Is This a Good Time to Reform the Mortgage Interest Deduction?

By :: March 28th, 2013

Housing industry lobbyists often make the case that, whatever you think of the mortgage interest deduction, now would be a terrible time to eliminate or restructure the subsidy. After all, they say, the housing market remains so shaky that ending the deduction would send home prices back into a tailspin.

However, there is a contrary case to be made: It may be that with both interest rates and prices so low, this could be the ideal time to redesign the tax subsidy for home ownership. Because monthly mortgage payments for many homeowners and buyers are lower than they have been for years, trimming or restructuring the MID might have less impact than we thought.

Last November, a panel of housing experts brought together by the Urban Institute concluded that “current housing conditions reveal several factors that would likely dampen the marketwide effects”  of reforming the mortgage interest deduction.

According to a summary of the session, the roundtable participants concluded that “post-recession housing market conditions have disrupted the normal relationships between user costs, rents, and house prices.”  In other words, the market is such a mess that it is no longer possible to predict what would happen if the MID were repealed today.

Studies of the pre-bust housing market found that eliminating the MID and the tax deduction for property taxes would substantially knock back prices, especially in communities with high housing costs. For instance, in a 2010 paper based on 2007 data, my Tax Policy Center colleague Ben Harris found that scaling back the MID would lower prices significantly.

But new research that looks at the housing market from 2006 to 2010 finds “no discernible relationship” between house prices and the MID, according to the session summary. What was clear to most researchers before the housing bubble burst is now ambiguous at least.

The roundtable included representatives of the U.S. Treasury Dept., the White House, the Federal Housing Finance Agency, Fannie Mae, Congress, the housing industry, the Federal Reserve Board, the Wharton School, and several think tanks including Urban.

Keep in mind that while studies often look at the consequences of eliminating the MID, most proposals would restructure, not repeal, the tax subsidy for home purchases. In addition, any reforms would likely be phased in over a period of years. This could soften any short-term effects.

Among the more realistic alternatives to outright repeal, Congress could cap mortgage debt at $500,000 instead of today’s $1 million, or replace the deduction with a refundable credit.

Such changes would shift the subsidy to people with low- and moderate-incomes who buy in low- and moderate-income neighborhoods. The current deduction mostly benefits the highest-income 20 percent of households.

While these revisions might lower high-end prices, they could stabilize prices for lower-priced homes. The online real estate site Zillow.com concludes that a $25,000 cap on all deductions would most affect zip codes with a mean home value of over $850,000.

The housing market seems to be recovering, and mortgage rates have begun to creep up from their historic lows last summer.  If those trends continue, the politics of the mortgage deduction will surely change again. But one thing is clear: We may know a lot less about the relationship between the mortgage deduction and housing prices than we thought we did.

 

 

22Comments

  1. Jack B  ::  7:51 pm on March 28th, 2013:

    What would be so terrible about getting rid of all subsidies and let market forces determine prices.

  2. Concernicus  ::  9:21 pm on March 28th, 2013:

    Everything. I have no desire to live in some Darwinian jungle where the strong are allowed to prey on the weak and the market will decide who survives.

    Want to live in some Randian utopia where the strongest live in splendor and everyone else is left to fend for themselves? Try Somalia.

  3. AMTbuff  ::  11:52 pm on March 28th, 2013:

    How about capping deductible interest at 5% of principal? That would phase out the deduction as inflation returns with very little immediate effect.

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    […] Howard Gleckman,  Is This a Good Time to Reform the Mortgage Interest Deduction? (TaxVox) […]

  5. Vivian Darkbloom  ::  10:53 am on March 29th, 2013:

    I would suggest a better idea would be to gradually reduce the amount of mortgage debt on which interest can be deducted. The current limit is $1.1 million (this includes $100K of home equity loan). Your 5 percent of principal would be affected not only be mortgage principal but also by interest rates which strikes me as more arbitrary.

