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Sunday, July 3, 2011

Mortgage Interest Deduction is a Subsidy in Need of Reform

The Pew Charitable Trusts released a study, The Costs and Benefits of Housing Tax Subsidies (6/30/11). It lays out mostly what has been known and previously studied and reported - the mortgage interest deduction primarily benefits higher income individuals and helps them to purchase a more expensive home than they otherwise would have purchased. While noting that home ownership improves communities, there is a downside. As noted in the executive summary to the 48-page report:

"these tax subsidies also distort the housing market and affect the allocation of capital across the economy. The current housing tax subsidies—for example, the mortgage interest deduction in particular—leads people to borrow more money and buy larger homes than they would otherwise, making the overall economy more leveraged. By effectively lowering the price of owner-occupied housing relative to other goods and services, housing tax subsidies encourage investment in and consumption of housing, particularly owner-occupied housing, over other types of investments, goods and services. The resulting distortion in the allocation
of capital likely lowers overall output and leads Americans to have personal assets that are more heavily skewed toward housing at the expense of diversification in other investments."

The report notes three housing subsidies:
  1. mortgage interest deduction
  2. deduction for property taxes
  3. imputed value of home ownership that is not required to be reported as income
For fiscal year 2010, Pew says the total subsidy is $304 billion. That is, the government could have collected that much more tax revenue (roughly) if these special tax rules did not exist.

While the subsidies benefited 84% of home owners, but the amount of benefit differs from a low of $370 to a high of about $18,000. It is not clear why the report says the benefits are to 84% of homeowners. Subsidy #3 above benefits all homeowners, but perhaps the value of that benefit still puts the homeowner's income below the filing threshold. For subsidies 1 and 2, a home owner needs to itemize deductions to claim the deduction and only 1/3 of individuals itemize deductions.

The Joint Committee on Taxation (JCT) issues an annual tax expenditure report, but doesn't include #3 above. For FY2012, JCT estimates the "cost" of the mortgage interest deduction as $94.1 billion and for property taxes $26.5 billion (page 39 of 2010 report). In addition, a subsidy omitted from the Pew report is the exclusion for gain from sale of a principal residence which the JCT estimates costs $17.5 billion.

Is "subsidy" the right word? Yes. When a taxpayer claims a deduction, exclusion or tax credit that is a special provision - that is, something not key to defining the tax base, it is a subsidy. Instead of having his federal tax bill reduced for a home mortgage interest deduction, the taxpayer could instead be getting a check from the federal government for the savings. The tax law is just a different way to deliver that benefit. (For more on this, see a 7/1/11 post of the Center for American Progress.)

There are many issues of delivering the benefit (subsidy) via the tax law including:

  1. The subsidy is buried in the budget in the form of reduced revenue. It does not show up as a line item as does the spending by the Housing & Urban Development Department (HUD). This also means that it is not subject to annual review or limitation. For example, if this year, 20% more individuals than expected, took out mortgages, this federal spending would increase even though not "authorized" by Congress and the President (other than that they allow the deduction). This is hidden spending. When President Obama or Congress says they are cutting spending, they are almost never talking about the $1.1 trillion dollars of spending buried in the tax law - which is far larger than many other categories of discretionary spending visible in the budget.*
  2. As a deduction, the benefit is skewed to those in higher tax brackets. For example, if two individuals each have $5,000 of mortgage interest. The tax savings (subsidy) to the person in the 15% bracket is $750 which the subsidy to the person in the 30% bracket is $1,500. One way to equalize the benefit would be to convert the deduction to a credit worth the same amount to each person.**
  3. The subsidies are difficult to measure. If the government just wrote checks to homeowners, it would be simple to determine the amount. As tax expenditures it is more difficult. One illustration of this the varying figures used by different groups in measuring the "cost" of the subsidies. For example, the JCT says the cost of the gain exclusion is roughly $17 billion annually while the White House budget report says it is $35 billion (see page 252 of FY 2012 budget report).

