A commentary in Small Business Trends yesterday argues that if the mortgage interest deduction (MID) is eliminated, small businesses would be adversely impacted. Scott Shane argues that the MID props up housing prices and creates home equity that small companies can use to fund their business activities, therefore we should keep the MID. He draws on research from the National Association of Realtors (NAR) that says getting rid of the MID would cause a 15 percent decline in housing prices, and argues from his own analysis of the market that if this happened the value of home equity loans would fall 20 percent, or a $140 billion decline in the amount of credit based on home equity potentially available for small businesses.
Unfortunately, his numbers are a bit off.
We'll ignore for now that the MID contributed to the housing bubble by creating artificial demand for homes and that the bursting of the bubble has had profoundly negative effects on small businesses. In fact, if the impact on housing prices is as strong as Shane and NAR suggest, they should be especially critical of the role the MID played in inflating housing prices. But on to the impact of the MID on housing prices.
In its most simplistic relationship, the mortgage interest deduction provides a subsidy to consumers of owner-occupied housing, artificially stimulating demand, which in turn drives up prices. However, the reality is more complicated. Since, only about 25 percent of taxpayers actually claim the MID, the number of consumers whose demand is directly affected is relatively small. For those taxpayers, it effectively increases their after-tax income. However, that additional income can be used for saving or consumption—it is a mistake to assume that all of the income benefits of the MID are specifically spent on housing.
For the MID to be an effective subsidy to the consumption of housing, consumers need accurate information as to the size of that subsidy. It needs to be highly visible to them. In theory, homebuyers could explicitly incorporate the value of an MID into their calculations of how much they can afford to spend. But if they do not, then the impact of the mortgage interest deduction subsidy on decisions to buying a home is quite limited.
Independent research over the past fifteen years also contradicts price-impact claims from the NAR (an organization that has built a substantial amount of its business because of the perceived value of the MID subsidy). A 1996 paper estimated that at most, the MID pushed housing prices up 10 percent. And this estimate assumed that the supply of housing remained absolutely stable. Of course, in reality the housing stock is not fixed in the long run, so the expected price effect would actually be smaller than 10 percent.
More recently, a 2011 study that examined the impact of the MID across income levels and age groups found that, based on the costs over time of homeowners (the “user cost”), the mortgage interest deduction pushes prices up by about 3 percent to 6 percent.
Another way to consider how housing prices might be impacted by a reduction or removal of the mortgage interest deduction is to consider how the MID benefit raises the amount of monthly mortgage payments that homeowners can afford to make. Using IRS and JCT data, my colleague Dean Stansel and I estimated the increase in after-tax income available to individuals due to the MID. This allowed us to estimate how much the MID increases the size of the mortgage that a hypothetical consumer could afford. Our results showed an increase of less than 1 percent in mortgage affordability, no matter what the income level. That increase in direct ability to purchase a home because of the MID is quite small, indicating that a complete elimination of the deduction would not cause a substantive reduction in home values from decreased demand.
So would getting rid of the MID lower home values 15 percent and trash $140 billion of home equity lines of credit for small businesses? It is possible that home values will decline that much over the next few years, but not because of getting rid of the mortgage interest deduction.
Also see blog post from last week debunking common myths about the value of the mortgage interest deduction.