    As step 1, I would eliminate the deduction for interest on home equity loans. There is no justification at all for this deduction and it could be eliminated immediately. It added considerably to the housing bubble and the ensuing financial problems overly-optimistic homeowners got themselves into and, indirectly, the rest of us. Then, reduce the amount of mortgage on which interest can be deducted by, say, $100K per year. Inflation already affects the $1 million limit, but this phaseout would accelerate that automatic phaseout. It (the phase-out) would also phase-in much more slowly for persons at the lower end of the housing scale and they and lenders would have a longer time to adjust. In effect, this is a ten-year phase-out.

    Recall that under the 1986 Act, personal interest was phased out over a 5-year period. The world did not end, nor did consumer spending.

  6. AMTbuff  ::  11:29 am on March 29th, 2013:

    “Your 5 percent of principal would be affected not only be mortgage principal but also by interest rates which strikes me as more arbitrary.”

    The 5 percent of principal is a generous allowance for “real” (inflation-adjusted) interest. Any interest beyond 5 percent is definitely due to inflation. Just as inflation-caused capital gains should not be taxed, inflation-caused interest expense should not be deductible. This is one place to start making that adjustment. The 1984 Treasury report on Tax Reform had something like this, but I forget the details.

  7. Vivian Darkbloom  ::  12:10 pm on March 29th, 2013:

    AMT,

    I don’t completely understand where you are coming from on this:

    1. If you want to target “real interest rates”, then using a nominal 5 percent of principal is a rather blunt tool. If the market rate is 3 percent at one point in time and at a different point in time the nominal rate is 8 percent, the “real rate” would quite possibly be the same and, at 8 percent, very possibly under 5 percent. Yet, you would restrict the deduction in the latter case;

    2. Your proposal does not address the real issue, in my view: Why should be allow an interest deduction (real or nominal) in order to enable one to make a personal acquisition?

    3. Doesn’t pegging this to the outstanding principal encourage people to assume and retain debt? Why should we prefer debt here to equity?

  8. Fred  ::  11:06 pm on March 29th, 2013:

    “The current deduction mostly benefits the highest-income 20 percent of households.”

    Of course – they are the ones who pay most of the taxes. It’s axiomatic that the people who pay the taxes are the ones who benefit from deductions.

    Except for refundable credits of course. Although those are just another form of welfare, and really shouldn’t be in the tax code.

    Paying people to buy a house – what could go wrong with that?

    You are also conveniently overlooking that itemized deductions phase out for high income taxpayers, so they are already getting a greatly reduced benefit.

  9. Annette Nellen  ::  11:44 pm on March 29th, 2013:

    I think it is always time to reform the home mortgage deduction! The deduction for interest on a second home and for home equity debt should be phased out. The $1 million limit should be phased down to something more reasonable such as perhaps $350,000 (which many people in the US would likely find high, but people in the Bay area would find low).

    People who say cutting back will harm the real estate market, I suggest we look at what benefit might come if the roughly $95 billion “cost” of the current mortgage interest deduction were spread more equitably among taxpayers. Since you need to itemized to claim the deduction and only 1/3 of individuals itemized and not all of them have a mortgage, perhaps only about 30% of individuals even use this deduction and the bulk of the benefit (per Joint Committee on Taxation data) goes to individuals with income above $100,000. Why not use some of that $95 billion to help middle and low income individuals buy a home? How would that affect the real estate market and communities?

    And, we should not overlook that any cut back of the mortgage interest deduction should be accompanied by a cut back of the property tax deduction. For example, why should there be a subsidy for property taxes paid on a vacation home or the value of one beyond a minimum value? I know that the tax deduction argument for taxes is different from mortgage interest, but there should still be a limit. When someone buys a vacation home or a $1 million home, they should be sure they have sufficient income to pay the property taxes in addition to their other taxes.

    None of this will happen though if Congress and the President don’t help to get the data out to the public about how the mortgage interest deduction works today, who benefits and that it really just helps higher income individuals purchase a more expensive home.

