suggests that the number of homes sold was almost 17 percent higher over the last decade than it would have been without the law.

Vernon L. Smith, a Nobel laureate and economics professor at George Mason University, has said the tax law change was responsible for “fueling the mother of all housing bubbles.”

By favoring real estate, the tax code pushed many Americans to begin thinking of their houses more as an investment than as a place to live. It helped change the national conversation about housing. Not only did real estate look like a can’t-miss investment for much of the last decade, it was also a tax-free one.

Together with the other housing subsidies that had already been in the tax code — the mortgage-interest deduction chief among them — the law gave people a motive to buy more and more real estate. Lax lending standards and low interest rates then gave people the means to do so...

The provision — part of a sprawling bill called the Taxpayer Relief Act of 1997 — exempted most home sales from capital-gains taxes. The first $500,000 in gains from any home sale was exempt from taxes for a married couple, as long as they had lived in the home for at least two of the previous five years. (For singles, the first $250,000 was exempt.)...

The change in the tax law had its roots in a Chicago speech that Senator Bob Dole, Mr. Clinton’s Republican opponent in the 1996 presidential election, gave on Aug. 5 of that year. Trailing Mr. Clinton in the polls, Mr. Dole came out for an enormous tax cut, including an across-the-board reduction in the capital-gains tax...

The law’s defenders say that it also removed at least one tax incentive that had pushed homeowners to trade up. Before 1997, people had to buy a house that was at least as valuable as their previous one to avoid the tax, or else take the one-time exemption. Now they could buy a smaller property or move into a rental.

But many economists say the net effect of the law was clearly to inflate the real estate market. Dean Baker, co-director of the Center for Economic and Policy Research, a liberal policy group in Washington, criticized the exemption as “a backward policy” that “helped push more money into housing.”...

Perhaps the most detailed analysis of the provision has been the study by a Federal Reserve economist, Hui Shan, who did the analysis while at M.I.T. Ms. Shan looked at homeowners with significant equity gains, before and after 1997, and compared the likelihood of their selling their house. Her study covered 16 towns around Boston and took into account a host of other factors, like the general rise in home prices at the time.

Among homes that had appreciated less than $500,000, she concluded that the change caused a 17 percent increase in sales in the decade after 1997. Before the law changed, many people apparently avoided paying the tax by simply staying in their homes...

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