It's Time to Drop the Home Mortgage Deduction

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It's Time to Drop the Home Mortgage Deduction: John M. Berry

May 19 (Bloomberg) -- With the federal government strapped for revenue, household saving from current income at a record low and too much money flowing into housing rather than productive business investments, it's time to scrap the personal income tax deduction for home mortgage-interest payments.

Yes, homeownership is widely regarded as the centerpiece of the American Dream, as those full-page ads from Fannie Mae constantly remind us. The reality is that being able to deduct mortgage interest payments has far more to do with driving up the price of large, expensive homes than with promoting home ownership.

For instance, almost 70 percent of U.S. households now own their homes and less than 30 percent of taxpayers claim the mortgage-interest deduction. In other words, a substantial majority of homeowners don't claim it.

Low mortgage interest rates are far more important than the deduction in making housing affordable. And while those rates undoubtedly will rise from their current very low level, the vast increase in competition among lenders in the mortgage market and the Federal Reserve's determination to keep inflation low should prevent mortgage rates from increasing to the high levels of the 1980s and early '90s.

Increasing Federal Revenue

As for the impact on the federal budget, just limiting the size of a mortgage on which interest can be deducted to $500,000 instead of the current $1 million cap would raise $48 billion over the next 10 years, according to a Congressional Budget Office estimate.

If the total deduction were eliminated, federal revenue would increase by hundreds of billions of dollars over a decade. If Congress and the president could restrain themselves from spending the extra revenue, the budget deficit would fall and national saving would rise. That in turn would smooth the inevitable reduction in the huge U.S. current account deficit, which has reached an unsustainable 6 percent of GDP.

Without the deduction, some homeowners likely would be less apt to take out home equity loans to support their spending habits. Just this week federal banking regulators cautioned financial institutions that they were encouraging excessive borrowing -- and taking on too much risk themselves -- by extending credit without adequate attention to whether such loans could be repaid.

Furthermore, economists have argued for years that, as a nation, we over-invest in housing and under-invest in business structures, equipment and software. While growth of productivity has been exceptionally high in recent years, more business investment could help keep that growth high in the long term.

Housing Subsidies

The over-investment is made worse, of course, by all the government subsidies for housing. Aside from the mortgage interest deduction, which reduced federal revenue by $61.5 billion last year, according to the Office of Management and Budget, that much or more was lost due to the deduction for state and local property taxes, capital gains tax exclusions when homes are sold and other income tax provisions.

Eliminating the mortgage-interest deduction wouldn't boost revenue by the entire $61.5 billion because of interaction with other parts of the tax code. For example, some taxpayers who now itemize the deductions would instead claim the standard deduction, which this year is $10,000 for a couple filing a joint return. At the same time, the availability of the standard deduction would limit the amount of additional tax many lower-income households would have to pay if the mortgage-interest deduction were eliminated.

Closing Tax Shelter

Economist William Gale of the Brookings Institution is all in favor of eliminating the mortgage-interest deduction, which he said in an interview is a very ineffective way of supporting home ownership.

Repeal of the deduction, Gale said, would ``adjust part of the government's fiscal problem, adjust part of the capital misallocation problem and close a tax shelter.''

For many higher-income taxpayers, the deduction is indeed a tax shelter. So are the deduction for property taxes, the break on capital gains and the untaxed income -- in the form of housing services -- that a homeowner receives on his equity investment. A landlord, with a similar investment, has to pay tax on rental income minus expenses.

Altogether, the benefits from those tax breaks are wildly skewed according to income levels and where taxpayers live. In general, higher-income households that can easily afford to own a house without such subsidies get the bulk of the benefits.

Last year the National Bureau of Economic Research published a paper by two Wharton School economists, Todd Sinai and Joseph Gyourko, who used data for the U.S. 2000 Census and other sources to compute the subsidy per owner-occupied unit in each state in 1999.

Unevenness Soars

That subsidy ranged from a low of $2,240 in North Dakota to $12,759 in Hawaii. Among metropolitan areas the disparity was much greater: $26,385 in San Francisco-San Mateo-Redwood City, California, and a scant $1,541 in McAllen-Edinburg-Pharr along Texas's Mexican border. Some East Coast areas also had huge subsidies and many in states such as Tennessee, Ohio and Louisiana got little benefit.

Given what has happened to home prices on the two coasts since 1999, the unevenness of the value of the combined tax breaks has soared.

It's clear from the Wharton economists' study that the extremely rapid rise in home prices in some high-income markets and the subsidies, including the mortgage-interest deduction, feed on one another. Certainly the existence of the deduction encourages purchase of larger, more expensive homes.

Eliminating the deduction probably would help cool off the overheated housing markets in some parts of the country, and in some areas home values could well decline. While that would lower the net worth of some households, it undoubtedly would also encourage them to save more out of current income. That would represent another increment to national saving and take another bite out of the current-account deficit.

Moreover, there is no reason that home prices would not continue to rise over time as personal incomes gradually grow.

In Britain

That certainly has been the case in Britain, which dropped its deduction about five years ago. Over the past two or three years, home prices have skyrocketed there even without the deduction.

Australia has also enjoyed a housing boom without the benefit of a mortgage-interest deduction. In Canada, which also has no mortgage-interest deduction, residential construction rose 14 percent last year, the sixth record year in a row, even though home prices rose a moderate 5 percent or so.

So there's plenty of evidence that you can have a healthy housing sector without a mortgage-interest deduction and that you can get rid of such a deduction without disaster striking.

President George W. Bush's tax-reform commission ought to think hard about that as they decide what to recommend later this year. Bush's charge to the commission ruled out taking away the deduction.

Nevertheless, former Republican Senator Connie Mack said it is being considered as one of the ways to offset revenue lost if the alternative minimum tax were repealed, according to USA Today.

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