    Thanks for the post.

  10. AMTbuff  ::  1:09 am on March 30th, 2013:

    1. Long-term rates track inflation expectations absent extraordinary circumstances such as today’s Fed purchases of mortgage debt or brief credit squeezes.

    2. and 3. The mortgage interest deduction provides horizontal equity between homeowners with mortgages and income-producing assets and homeowners who have used their other assets to pay off their mortgages. Without the mortgage interest deduction the latter group pays lower taxes despite having the same net worth.

    The obvious deficiency of retaining the mortgage interest deduction is that it distorts the rent vs. buy decision. Once the market prices for renting and buying adjust for tax treatment this distortion is mitigated. Partial retention of the deduction is a compromise between the objectives of horizontal equity between renters and buyers on one hand and between buyers and free and clear owners on the other hand.

  11. Steveinch  ::  9:31 am on March 30th, 2013:

    It is interesting when an old post comes back.

    Here is something I wrote almost two years ago about the incidence of the mortgage interest and property tax deductions.
    http://uspoliticaleconomics.blogspot.com/2011/07/some-truth-on-tax-expenditure.html

  12. AMTbuff  ::  2:43 pm on March 30th, 2013:

    Nice article, Steve. All the fairness arguments made by advocates of limiting deductions are a smokescreen. The motivation is increased revenue, almost regardless of fairness.

  13. Vivian Darkbloom  ::  4:20 pm on March 30th, 2013:

    Here are a couple of reasons the mortgage interest deduction and the property tax deduction are not proportionately “enjoyed” as much by top earners as middle class earners per the 2009 data presented by Steveinch:

    1. Top earners are limited in the amount of mortgage interest they can deduct due to the $1.1 million cap on the amount of mortgage on which interest can be deducted (this includes $100K of home equity loan). I assume here that top earners own homes of a value that is proportionate to their income;

    2. Pease limitations further limit the deduction for top earners and I assume this limit was applied before the deductions as reflected in Steve’s chart.

    So, in effect, one main reason why top earners don’t benefit as much from the MI and PT deductions is that they are already subject to significant limits for those taxpayers. Any discussion of “fairness” would take that into account.

    I favor eliminating these tax expenditures (and most others). The reason for this is not “fairness” and frankly I don’t think most people who do argue that tax expenditures should be eliminated base those arguments on “fairness” grounds. Rather, the argument is that it would make the tax code simpler and would eliminate many economically distorting subsidies. If one wants to get into a “fairness” debate, then the debate should not be over whether to eliminate these subsidies, but rather who should benefit from rate reductions that eliminating them would enable.

  14. Michael  ::  6:06 pm on March 31st, 2013:

    With the 1 percenters owning 25% of the economy, the upper 10% owning as much as the bottom 80 percent, I would like to suggest that we are moving to a Darwinian jungle. Robert Reich says that 83% of the economic expansion first goes through the 1 percenters. Economist David Cay Johnston says that 50% of Americans are experiencing a job that pays $10 an hour, or less. The upper crest of the 1 percenters have so much wealth and influence, they have become the traffic cops of the U.S. economy, thwart and reshape policy, and have more and more elected officials in their pocket. The rich complain that big government is in their way, but the truth of the matter is, the rich need big government, as the welfare mommas do, too.

  15. Tax Roundup, 4/1/2013. Taxes are due two weeks from today. No fooling. And…Zumba! « Roth & Company, P.C  ::  9:22 am on April 1st, 2013:

    […] Howard Gleckman,  Is This a Good Time to Reform the Mortgage Interest Deduction? (TaxVox) […]

  16. Michael Bindner  ::  7:54 pm on April 8th, 2013:

    If a credit is a possibility, it would be a more lucrative child tax credit with the savings to help all families afford housing (both rental and owned). It would also help to encourage child birth, which is the best cure for the aging crisis (provided the credit is large enough to increase child birth and punish those who chose not to).

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