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If you eliminated the mortgage interest deduction but kept the move revenue-neutral by lowering marginal tax rates, a sizeable majority of taxpayers would benefit. So who would stand to lose?
In 2009, only 22.1 percent of federal income tax returns contained the mortgage interest deduction. (The figure has remained between 21 and 26 percent since 1991.) Data from the congressional Joint Committee on Taxation (JCT) shows that only a small portion of taxpayers with incomes below $50,000 claim the deduction. In contrast, two-thirds of those with incomes above $100,000 do so (see Figure 1).
The reason for this disparity is twofold. First, homeownership rates are much lower in lower-income groups. Second, lower-income homeowners are far less likely to itemize because the sum of those deductions would frequently be lower than the standard deduction. Even when they do itemize, the incremental benefit over and above the standard deduction is often quite small and not worth the effort. Furthermore, higher income taxpayers stand to benefit more because they have larger mortgages and face higher marginal tax rates.
How big is the benefit? According to the JCT, after you adjust for the difference between the standard deduction and the mortgage deduction, for a taxpayer with average income, the mortgage interest deduction is about $10,000 but only reduces taxable income by $7,600. At the 2009 average tax rate of 12 percent on adjusted gross income, that amounts to a tax savings of $912, or $76 a month.
But these numbers provide an incomplete picture, since the tax savings can vary substantially based on income level, age, and location. Using the most recent data from the JCT and the Internal Revenue Service, we found that taxpayers with incomes below $75,000 save less than $200 per year, while those with incomes above $200,000 save about $1,800 (see Figure 2). As a percentage of their overall tax bill, however, the lower-income groups save more.
Proponents of keeping the mortgage interest deduction often claim that repealing it would cause housing prices and therefore homeownership rates to fall. Lawrence Yun, chief economist for the National Association of Realtors, has repeatedly warned that getting rid of the deduction could reduce housing prices by 15 percent. “Whatever deficit reduction might be realized by taking a carving knife to the [deduction] would come at an intolerably steep price: trillions of dollars in wealth destruction and a new uncertainty in what has long been recognized as a bedrock of our economy,” Yun wrote last year.
Even assuming Yun’s estimate is correct—and there are a number of studies suggesting the deduction has a much lower impact on home values—there is scant evidence that higher housing prices are a good thing in themselves. Typically we associate a decrease in price (and increase in quality) with innovative growth, not with problems that the federal government need to solve. Housing price appreciation is only “good” from the perspective of owners using their property as investment assets. Surely those who are currently priced out of the housing market wouldn’t consider a 15 percent decrease “intolerably steep.” And the removal of artificial government barriers to housing depreciation would be the best way for the market to find bottom, begin clearing backlogged inventory, and start the road to real recovery on a stronger financial footing.
Mend It or End It?
The mortgage interest deduction has come under increased scrutiny over the past two years as part of deficit-reduction talks in Washington. So what would reform look like? There are three main possibilities: tweaking the deduction to better meet its stated policy goals, repealing it outright, or coupling its elimination with adjustments in the tax code to make the move revenue neutral. Before choosing one of these three, policymakers should consider whether promoting homeownership is even an appropriate role for government. We would argue that it is not, as borne out by the last two decades of ownership-goosing policies that contributed to the inflation and then collapse of the housing bubble.
Most proposed changes to the deduction thus far have sought to balance out its inherent favoritism toward wealthy homeowners. The December 2010 report by the presidentially appointed National Commission on Fiscal Responsibility and Reform (known as Simpson-Bowles, after co-chairs Alan Simpson and Erskine Bowles) proposed scrapping the deduction for a tax credit that would be capped at 12 percent of paid interest while lowering the maximum amount of the loan this could be applied to from $1.1 million to $500,000. Other proposals have suggested lowering the maximum mortgage interest available for deduction rather than creating a tax credit.
These changes would promote homeownership more effectively by targeting the subsidy at those who are on the margin between renting and owning, rather than simply encouraging higher spending on housing by those who are already homeowners. But like other recent tax policy attempts to jump-start the housing market, it is likely that such changes would have unintended consequences and end up becoming different means of creating similar distortions in economic decision making.
The better, though more politically challenging, option is to completely eliminate the mortgage interest deduction from the tax code. This would mostly affect young wealthy homeowners, with little negative impact on most other households. Low-income families would likely benefit, since any subsequent decline in home values would make housing more affordable. The housing market, which as of this writing has a three- to four-year supply of homes available, would be able to clear some of its inventory, possibly boosting homeownership rates in the near term.
But eliminating the mortgage deduction without any other adjustments would increase taxes for the one-fourth of taxpayers who use it to reduce their taxable income. Had the deduction been fully eliminated in 2008, households earning between $100,000 and $200,000 a year would have seen a collective tax hike of $10.2 billion that year. Households making less than $100,000 would have paid $4.2 billion more in taxes. It is true that the deduction distorts the economy, but a sharp increase in tax liabilities would also have negative economic consequences.
Policymakers who are more concerned with the benefits of reducing the debt than the impact of a tax increase may find the elimination-only route the most enticing. According to a report by the Joint Committee on Taxation, ending the deduction without any other income tax adjustment could cut as much as $94 billion from the fiscal year 2011 federal budget deficit, or around 6 percent. The question for policymakers is whether this deficit-cutting cash is worth a not-so-tacit increase in income taxes by more than 9 percent.