The Mortgage Interest Deduction Needs To Be Slashed

As Congress gears up for a fierce battle on budget issues, it should fundamentally rethink the tax deduction for interest paid on home mortgages. The mortgage interest deduction (MID) is a huge budget item — almost $100 billion per year in federal taxes foregone. But in order to even start the discussion, Congress has to dispel two great myths about home ownership in the U.S. The first is that the MID promotes home ownership; the second is that its primary benefit is to the middle class. Both are false.

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 aging 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 U.S.. This international comparison suggests that the link between the MID and home ownership is quite weak.

This suggestion is supported by a recent empirical analysis of the MID and home ownership in the U.S. by Professors Hilber and Turner. They first look at tightly regulated metropolitan markets, like Boston, Massachusetts, with a meager 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 other words, in markets with an inelastic supply of homes, the MID will increase the prices of homes rather than their quantity.

In loosely regulated metropolitan housing markets, like 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, Hilbert and Turner conclude that the positive impact of MID on homeownership obtains “only for higher-income groups, increasing their likelihood of home ownership by about 3.6 to 5 per cent depending on income status,” and has no impact on lower income groups.

Why does the MID have such a disparate impact by income group? Because the MID is available only to the one third of taxpayers who itemize their deductions. These are mainly in the top half of households by income, with the highest percentage of itemizers in the top income tax bracket. Moreover, the MID is more valuable to itemizing taxpayers in the highest tax bracket than to middle-income taxpayers in lower tax brackets.

Therefore, Congress should limit the MID at a substantially lower cost to the federal budget.

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

Congress should limit the MID to mortgages on the primary residence of the taxpayer or joint filers — one per family. Allowing interest deductions on mortgages for second homes obviously does not advance the goal of home ownership. But taking out large mortgages to finance the purchase of homes on “spec” — hoping to sell quickly for a profit without even 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 utilized 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, taken years ago, to prohibit tax deduction for interest on consumer loans.

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% 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 to be influenced by tax incentives to purchase a home than high-income taxpayers. High-income taxpayers would probably buy homes regardless of the tax treatment of mortgage interest, though the MID may motivate them to buy more expensive homes.

If a tax credit is too radical a change, Congress could better target the MID on home ownership in other ways. For example, Congress could limit its availability to taxpayers with annual incomes below a specified level, such as $200,000 per year. Alternatively, Congress could lower the maximum mortgage amount eligible for the MID from $1 million to $500,000. Both proposals would eliminate situations where the MID has a low probability of persuading families to move from renters to home owners.

In short, since Congress is trying to find ways to reduce the budget deficit, it should limit the scope of the MID to the extent it does not promote home ownership. For that reason, Congress should definitely eliminate the availability of the MID for second homes and home equity loans. Furthermore, Congress should revise the MID to aim it better at the middle-income families whose decision to rent or own would be most influenced by tax benefits. These three changes would together increase federal tax revenues by roughly $15 billion year — without any adverse impact on the U.S. rate of home ownership.