It's hard to have a rational discussion about closing the deficit without considering tax reform. And one of the most effective ways to reform the tax code is eliminating the ability to write off mortgage interest.
The fiscal benefits of this are straightforward. Mortgage interest deductions cost the Treasury as much as $130 billion per year in lost tax revenue. Consider just how much that is. If the cost of subsidizing mortgage interest were a line item in the federal budget, it'd rank as the seventh costliest -- just ahead of education and veterans benefits. The federal government spends more money subsidizing mortgages than on anything other than defense, entitlements, unemployment insurance, and interest. Pretty incredible.
Predictably, though, mere talk of eliminating the credit draws all sorts of hysterical warnings. Some say it'd be a huge tax increase on the middle class. A sucker punch to the housing industry. An attack on the American dream.
Don't buy it. These criticisms are mostly misguided. Here are two of the biggest false claims.
1. It'd be a huge tax increase on the middle class
First, let's get one thing out of the way: The elimination of a tax deduction is not the same as a tax increase. Marginal tax rates don't change.
But that's semantics. The reality is people would pay more taxes. According to The New York Times, House Speaker Nancy Pelosi (D-Calif.) warned that merely reducing the mortgage interest deduction would "force middle-class homeowners to subsidize tax breaks for the wealthy."
Not really. The only taxpayers who gain from the credit are the roughly one-third of filers who itemize deductions rather than take the standard deduction. By and large, these are upper-income folks.
The Tax Policy Center crunched the numbers and found that a complete elimination of the mortgage interest deduction would raise taxes on only 21.5% of middle-income workers, with an average increase of just $215 a year. The bulk of the increase would fall on the top 10% of wage earners. It's about as progressive as it gets.
The only difference the vast majority of Americans would see from eliminating this credit is a smaller budget deficit.
2. Homeownership rates would decline
First we have to ask: Is that a bad thing?
Realtors, mortgage companies, and politicians would love you to think the answer is yes. As President George W. Bush proclaimed in 2002: "I do believe in the American dream ... and owning a home is a part of that dream. It just is. Right here in America, if you own your own home, you're realizing the American dream." However, reality, as the financial crisis proved, is a little different. High rates of homeownership increase the odds of people living in homes they can't afford. It also decreases labor mobility -- the option of quickly moving to where the jobs are. University of Toronto professor Richard Florida finds that "The most innovative, most productive, and most highly skilled regions have rates of homeownership of 55-to-60 percent, while those where homeownership exceeds 75 or 80 percent are economically distressed."
But that's another topic. Would eliminating the mortgage interest deduction decrease homeownership rates?
Since only those who itemize deductions gain from the credit, the answer is likely no. If you itemize deductions, you're probably relatively wealthy. And if you're relatively wealthy, you're probably going to own rather than rent regardless of tax incentives.
There are good historical examples backing this up. Homeownership rates in the U.K. actually rose after it eliminated a mortgage interest deduction in 2000, from approximately 70% to around 72% by 2005. Furthermore, homeownership rates in the U.S. are roughly equal to those in Canada and Australia, both of which don't allow mortgage interest deduction. The correlation between mortgage interest deductions and homeownership rates seems elusive.
Here's another example: Credit card interest used to be tax deductible until President Ronald Reagan signed the Tax Reform Act of 1986. If you follow the logic of those protesting elimination of the mortgage interest deduction, this should have caused credit card balances to drop as the benefit to borrowers diminished. Instead, balances grew 11% between 1986 and 1987. The benefits of charging up a MasterCard (NYSE: MA) or Visa (NYSE: V) overwhelmed the small rebate borrowers received every April 15.
For the same reason people didn't stop working in the 1950s when top marginal tax rates were over 90%, they won't stop buying homes if the ability to deduct mortgage interest is taken away. The decision to own a home is based on much, much more than tax incentives.
Get it done with
Would taking away the credit cause housing prices to fall? Marginally, yes, especially for more expensive homes. But this only highlights another downside of the credit: It artificially props up housing prices by incentivizing small down payments and large mortgages, which is hardly something we should be proud of and try to preserve.
Ultimately, there are few sane arguments for why eliminating the mortgage interest deduction shouldn't be done. It raises a ton of revenue. It won't affect the majority of taxpayers. And it helps bring the housing market back into natural equilibrium. If anything, the biggest danger is that it makes so much sense that our lawmakers will reject it.
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.
