Time to scrap the mortgage interest deduction

By Philip Klein | MARCH 27, 2014 

 

In theory, the mortgage interest deduction is supposed to encourage home ownership. But when...

In the coming weeks, Americans will spend an average of 13 hours and $210 to prepare their federal taxes. Beyond the compliance burden the federal tax code imposes, it also distorts economic activity and discriminates against some taxpayers in favor of others. But one of its most egregiously unfair provisions is also among its most popular — the mortgage interest deduction.

In theory, the mortgage interest deduction is supposed to encourage home ownership, a questionable goal for government to begin with.

The purpose of taxes is to raise money to finance government services, not to manipulate human behavior or economic activity.

When lawmakers tell taxpayers that they can keep more of their money — but only if they spend that money the way politicians want – it’s just as much an exertion of government power as a spending program.

Allowing individuals to deduct mortgage interest payments drives up taxes on other Americans given the need to recoup the lost revenue, or, alternatively, adds to the deficit. The mortgage interest deduction itself drains $100 billion annually from the U.S. Treasury.

When other tax policies meant to encourage home ownership are added — including the deductibility of state and local property taxes and the exemption of capital gains taxes from selling a home — that number rises to $175 billion.

But even if one were to accept that boosting home ownership is a worthy goal for government, the interest deduction and accompanying tax benefits for homeowners should be seen as a miserable failure. That's the conclusion of economists Andrew Hanson, Ike Brannon, and Zackary Hawley in a study prepared for the R Street Institute, a right-of-center think tank, and published in National Affairs.

The authors took a detailed look at the distribution of existing tax benefits for home ownership and found that the benefits do more to help wealthier Americans purchase larger homes than they do to encourage lower-income Americans who otherwise would be renting to purchase homes in the first place.

The study found that in Atlanta, Denver, Detroit, Minneapolis, Philadelphia, Phoenix, Seattle and Washington, D.C., 80 percent of taxpayers earning more than $100,000 claimed the deduction, compared with just 25 percent of those earning less.

In monetary terms, the deduction is also significantly more valuable for higher-income households.

The deduction applies to mortgage debt of up to $1 million and debt from second homes can count toward that amount. Furthermore, because high-income earners are taxed at a higher rate, each dollar of earnings they get to deduct from their taxes is worth more.

A family with a household income of $500,000 with $1 million in mortgage debt being financed at 4 percent would generate $16,000 per year in tax savings, according to the authors’ calculations. In contrast, a household earning near the national median income of $51,000 with a home worth $221,000 (the median price), would receive tax savings of one-tenth that amount.

There are several leading objections to scrapping the mortgage interest deduction. One is that it would drive down home prices.

Another is that American homeowners already purchased homes and did tax planning on the assumption that the tax benefit would be in place.

As to the first argument, while it’s true that limiting or eliminating the deduction would reduce the artificially inflated value of homes, that would be true of homes everywhere. That means homes would be cheaper for people shopping for new homes, as well as those hoping to sell their current homes and purchase new ones.

Also, proposals to reform the mortgage interest deduction can be designed to phase in the changes over time, so that homeowners can gradually adjust.

Recently, House Ways and Means Chairman Rep. David Camp, R-Mich., offered a comprehensive tax reform proposal that would allow individuals with existing mortgages to keep the deduction as is, while gradually reducing the cap to $500,000 for new mortgages.

Another idea proposed by the authors is to change the deduction to a flat rate tax credit, to “limit the subsidy provided to upper-income taxpayers while simultaneously expanding it at the lower end of the income distribution.”

My preferred approach would be to slowly phase it out over time as part of a broader tax reform that lowered tax rates for everybody.