If you want less of something, stop subsidizing it. And if you need more of something, stop giving it away.
These seem like basic truths, but after a crisis caused by too much mortgage debt and a deficit blown open in large part by sinking tax revenue, it's amazing to see the persistence of arguments for keeping the mortgage interest tax deduction.
The deductibility of mortgage interest will lower tax revenue by $1.4 trillion over the next decade. There's a raucous debate over what to call that money. Some say it's nothing; tax deductions don't "cost" the government anything, they say. Others call these laws "spending in the tax code," or "tax expenditures." It's easy to see why. If, instead of a tax deduction, the government wrote homeowners a check for 30% (or whatever your tax rate is) of the amount paid in mortgage interest, the effect on deficits would be exactly the same. One is a tax deduction, the other is a cash subsidy, but in practice they're nearly indistinguishable.
At any rate, you don't even have to be in favor of higher tax rates to favor chucking the mortgage interest deduction. Getting rid of it could lower tax rates (more on that in second).
The real insanity of the deduction is what it incentivizes. The origin of the deduction -- and its strengthening in 1986 -- lies in promoting homeownership, but its success here is dubious. Homeownership rates in the U.S. are on par with those of Canada, Australia, and England -- none of whom allow mortgage interest deduction. A study by the London School of Economics and Kansas State University found the deduction "has no statistically significant impact on homeownership attainment." Most of those who own a home would do so without a subsidy.
What the deduction has done is nothing to feel good about. A study cited in a Brandeis University paper reckons the deduction keeps home prices about 10% higher than they otherwise would be. The National Association of Realtors, a fierce proponent of the deduction, claims its elimination would cause home prices to fall 15% -- implying, if only by accident, that it inflates prices by an even larger amount. The NAR goes on: Killing the deduction "means about a $20,000 to $30,000 reduction in housing equity for a typical homeowner." That, or it made you overpay by $20,000 to $30,000 in the first place.
Before 1986, when the deduction took its current form, between 65% and 70% of nationwide home values were backed by equity, with the rest financed by debt (a home worth $100,000 had, on average, a $30,000 mortgage). That debt-averse attitude changed in the late 1980s and plunged throughout the 1990s and 2000s. By 2005, equity backed less than 55% of home values. Mortgages became the rage, and the deductibility of interest no doubt played a role. A recent Fannie Mae survey found that tax advantages of having a mortgage are nearly as important to homeowners as the sense of community that comes with homeownership.
The standard rebuttal here is that the mortgage interest deduction provides middle-class tax relief. But this is arguable at best. Only those who itemize deductions gain anything from the mortgage interest deduction -- a qualifier that applies to just 54% of those with mortgages. For those who do qualify, the deduction is skewed overwhelmingly toward higher incomes. For those in the 50th income percentile, the average annual benefit from the mortgage interest deduction is $215; for those in the 99th percentile, it's $5,393. Renters and those without a mortgage subsidize the leverage of a primarily well-heeled group -- and the more debt, the better. Some policy.
But again, nixing the mortgage interest deduction doesn't necessarily mean higher tax rates. It can be quite the opposite. In 1986, President Ronald Reagan's Tax Reform Act lowered marginal tax rates and paid for it in part by eliminating several deductions -- including interest on most personal debt (except mortgages, where the deduction was strengthened). There are calls today to move in the same direction. Last fall, the bipartisan chairmen of President Barack Obama's deficit reduction committee proposed eliminating most tax deductions (including mortgage interest), but lowering marginal tax rates from today's high of 35% down to 23%.
What would we get for this? Tax rates would come down and become more competitive worldwide. With a broader tax base, deficits would shrink by more than $1 trillion over a decade. Home prices would become more affordable. The incentive to go hog wild in debt would disappear. It's a win on nearly every count.
What do you think?
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.
