How to Refocus U.S. Mortgage Interest Relief

Robert C. Pozen

The mortgage interest deduction is a huge budget item – almost $100bn per year in federal taxes forgone – with a
weak link to its stated goal of promoting home ownership. In its most recent budget, the Obama administration
proposed to eliminate the MID for all taxpayers with annual incomes of $250,000 and higher. But this proposal was
rejected by Congress when the House was controlled by Democrats.

A more realistic approach would be for Congress to adopt the three-point plan for MID in the deficit
commission’s report: no interest deductions for mortgages on second homes and home equity loans, together
with lower size limits on home mortgages eligible for the MID.

The MID is currently available for mortgages not only on a family’s primary residence but also on second or even
third homes – up to a total principal amount of $1m for all mortgages per couple. In addition, a couple may deduct
interest on up to $100,000 in home equity loans – typically second liens on a home where the loan proceeds may
be used for any purpose.

Congress should begin by limiting the MID to mortgages for one primary residence per family. Allowing interest
deductions on mortgages for second homes obviously does not advance the goal of home ownership but has a big
cost. Taking out large mortgages to finance the purchase of homes on “spec” – hoping to sell quickly for a profit
without occupying the premises – was a significant cause of the financial crisis.

Similarly, Congress should prohibit taxpayers from taking the MID on home equity loans, since they do not
promote home ownership in most cases. The proceeds of home equity loans are frequently used to purchase cars,
pay tuition or take leisure trips. The application of the MID to home equity loans is simply a circumvention of the
Congressional decision, made years ago, to prohibit tax deductions for interest on consumer loans.

After adopting these two changes, Congress could then confront the more difficult question – does the MID for first
mortgages on primary residences in fact promote home ownership? In giving an answer, Congress should look
carefully at the empirical data on the American and foreign housing markets.

The MID is not allowed in three countries with the most similar housing markets to the US market – Australia,
Canada and England. All are advanced industrial societies with a large middle class, an ageing population and an
Anglo-Saxon legal tradition. Nevertheless, without the MID, the home ownership rate in all three of these countries
is higher than the one in the US.

More specifically, the weakness of the link between the MID and home ownership is demonstrated by a recent US
study by Professors Hilber and Turner. They first look at tightly regulated metropolitan markets, such as Boston,
Massachusetts, with a meagre supply of land and strict zoning regulations. In such markets, they conclude that the
MID has a negative effect on home ownership.

Why? The MID operates to raise the demand for homes by making them less expensive on an after-tax basis for
certain potential home buyers. When the MID raises the demand for homes and the supply is hard to expand, then
the effect is to increase home prices and decrease home ownership.

In loosely regulated metropolitan housing markets, such as Houston, Texas, the relationship between the MID and
home ownership is stronger because there is a lot of vacant land and zoning regulations are not very strict. In such
markets, when the MID raises the demand for homes, the supply does expand in response to the stronger
demand. However, Hilber and Turner conclude that the positive impact of the MID on homeownership extends only
to higher-income groups, and does not affect lower income groups.

Why? Because the MID can be taken only by the one third of taxpayers who itemise their deductions. These are
mainly in the top half of households by income, with the highest percentage of itemisers in the top income tax
bracket. Moreover, the MID is more valuable to itemising taxpayers in the highest tax bracket than to middleincome
taxpayers in lower tax brackets.

In order to strengthen the link between tax incentives and home ownership, Congress could turn the MID into a tax
credit – for example, a tax credit equal to 20 per cent of interest paid on first mortgages for primary residences. A
tax credit would be more attractive to most middle-income families than a tax deduction, and they are more likely
than high-income taxpayers to be influenced by tax incentives to purchase a home.

If a tax credit is too momentous a change, Congress could better target the MID on home ownership for middleincome
families in other ways that reduce the budget deficit. For example, Congress could gradually lower the
maximum mortgage amount eligible for the MID from $1m to $500,000 per couple. The UK totally phased out its
MID over 12 years without any significant impact on its housing market.

In short, since the US faces a severe budget crunch, Congress should focus the MID more on promoting home
ownership by preventing its use for second homes and home equity loans, as well as decreasing the maximumsize
mortgage eligible for this deduction. Together these limits on the MID would raise tax revenues by roughly
$150bn over the next decade.