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Should mortgage interest be deductible?

It shouldn't, and here's a proposal to phase it out.

By Karen Datko Apr 14, 2010 1:08PM

This guest post comes from Frank Curmudgeon at Bad Money Advice.

 

Continuing in the spirit of the tax season, last week saw at least two blogs, Weakonomics and WalletPop, asking if allowing taxpayers to deduct mortgage interest is really, after all, a good idea. Both wasted little time before concluding of course not.

 

In as much as this policy has any sincere defenders, the argument in favor is that it encourages homeownership. But why homeownership, of all things, is a worthwhile goal is generally left unexplored. I suppose a person might imagine some sort of Jeffersonian argument about how a nation of property owners makes for a more stable democracy. Alas, our leaders in Washington are rarely so philosophical.

 

When a politician says he favors mortgage deductibility because it encourages homeownership, it is a wink and/or nod in the direction of those who already own homes. It is an important bit of government largess for those voters because they get a nice tax break and, possibly more significantly, anybody they sell their house to will also get a nice tax break.

The history of this particular corner of the tax code is worth reviewing. As much as generations of politicians have defended it, it was never consciously enacted as policy. It just sorta happened.

 

In the late 19th and early 20th centuries, American government relied principally on two income sources: property taxes, and import duties and excise taxes. The duties and excises made many items more expensive for consumers, and so were a fairly regressive form of taxation. The property tax fell most heavily on big landowners, but missed entirely the newly emerging class of wealthy bankers, merchants and other businessmen who made money from assets other than real estate.

 

The income tax was introduced to tax very high incomes so that those businessmen would pay their fair share. (See first 1040 form here (.pdf file).) The presumption was that any income at that level could only be due to the operation of a business of some kind, so it made sense to tax only net income. Thus, taxpayers could deduct from their inflow the assorted expenses they incurred in making money, including interest payments.

 

Oldsters like me remember that for most of the 20th century all interest paid -- credit cards and auto loans included -- was deductible. That changed in 1986, when, in one of the few instances of tax reform worthy of the name, most consumer interest became no longer deductible. The main exception being, of course, interest on home mortgages. As much as getting rid of that too would have made sense, it was pretty clear to all involved that it would have been both politically impossible and disastrous for house prices.

And it really would have been a blow to house prices, just as it would be today, if the deduction were simply repealed. How much of a blow is open to conjecture, but, according to WalletPop, doing away with it would raise about $100 billion a year for the government. You can’t raise that kind of money without meaningfully changing the economics of the thing you are taxing.

 

The flip side to the fact that pulling the rug out from under home mortgages would be bad for homeowners, and possibly a shock to the economy as a whole, is that the mortgage interest deduction must therefore be distorting the marketplace. I am not the kind who objects to such distortions on principle. But what we have here is a large, and I would argue largely accidental, subsidy for something not obviously in need of subsidy.

 

And it is not all that clear that this subsidy is as helpful to homeowners as it may at first appear. Yes, it makes mortgages less expensive. But it also increases what homeowners had to pay for the house to begin with.

 

The core challenge, obviously, is not in reaching consensus that this is bad policy but in finding a way out that is politically and economically feasible. It seems to me that the only course of action is to phase out mortgage deductibility over many years. That may not help reduce the deficit appreciably during the careers of the politicians who vote for it, but it will extract us from the mess we got ourselves into a hundred years ago.

 

In a small way, we have been phasing out mortgage interest deductions ever since 1986. One of the many new restrictions on interest deductibility introduced with tax reform that year was a $1 million maximum on the size of the deductible mortgage. That limit was not indexed to inflation and in the intervening 24 years has already shrunk by almost half in real terms.

 

Why not accelerate that process a bit? I propose that starting in 2012, the limit on the size of deductible mortgages be reduced by $50,000 a year, until it’s all gone in 2032. I think this is politically feasible, as the burden will fall on “the rich” first, and although it can only reduce house prices it will do so very gradually, almost imperceptibly, over many years and is unlikely to cause any big dislocations.

 

Related reading at Bad Money Advice:

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