Recent discussion in Washington has ignited a small fire of hope among many pundits and economists: The mortgage interest deduction has come into the spotlight. The mortgage interest deduction (MID) allows individuals to subtract money spent on the interest of their home loans from their taxable income. It has long been considered one of those politically untouchable programs touted for helping members of the middle class become homeowners. It sounds great, but the reality is different. That’s why its elimination was listed number one on NPR’s “Six Policies Economists Love (and Politicians Hate).” Let’s examine why.
For deductions, the amount of money you receive depends on your income tax bracket. Consider three households: The lower class Johnsons pay no income tax, the Joneses of modest income pay an income tax of 15 percent and the Murphys of luxurious income pay 35 percent. Suppose they all buy similar homes and pay $1,000 in mortgage interest. Since the Johnsons pay zero income taxes, they have nothing to deduct and receive no benefit. The middle class Joneses get 15 percent back, or $150, and the upper class Murphys get $350. When all three households buy the same house, it is a purely regressive benefit. Sadly, this is true of all deductions.
Furthermore, the MID allows for up to $100,000 of mortgage interest on a second home. Continuing the story, the affluent Murphy family buys an expensive vacation home in Florida deducting $100,000. The government has now distributed benefits of $35,350 to the upper class, $150 to the middle class and nothing to the lower class.
Anytime the government subsidizes a group of people, the cost is born by those who are not among that group. Therefore, the cost of the MID is born by renters. When one considers that the poorest Americans are nearly always renters, the policy becomes even more difficult to justify. It transfers wealth from the poorest to the richest, reverse Robin Hood style.
Multiple studies by the Tax Policy Center have concluded that the benefit of the deduction is worth substantially more to upper income earners. To the average household in the top 1 percent, the deduction saves more than $5,000 per year. However, for households in the middle 20 percent of incomes, it is worth a mere $215 per year. And for those in the bottom 20, it has virtually no value. The bigger the house, the bigger the check from the IRS. I call it “Mansion
According to President Barack Obama’s 2010 budget, the MID will cost the federal government $131 billion in 2012. About two-thirds of that money will go to the top 20 percent of income earners. The Tax Policy Center concludes that eliminating the MID would raise more than $1 trillion in revenue over the next 10 years (Hint, hint, Congress).
In order to receive the MID, one must itemize their tax deductions. That is, most individuals choose between a standard deduction, available to anyone, or itemizing the value of multiple deductions. On average, 87.1 percent of those in the bottom 40 percent of income earners do not itemize, rendering the MID worthless to them.
Research by Edward Glaeser and Jesse Shapiro, economists at Harvard University, shows that the deduction has had little if any effect on increasing homeownership because it is targeted at the wealthy, who are almost always homeowners regardless. The homeownership rate has hardly budged in over 60 years. In their paper, they discuss that the real beneficiaries include the construction industry, which gets to build bigger mansions, banks that get bigger loans and entities such as Fannie Mae and Freddie Mac.
Homeowners in San Fransisco or New York City who face exorbitant real estate prices may be particularly apprehensive to changes in the MID. However, Glaeser’s research finds that the deduction has caused more harm than good in coastal areas where real estate supply is limited. Instead of helping families become homeowners, the subsidized demand has driven up prices, making it more — not less — difficult to purchase a house for middle-income Americans.
Last, but certainly not least, subsidizing interest on home loans encourages high leverage. It encourages consumers to bet on housing as an investment because the bigger your loan, the bigger your tax benefit. The deduction effectively makes risky investments in housing less risky. Thanks to the Great Recession, we all know what happens when overinvestment in real estate creates a housing bubble.
The MID survives on an ample dose of belief in its benevolence and lobbying from the real estate industry. It is not benevolence but effectiveness that makes a policy worthwhile.
No matter whether one believes the government should encourage home ownership, it is quite clear that the mortgage interest deduction is a failure. The policy is wildly regressive and ineffective in its goals. It distorts the tax code and decreases revenue by more than $100 billion annually, largely from the wealthiest Americans. It distorts the economy and drives up real estate prices. Lastly, it shares in culpability for the bursting of the housing bubble. It is one of the most politically popular tax deductions and in a word, reprehensible.
There are some no nonsense solutions. At the very least, Congress could lower the cap on loans from its towering height of $1 million and eliminate the eligibility of second mortgages. As it stands, the policy is purely indefensible and in need of reform. However, the most sensible solution of them all would be to eliminate it completely.