Reform the mortgage interest deduction

A Modest Proposal for Tax Reform

 

Experts tell us a key to sticking to your resolutions is keeping them attainable and within reach: don’t aim for the moon if a nearby rooftop will do. The ritual of New Year’s resolutions is, if anything, a universal impulse. Even Congress isn’t immune to the yearly callings of renewal and improvement. This year, one of those resolutions is fundamental tax reform.

After Congress managed in 1986 to largely accomplish the herculean task of tax reform by eliminating the many deductions, exemptions, and credits, those special tax provisions, like desserts, ultimately proved too tempting, betraying erstwhile commitments to diets and good policy alike. The reform was largely undone over time. 

Even the vaunted ‘86 reform left a few things untouched, some habits just proving too difficult to shed. If certainties are limited to death and taxes, a sub-certainty comes in the form of the mortgage interest deduction (MID), which is like the smoking addiction of the tax code.

We don’t know exactly what will emerge from tax reform discussions, but supposedly everything is on the table (or chopping block, depending on how you see it). Except the MID of course. Defended as a way to encourage homeownership, one would be hard-pressed to come up with a worse way to accomplish this goal.

The MID “costs” around $130 billion per year according to the Joint Committee on Taxation, an amount steadily increasing over the last several decades. And yet, homeownership rates have stayed pretty flat.

It’s also highly favorable to the richest homeowners – the most likely homebuyers. Because it only applies to itemizers, those with the largest interest payments, and those with the highest marginal tax rate, the MID acts as “a reverse Robin Hood” as tax expert Howard Gleckman puts it. According to a 2012 Reason Foundation study, those households with income over $200,000 save twelve times more than those with incomes between $40-75,000.

Finally, because the value of the deduction increases with the size of the mortgage, at the margin this incentivizes people to buy more expensive homes then they otherwise would. While it’s doubtful that it has much impact on the decision to buy or rent, its overwhelming incidence on likely homeowners means it just encourages bigger houses and more debt.

That such a bizarrely inequitable provision could make its way into the tax code is less a story about bad policymaking than one about sensible intentions combined with inertia. In the beginning of the income tax 100 years ago, all interest payments were deductible because they were treated as business expenses. Few people had mortgages, let alone were subject to the income tax in those early years. Today the MID is “little more than a historical anachronism,” says market observer Barry Ritholtz. It was not a homeownership strategy but an artifact of a broad tax principle.

Inertia keeps it hanging around. According to a recent survey, 74 percent oppose eliminating the deduction even if it would lower the budget deficit – even a majority of renters feel this way. Additionally, supporters insist elimination will cause a decline in house prices.

So if going cold turkey on the MID in the New Year is unlikely, we should at least reach for a modest improvement.

Maybe, to paraphrase Kirk Lazarus, you never go full reform. Instead of eliminating the deduction tied to debt, consider turning it around and make it a credit tied to equity. That is, a credit proportional to the amount of equity in one’s house. Essentially a subsidy to saving, it encourages people to buy an appropriate amount of housing and avoid overleveraging.

The higher your equity-to-value the larger your credit. That way, the rich don’t simply benefit more by buying larger houses with large down payments. As you make progress paying down principal, that ratio would increase along with your tax benefit.

To maintain progressivity, the benefit could phase out above a certain income level. To pacify current homeowners, existing mortgage holders could still deduct mortgage interest so that they are held-harmless, but new purchases starting in, say, 2015 could claim the credit. In addition to eliminating the perverse incentives of the MID, this system would help discourage the kind of widespread underwater scenario we see today, and the debt overhang problems that will be with us for years.

Subsidizing homeownership through the tax code may be a habit we can’t quit. Let’s use the New Year to at least cut back.

Thallam is director of financial services policy at the American Action Forum, a center-right policy research center in Washington, DC.