Is The Mortgage Interest Deduction Coming To An End? Part 2

The July 7 note on the future of the mortgage interest deduction (MID) drew a strong reaction from Mr. Bob Jones, the chairman of National Association of Home Builders -- not a simple comment, but instead a letter fired off to the bosses at CBS. This post is a response to his letter, and you can read it here (scroll down to the second comment).

Some background: home building is a big and important industry to the U.S. economy, one that led us out of most or all past recoveries. But this time around, builders and realtors have many unsold houses on their hands. Prices have fallen, but individuals' income and confidence are so weak that even though mortgage rates are at record lows, sales are very low.

Here's a graph of the long-term history of housing starts. Note that in long-ago recoveries, that is, prior to 1990, housing starts would soar after the recession ended in response to low interest rates, then back off for a while until the next slowdown and start all over again. But after 1990, home building went through a rise that was pretty much uninterrupted until 2006 or so (the blue line). The red line plots consumer debt service payments as a proportion of income. Home building and the debt load rose together to fairly high levels.

Back to Mr. Jones's letter. He presents a long list of my mistakes. Where he and I disagree, I think, is not on the statistics, but their interpretation, and what the recent past tells us about the merits of the MID to U.S. economic policy.

By the way -- since the initial MID post, another group, the International Monetary Fund, has suggested to the U.S. that we cut back on the mortgage interest deduction, as a budget-balancing measure.

Mr. Jones objects to me picking on the MID, saying that it did not cause the housing bubble or credit crisis. By itself, no: he correctly points out that it has been around forever and not done this sort of damage.

But the MID is an important part of the U.S. housing system mosaic. It costs about $130 billion a year these days (fact). The MID subsidizes interest rates, so buyers can afford to borrow more and buy bigger homes. It also allows people to pay less attention to the purchase prices of their homes, the cost of their loans, and brokers' commissions, title insurance and the rest. By increasing borrowing, it allocates more resources into houses than would be the case without the MID subsidy. (Those three points were all my inference.)

The financial crisis started with mortgage borrowing, and with the Clinton and Bush administrations trying to drive up the rate of home ownership. (Those are facts; see here.) People borrowed more than they should have, and part of the mortgage brokers' or banks' calculations was what the borrower would get back in tax benefit.

Mr. Jones says I am wrong about who benefits from the MID. I don't want to get too far into "dueling statistics," because there is no satisfactory way to settle the point here.

But there's an important difference between the "deductions" through the MID and the "benefits" people realize. Deductions are what people list on their returns; benefits are the reductions in taxes. Assume two people, each with $1,000 of interest to deduct. To someone who earns a lot of income, and thus has a high federal tax rate, the same amount of MID provides a greater tax benefit. Moreover, high-income people in states such as New York and California, get even more benefit because their local income tax rates are very high. High income people in New York City, for instance, pay a top marginal rate of about four percent, on top of a state rate of nearly nine percent.

Thus if you live in a state with no income tax and are paying a 10 percent marginal federal rate, your benefit (the tax saving) is $100. Paying the top rates in New York, your benefit is more like $500.

Higher tax rates, higher benefits for the same deduction. And who does the most borrowing? It's the high income people. In my July 7 post I cited a study from the Tax Policy Center of the Brookings Institution and Urban Institute, which in turn cited a study on the distribution of MID's benefits. Here is how the Tax Policy Center summarized it:

Three large metropolitan areas receive over 75 percent of the net positive benefits: New York City-Northern New Jersey, Los Angeles-Riverside-Orange County, and San Francisco-Oakland-San Jose.

Mr. Jones points out:

Your claim that taxpayers in New York City, Los Angeles and San Francisco account for 75% of the benefits of the MID is wrong. According to IRS data the entire states of California, New York and New Jersey received just 30% of the MID tax benefit in 2007.

Mr. Jones also suggests the CBO proposals would "pull the rug out" from under a fragile housing sector. Actually, their proposals are not for sudden changes, but rather are phased in over many years.

I'm running out of space. Here is what I think it comes down to. The MID encourages excessive borrowing and drives home prices higher than they would be otherwise (opinion). And the existing MID benefits high income, high tax-rate people disproportionately (opinion).

Mr. Jones points out that in 2007, 84% of mortgage interest deductions were claimed by taxpayers with incomes of less than $200,000. I haven't checked it, but I'm sure his number is correct. (But again, that's deductions, not economic benefits.)

Households with incomes over $200,000 number about 2.5 million, out of 117 million total -- about two percent. (That's for 2008, from the Census Bureau.)

Do two percent of the households, even if they're the wealthiest two percent, deserve 16 percent of the deductions (and a far greater portion of the real benefits)? Someone believing in trickle-down, supply-side economics would say yes. Someone trying to balance a budget might say no.

Mr. Jones also says that 86 percent of interest paid was taken as an itemized deduction. Does that mean that the lowest 14 percent got no credit for the interest they paid? Again, out of proportion.

The high-income people already have big houses. We could encourage them to buy bigger houses. At the other end of the scale, there are a lot of people that would like to buy a house but can't, and that is what the CBO recommendations (page 187) are aimed at:

[R]eplacing the mortgage interest deduction with a tax credit-would redirect the tax advantages of home ownership to lower-income taxpayers, many of whom currently cannot take advantage of the deduction for mortgage interest. According to a 2005 report of ... President [Bush]'s Advisory Panel on Federal Tax Reform, only 54 percent of taxpayers who pay mortgage interest receive a tax benefit. Converting the mortgage interest deduction to a 15 percent credit would equalize the interest rate subsidy to borrowers, regardless of tax bracket or whether deductions are itemized. Thus, in ways that itemized deductions cannot, the mortgage credit is designed to encourage home ownership among people with lower incomes.

But we can't all live in McMansions. There are better ways to promote home ownership than with itemized deductions.