No.

The New York Times suddenly discovered a study by Fed economist, Hui Shan, which they think reveals a new cause for the housing bubble. Shan's study found that a 1997 tax change allowing capital-gains-tax-free sales of homes (up to $500,000 of gains for couples and $250,000 for singles) increased housing sales. The Times concluded that this change might have contributed to the housing bubble by increasing the demand for owner-occupied housing. They tell the story of an investor who repeatedly bought homes, lived in them for the required two years, and then sold them at a tax-free profit, and inferred from this anecdote that this was a significant part of the bubble.

But Hui Shan did not conclude that the 1997 law increased housing prices—only sales of houses that qualified for the gains exclusion—and the capital gains/bubble hypothesis rests on pretty shaky ground.

Let’s recap what the 1997 law did. Pre-1997, homeowners who sold a home and purchased a more expensive one could defer capital gains tax indefinitely. Homeowners age 55 and over who sold a home qualified for a one-time exemption on gains up to $125,000. Homeowners who died in their homes were forgiven capital gains tax altogether (as they were on all other assets because of so-called “step-up in basis”—the provision that spares heirs tax on capital gains earned by decedents).

The consequence of this law is that, before 1997, almost nobody paid capital gains tax on homes. Sally Wallace, David Weiner and I found that in 1993, of $50.5 billion of gains reported on home sales, $48 billion was exempt from tax either because of the rollover provision ($30 billion) or the special break for older owners ($18 billion). We also found that, while the tax collected almost no revenue, it created significant distortions. Look at this chart showing a 20 point increase in the percentage of homeowners who switch to renting when they turned age 55 (and qualified for the gains tax break).

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So the old law discouraged down-sizing or renting, especially for those under age 55. That is, they consumed too much housing. How does eliminating that distortion inflate housing prices???

Another revealing measure is to compare tax expenditures on housing capital gains before and after the tax change. In 1996, the JCT estimated that the rollover provision would reduce tax revenues by $18.8 billion in 1998 and the special tax break for taxpayers age 55 and over would be worth $5.1 billion. In 1997, JCT estimated that the tax expenditure for the new provision would be $5.6 billion in 1998. In other words, the tax subsidy for owner-occupied housing declined by $18 billion. And that inflated the bubble?

The other argument that might be made is that even though the prior law raised almost no revenue, it amounted to a huge implicit tax (because it locked people in homes more expensive than they wanted) so eliminating it raised the after-tax return to housing. This assumes that people accounted for this when they decided how big a house to buy or whether to own or rent, which I think is unlikely except for those who wanted to buy homes as short-term investments.

As the NY Times article notes, there are flaws in the implementation of the 1997 law. It shouldn’t apply to people who flip homes every two years. But, on balance, eliminating a tax that encouraged people to consume too much housing while raising virtually no revenue was a good thing. And it certainly is not a significant factor in the housing bubble.