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Wednesday, August 24, 2005

Taxes and Real Estate Bubbles

One of the principles I try to teach my students is that taxes are important, since it's after-tax cash flows that matter. Patri Friedman at Catallarchy makes an excellent point that can be used to illustrate this concept. He argues that the real estate bubble may in part be due to the elimination of taxation (within limits) on gains from sales of a primary residence. This makes the after-tax proceeds from selling a house higher, and makes houses more attractive. Hence, prices increase.

Click here for the whole piece.

A similar argument can be made for the effect of the recent cut in tax rates on dividends. Bloin, Raedy, and Shackelford have a paper on the topic, titled "the Initial Impact of the 2003 Reduction in the Dividend Tax Rate. It can be downloaded free (PDF format) from the SSRN here. In short, they find that firms increased dividend payouts (and decreased the extent of share repurchases) following the tax cut.

So just remember - taxes matter.

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