On the Mortgage Interest Deduction

Ask anyone on the Hill, and they’ll tell you the Mortgage Interest Deduction (MID) is a third rail that no one—not fiscally conservative republicans or social goal of homeownership supporting democrats—wants to touch. And its ironic because the MID is fiscally very irresponsible, and doesn’t help the progressive goal of expanding affordable homeownership.

The MID has been the subject of much debate on blogs and column space over the past couple months, particularly in light of the Bowles-Simpson plan which not only touched, but stepped two feet on the MID third rail. Though since they were already limbs splayed wide on a dozen other third rails they probably figured another couldn’t hurt more. Changes for the MID are also suggested in the Bipartisan Policy Center’s fiscal responsibility plan, as well as the EPI/Demos/Century Foundation proposal.

So if such a range of views think poorly of mortgage interest deduction, why do we have it? Megan McArdle sketches out the rough origination of the MID (so I don’t have to):

The reason we have a mortgage interest tax deduction is that all interest used to be deductible, because way back when the income tax was invented, consumer credit wasn’t really much of a concept, so interest on loans was much more likely to be a business expense incurred in the acquisition of an income-producing asset, rather than a personal expense incurred in the acquisition of a 60-inch flat panel television with built-in Blu-ray player…

Seventy years later, the tax code had accumulated a huge number of special tax deductions, which meant that the marginal rates had to be very high in order to collect any revenue at all. Some economists pointed out that it was not actually a good idea to have a tax code with more holes than a really enormous Swiss cheese, and the Reagan administration embarked upon its great and noble mission to eliminate the years of accumulated loopyness, allowing us to have lower marginal rates on a much broader base.

During that process, the people writing the new legislation noticed that most consumers had accumulated mortgage and credit card debt, and maybe some auto loans and a student loan or too, plus a personal loan down at the credit union for the time their brother in law got drunk and slugged a cop and had to be bailed out even though payday was still a full week off.

It was fairly obvious that, with the possible exception of the student loans, none of this debt had any connection to an income-producing asset. So they pencilled out the deductibility of interest payments. Then they realized what this would do to housing prices, and the mood of taxpayers who had just lost their largest deduction, and pencilled it right back in.

So the MID comes out of politically motivated tax policy. And it has stayed in place on similar concerns (also discussed by McArdle here). But what has been the result?

If the overall goal was to promote homeownership, then the data point to a social failure (on top of the inherent fiscal failure of the tax policy). Christian A. L. Hiber and Tracy M. Turner have a new paper out that concludes land use restrictions had a much higher impact on homeownership rates than the MID:

We find that the MID only boosts homeownership attainment of higher income households in less tightly regulated housing markets. In more restrictive places — typically larger coastal cities — an adverse effect exists. The MID is an ineffective policy to promote homeownership and improve social welfare.

Adam Ozimek further summarizes the findings: “in areas where supply is slow or non-responsive to increases in demand, the MID may just drive house prices up instead of increasing homeownership, and may even decrease home ownership among some groups.”

Even the progressive Tax Policy Center blog TaxVox (from the Urban Institute and Brookings Institute) argues that most benefits go to high-income households that would probably buy a house with or without the deduction. Since non-itemizers get no benefit from the deduction, it is not surprising that most of the subsidy goes to upper-bracket taxpayers.”

This all indicates the MID is a failure from the progressive perspective.

The OMB calculated this year that the MID would cost $104.5 billion in fiscal year 2011. According to this CNN Money article, the MID will cut individual tax liability by $573 billion between fiscal years 2009-2013. From the conservative perspective, reducing people’s tax liabilities is a good thing, since people should be able to use their money has they see fit instead of being redistributed by the government. However, the MID isn’t about the government taking less income—its about giving money back to homeowners to reduce their net tax liability.

This perspective is important for conservatives to understand. Having the government only take 10 percent of your income instead of 30 percent is a tax cut. However, having Uncle Sam take 30 percent, but then cutting the tax bill down based on the dollar figure of particular interest paid by a specified type of American is not a real tax cut. And its not fiscally conservative. The government certainly does not have a right to all money, but arbitrarily finding ways to deduct tax liability is actually redistributionist—especially since this tax deduction favors owners over renters.

Thus, the MID is also a failure from a conservative perspective.

Again, why do we have this?

Some argue that homeowners that have calculated into their decision on whether or not to afford a home the tax deduction. While I haven’t seen data showing this to be a persuasive argument , that doesn’t mean it should be ignored. The national average deduction taken in 2008 came out to $273 a month, which could have factored into people’s decisions. Nevertheless, we could get around this by phasing it out over some period of time for current residents, allowing homeowners to adjust their budgets.

Beyond this, it seems that the political unease over ending the deduction (aka politics) is the real issue here. But the signs are bright that this might be an issue all sides in Washington can find common ground on—particularly if alternative means of promoting affordable housing are pursued instead of the MID, like downpayment subsidies. Again I don’t personally favor any subsidies for affordable housing, but we are going to have them, making them thoughtful, direct, on-budget, narrow, and calculated through responsible accounting is preferable. The mortgage interest deduction does not meet that standard.

(Also, if you’re interested in where the mortgage interest deduction goes, see this list from Tax Foundation. Maryland benefits the best, North Dakota wouldn’t notice the MID if it were to disappear tomorrow.)