* HUD's budget indicates it spent $259 million (yes, million) on certain housing initiatives in FY 2010. That really pales in comparison to $300 billion (yes, billion) for homeowners. HUD's total budget for FY2010 was $49.3 billion (some of this money also benefited homeowners).

** The JCT has more on how the mortgage interest deduction is used among different income levels of taxpayers. For example, about 1/3 of taxpayers claiming the deduction had income between $100,000 and $200,000 and claimed 39% of the tax benefit. Those with income of $200,000 or more represented about 10% of the claimants, but claimed almost 30% of the benefit (due to their higher tax rates).

There are also issues of a housing subsidy in that it favors (encourages) investment in housing over other investments. A report by President Bush's Tax Reform Advisory Panel (2005) noted that the effective tax rate on housing investment was zero, but 26% on corporate investments (page 71 of final report).

One of Pew's recommendations is to convert the mortgage interest deduction to a credit. President Bush's Tax Reform Advisory Panel also suggested converting the deduction to a 15% credit with the mortgage amount capped based on the regional home prices (page 61). They also recommended that the deductions for mortgage interest on a second home and on home equity loans be eliminated (page 73). This is something also often overlooked or unknown regarding the mortgage interest deduction.

The mortgage interest rules allow a deduction for interest on up to $1.1 million of debt on a personal residence or combination of personal residence and second home (such as a vacation home). Or it can include interest on up to $100,000 of home equity debt where proceeds were used for personal purposes. This also creates inequities in the tax rules. For example, if you borrow $100,000 on credit cards, you may not deduct the interest, but borrow the same amount as a home equity loan and you can deduct the interest. Also, while people say the mortgage interest deduction is needed to encourage home ownership, it also applies to debts on vacation home and home equity borrowing. Also, data shows that home ownership rates in the US are no different than in countries without the tax subsidies.

Will the Pew report bring more attention to the cost of the home mortgage interest deduction, its inequities and possible improvements that can help reduce the deficit? Perhaps their report will catch more media attention that those of academics (for some of this research, see references cited in a report of the Tax Policy Center of May 2010 and the Center for American Progress).

What do you think?


Robert D Flach said...


I explain why I would keep the itemized deductions (tax expenditures) for state and local icome taxes, and real estate taxes and interest on acquisition debt for the primary personal residence over at THE WANDERING TAX PRO -


Sell Mortgage Note said...


Mortgage interest includes interest you paid on loans to buy a home, home equity lines of credit, and construction loans. You can only deduct interest paid on your main home and a second home. Thanks a lot...

Gmac Mortgage said...

If the mortgage deduction is eliminated, the motivation to own a home would fall, especially where home values are not appreciating. Special interest groups will oppose even the smallest change.

David Goldsmith said...

I disagree. The mortgage interest deduction makes perfect sense and is not a subsidy:

o If interest income is taxable, then interest expense ought to be deductible. Otherwise, you don't have a consistent definition of taxable income.

o Deducting mortgage interest does not necessarily favor buying a home over renting. The owner of rental property can deduct mortgage interest and this is reflected in property rental rates.

Professor Nellen said...

Thanks for the comment David. I assume your argument is that since the lender is reporting the interest earned on the mortgage as income, the payor should get a deduction. Our tax system doesn't necessarily follow such symmetry. Along those lines, the purchase of groceries and clothing should be deductible because the store picks up the income. We instead need to look at the nature of the tax. An income tax taxes income so that is income less costs of producing the income. The mortgage interest on a personal residence doesn't produce income other than the imputed value of owning your home which is not considered income although OMB treats it as a tax expenditure.

To follow the interest income/expense theory, all interest paid by individuals would be deductible. But again, it is not producing the interest income that is taxable for that particular borrower.

The taxes not collected due to the home mortgage interest deduction - about $90 billion each year, could be better spent to benefit a larger group of taxpayers, to help people who do not own a home and to reduce our debt.

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