The federal income tax code is full of complicated deductions, credits, and loopholes, which together exempted $1.2 trillion from taxation in 2009. The single largest benefit, amounting to around 35 percent of the total, is the mortgage interest deduction. This longstanding incentive, which allows individual taxpayers to deduct up to $1.1 million in home loan–related interest payments from their taxable income, has warped the real estate market and overwhelmingly benefited higher-income Americans, all while failing to achieve its stated policy objection of promoting homeownership. As Congress continues to debate federal budgetary and tax policy in an atmosphere of debt ceilings and ratings downgrades, the time has come for the mortgage interest deduction to go.
All taxes on income create distortions in economic decision-making. The more something is taxed, increasing its relative cost, the more individuals will substitute a good that is comparatively cheaper. This is as true of taxes on income produced by labor and capital as it is of taxes on goods and services. Such market distortions reduce efficiency, creating what economists call excess burden or deadweight loss.
The least distortionary income tax system is one with the broadest possible base and the lowest possible marginal tax rates. If that $1.2 trillion in itemized deductions was instead spread throughout the tax base, the average tax rate could be reduced by roughly a fifth, from 17.8 percent of taxable income to 14.5 percent. Such a tax cut would directly increase the reward for productive, income-generating activity. Closing loopholes such as the mortgage interest deduction while lowering overall rates would lead to a more productive economy.
100 Years of Deduction
Some form of the mortgage interest deduction, or MID, has been in existence for as long as the income tax itself. On the very first federal tax form in 1913, a taxpayer was allowed to deduct “all interest paid within the year on personal indebtedness of taxpayer.” Back then, very few people actually paid income taxes: The income bracket levels were set very high and rates very low, so only the very rich had to contribute. As a result, the distortions in individual decision-making created by the interest deduction were relatively small.
During World War II, tax rates were hiked substantially to raise revenue for the war effort, while exemptions and tax brackets were significantly reduced. The broadening of the income tax to more than just the highest-income individuals, combined with an increase in homeownership rates, greatly expanded the impact of the mortgage interest deduction.
In 1986, the Reagan administration embarked on an ambitious plan to eliminate loopholes from the tax code in order to reduce marginal rates. The resulting tax reform deal eliminated interest deductions on credit card balances, car loans, and most other kinds of loans. But the mortgage deduction remained.
The main policy reason cited to justify the tax break for mortgages is the belief that it helps increase the homeownership rate, which in turn promotes social stability, responsibility, and wealth creation. Homeowners tend to treat their property better than renters do (just as car owners treat their own cars better than cars they rent), therefore increasing the value of that property and the property of their neighbors.
But the historical record shows that the mortgage interest deduction is a fairly ineffective tool for increasing homeownership. The percentage of U.S. households occupied by owners remained between 62 and 66 percent from 1960 to 1997, peaked as high as 69 percent during the housing bubble, and currently sits at around 66 percent. That’s virtually the same rate as many Western countries, including Canada, that have no mortgage interest benefit. (There are only a handful of international examples of anything like this tax break.)
If the deduction had a significantly stimulative effect on homeownership, we would expect to see a fast and continuous increase in the ownership rate as the dollar amount of the deduction continued to rise. But that has not been the case. For example, the dollar amount effectively doubled between 1995 and 2008, with little noticeable effect on how many Americans owned their homes. The primary impact of the deduction is to increase the amount spent on housing by consumers who would choose to own anyway, thereby subsidizing housing-spending rather than homeownership.
One possible reason the deduction isn’t converting consumers from renters into owners is that the promise of homeownership as an investment vehicle is routinely overstated. A 2011 study by the economists Eli Beracha of East Carolina University and Ken H. Johnson of Florida International University concluded that if individuals had the same amount of money to spend on housing and investment between 1978 and 2009, a majority of renters would come out ahead over the 30-year period. That’s because rent tends to be cheaper and more flexible than mortgages, and people could use their excess income to invest in the capital markets, which tend to outperform housing prices over the long haul.
Encouraging existing homeowners to go further into housing debt creates numerous distortions to the allocation of capital, since housing consumers have been using credit rather than their own assets to finance home purchases. This was a direct contributor to the housing bubble and subsequent collapse, which has driven rates of homeowner equity steadily downward, to below 50 percent. So not only did the deduction help create a damaging bubble, it did so while contributing to the reduction of overall ownership.