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The most appropriate policy action would be a complete elimination of the mortgage interest deduction combined with reductions in marginal income tax rates to make the repeal revenue-neutral. Given that a full repeal would have broadened the tax base by $470.4 billion in 2008, we estimate that the 2008 average tax rate of 18.2 percent could have been lowered nearly 8 percent, to an average rate of 16.8 percent, without reducing the amount of revenue collected.
It is likely that a full and immediate repeal would face staunch opposition. And an overnight change may also be poor tax policy considering that some individuals depend on the mortgage interest deduction to afford their home. Therefore, we suggest phasing out the deductions for existing mortgages in much the same way deductions for credit-card and car-loan interest were phased out in the 1980s. Policymakers could end the deduction for new mortgages while targeting a specific tax year that it would go away for existing mortgage holders, and reduce the mortgage interest cap a certain percentage each year. This would soften the impact on existing mortgage holders.
Stop the Social Engineering
While the mortgage interest deduction is one of the most popular provisions of the federal income tax code, its actual impact is poorly understood. It is ineffective at promoting homeownership and has a negative impact on the housing market by distorting the allocation of capital in the economy. The deduction overwhelmingly benefits high-income households and comparatively wealthy young people with large mortgages who have not paid off much of their loans, particularly in wealthy, high-tax states such as California, New York, Massachusetts, and Connecticut. By contrast, low-income households that do not itemize and senior citizens with little mortgage debt get almost no direct benefit from the deduction.
Instead of promoting homeownership, the deduction promotes an increase in personal debt for young and high-income households. This contributed to the buildup of the housing bubble during the early 2000s, when more and more debt was used to finance homes. In the end, when the price bubble collapsed, individuals were left with very little equity in their homes, erasing all ownership gains of the last decade and putting the market back to levels seen in the 1990s.
If the elimination of the deduction leads to more financing by other means than excessive debt, we would likely see a much healthier housing market in the future. In a June paper for the National Tax Journal, the MIT economist James Poterba and the University of Pennsylvania economist Todd Sinai estimate that taxpayers could reduce their mortgage debt by 30 percent, or as much as 70 percent by liquidating all investments and assets, if the deduction were repealed. Any substantive mortgage-debt reduction like this would be beneficial to the economy, putting households on more stable financial footing and making them less vulnerable to sharp downturns in the market.
A repeal coupled with a matching tax rate reduction would reduce taxes for 75 percent of taxpayers while creating a more efficient tax system, one that produces fewer distortions in the market while encouraging economic growth. And as the housing collapse enters its fourth year, we need all the growth we can get.