Fed policymaker: Mortgage-interest deduction can be bad incentive

A key Federal Reserve official signaled Monday that Congress should consider rolling back the tax deduction for mortgage interest and other provisions that he said could contribute to financial instability.

Narayana Kocherlakota, the president of the Federal Reserve Bank of Minneapolis, said in a speech in Big Sky, Mont., that the tax code now provides both taxpayers and financial institutions incentives to carry at times excessive debt. 

Kocherlakota, currently a member of the policy-making Federal Open Market Committee, specifically singled out the mortgage-interest deduction and a policy that allows banks to deduct interest payments on debt. 

In his prepared remarks, released by the Minneapolis Fed, Kocherlakota did not precisely call for a repeal of the mortgage-interest tax break, instead proposing lowering the amount a household can deduct.

But he also encouraged policymakers, at a conference of bankers, “to ask broader questions about the mortgage interest and corporate interest tax deductions.”

“What are the social benefits associated with these deductions? Can these social benefits be achieved using an approach that does not undercut the stability of the financial system?” he asked.

The central bank official’s comments come as Washington officials in both parties are looking into an overhaul of the tax code, even though those talks have taken something of a backseat with the looming Aug. 2 deadline to raise the $14.3 trillion debt ceiling.

A revamping of the tax code would presumably include both lowering rates and eliminating a host of tax credits and deductions, though there is currently some question over whether the individual and corporate codes would be tackled in tandem. 

That said, the mortgage-interest deduction has survived past prunings of the tax code, and key officials have signaled in recent months that it would likely survive another tax reform push. 

“Honestly, there’s not a lot of support for getting rid of the mortgage deduction on Capitol Hill,” Rep. Eric Cantor (R-Va.), the House majority leader, told a March audience of real estate agents. 

But in his Montana remarks, Kocherlakota noted that troubles in the U.S. housing market are widely seen as the major cause of the recent financial crisis.

He also suggested that officials could support the American Dream of home ownership in a more stable way by scrapping the mortgage-interest deduction for a credit that counterbalances part of a homebuyer’s down payment.

“Such a tax credit would encourage home ownership without simultaneously providing more incentives for households to accumulate more debt,” Kocherlakota said.

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