Is The Mortgage Interest Deduction Coming To An End?

Last Updated Jul 7, 2010 6:31 PM EDT

In the past few days I have read, in a couple of different credible sources, about proposals to end the home mortgage interest deduction. From the individual's perspective, the home mortgage deduction is great, especially if you have bought more house than you really can afford, and are in the early stages of paying it off.

But from a tax and economic policy standpoint, its benefits are distorted, and it surely had a part in the overbuilding of the last 10 years. The bottom line is that it costs $130 billion a year, and that most of it goes to high-income people. Now that we've got a big deficit to fix, maybe it's time to reshape the benefits to make the subsidy work harder.

But before I get too far into the policy weeds on this, consider what my expert blogging colleague Jane Bryant Quinn says about the deduction. Not about the policy, but rather the idea we hear from tax advisors -- "Don't pay off the mortgage, because you need the tax deduction:"

--It never, ever helps you out financially to keep a mortgage you don't need. The loan costs you more - far more - in out-of-pocket cash than the amount you save in tax.

I respect this view. There is, however, an arithmetic case to be made for carrying the mortgage if you can earn more than the net mortgage cost in some other investment. (But who knows what that investment would be these days, much less for 30 years?) The right answer is a personal one, and it depends on whether you are an intelligent risk-taker, and how you feel about owing money to other people, your personal savings discipline, and most of all how much money you've got. My friend Tom is one of the most astute investors I know, but hates owing money and couldn't wait to pay off his mortgage.

But back to the policy angle. (Thanks to the Financial Times' Lex team for this line of reasoning.)

The home mortgage interest deduction is a subsidy to homeowners, because it allows people to afford more house for a given amount of salary and down payment. It's also a subsidy to homeownership, which is seen to be a good thing because it makes people more attached to their communities. (The Tax Policy Center of the Urban Institute and Brookings Institution has comprehensively studied the issue.)

But as an incentive to increase homeownership, it's not so effective, says Tax Policy Center:

[R]esearchers find that the current MID is not a cost-effective tool for increasing homeownership because its main beneficiaries are not individuals on the margin between renting and owning. The deduction is only available to itemizing taxpayers and its value rises with an individual's tax rate. The result is that most benefits from the deduction are concentrated at the high end of the income distribution, where homeownership rates are likely to be high with or without the deduction.
Moreover, research comparing countries with and without mortgage interest deductions has found little evidence that it increases homeownership.

It's also an enormous subsidy for banks, or whoever it is that makes mortgage loans these days, because the loans wind up larger than they would be otherwise, and the subsidy makes people less sensitive to the costs of the loan. It's also a gift to real estate brokers, title insurers, and all those sorts of businesses that benefit from higher prices at closing time.

The MID also has the potential to affect homeownership through its impact on home prices. The subsidy makes individuals willing to pay a higher price for the same home... At the extreme, [researchers] estimate an upper-bound estimate of the effect on prices at 10 percent, assuming that the housing stock is totally inelastic.
And the benefits are unevenly distributed, too:
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.
[T]he mortgage interest deduction is more regressive than the tax system is progressive, in part because in addition to receiving a larger tax benefit per dollar of deduction, wealthy individuals also own more expensive homes.
Sorry, folks, the experts tell us it's not an effective subsidy. (This conclusion is coming from a guy who gets more than his share from it -- there's a mortgage on my apartment, and the co-op has a mortgage on the building, too.)

The Congressional Budget Office, in its 2009 budget options (page 187), made some practical proposals. First, reduce the maximum amount of mortgage debt on which interest is deductible from the current $1.1 million to $500,000 by 2018. The tax increase: $41 billion over 10 years.

The second alternative would replace the deduction with a 15 percent tax credit for interest on mortgages below the declining limits in the first alternative. (In 2005, the President's Advisory Panel on Federal Tax Reform proposed a variant of that approach.) The change would reduce taxes for some owners and raise them for others, with a net increase of $13 billion in 2013 and $388 billion over the period from 2013 to 2019.
Here's the economic punchline:
Reducing the maximum mortgage on which interest could be deducted should make affected homeowners less willing to invest in housing rather than in stocks, bonds, savings accounts, or their own businesses. Between 1981 and 2007, about 38 percent of net private domestic investment went into owner-occupied housing. That share is large enough that a reduction in investment in owner-occupied housing-even if only for homes purchased with large mortgages-could eventually boost the amount of capital available to other sectors of the economy and increase total economic output.
In earlier posts we've discussed here that Clinton and Bush administrations' expanded credit to lower-income borrowers led to overbuilding, but the housing boom built plenty of supersized homes and vacation retreats too. The mortgage interest deduction, which is more valuable the higher your tax rate, had a lot to do with that.

To me, lower deductions and a credit that puts the subsidies where they belong look like a good idea.