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How to End the Mortgage Interest Deduction

The tax-deductibility of mortgage interest is not a good thing. Sure, it saved me $1500 on my taxes last year, and I appreciate that. But that's me wearing my homeowner's hat (eyepatch?) or my libertarian "all tax loopholes are precious" T-shirt. When I look at this deduction as an economist, it stinks.

Renting is a substitute for homeownership, so to the extent mortgage interest deductibility is an incentive for homeownership, it harms those involved in renting. Lessees get no tax break comparable to their homeowning peers, and lessors are harmed by the artificially-reduced demand for units.

It's not true that the tax benefit of mortgages is entirely consumed by higher housing prices. Certainly, deductibility does contribute to higher house prices at the margin. And, as a result, to higher property taxes! But the impact of deductibility decreases with the size of the down payment, and is zero for those who pay cash for their homes.

Mortgage lenders have a tremendous advantage over other lenders. Tax deductibility of mortgage interest reduces the effective (after-tax) interest rate of a mortgage, an incentive that other forms of lending cannot match. If you're in the 25% tax bracket, a 6% mortgage only costs 4.5% after taxes. If you live in Oregon and pay the 9% state income tax too, that mortgage only costs you 4%! The mortgage lender can get revenues based on a 6% interest rate while customers only effectively pay 4%. It's tough for a non-mortgage lender to compete against such a huge subsidy.

Thus, the trend — obvious to anyone who sees the incessant commercials on TV — toward home equity loans and lines of credit, and paying off other debts by refinancing the mortgage. Frighteningly, this turns unsecured debt into secured debt, and debt secured by an automobile into debt secured by the home. This is a large distortion of the consumer credit market.

It's unclear without looking at the numbers (and I am really lazy) whether tax deductibility of mortgage interest is "anti-progressive" in the tax sense, but my intuition tells me it is. While "middle-class" families save a thousand or two on taxes, the rich may save tens of thousands, both because they buy more expensive homes (paying more interest) and also because the deduction applies to income that's taxed at a higher rate to begin with. I am not bothered by "anti-progressive" taxation and in fact I would consider it a feature, not a bug, because it would boost economic growth. The point of mentioning it is to simply note that it's offensive to fairness for the mostly-poor renters to subsidize the opulent homes of the rich. (But I'd rather not go into this much; it's easy to dismiss by characterizing deductibility as merely a reduction in the effective tax rate, not a subsidy.)

The tax deductibility of mortgage interest isn't fair to renters, isn't fair to non-mortgage lenders, has complex effects on home prices and property taxes, and is of dubious fairness from an overall tax standpoint.

Fortunately, it's easy to get rid of. Here's the Cap'n's plan:

  1. Announce that mortgage interest deductibility will be phased out, beginning in 5 years.
  2. In five years, place a $20,000 cap on the size of the deduction.
  3. Reduce the cap by $1,000 each year thereafter until deductibility is gone.

Announcing that it will begin in the future, instead of immediately, gives people time to plan and time for markets to adjust — no one will "get caught" by the change. A generous initial cap ensures that very few people will be affected in the beginning. Steady reduction of the cap will gradually remove the offending provision of the tax code.

The specific numbers are negotiable. I picked figures with the expectation that they would leave almost all 30-year mortgage holders virtually unaffected, unless they refinanced. Yes, I agree that 25 years is a long time to wait, and I'd be happy if it was faster, but I fear this is a political sacred cow and wanted to propose something slow enough that it won't spook people. In the meantime, the problems of the current arrangement would persist, so it's worthwhile to reexamine these numbers with an eye toward targeting the shortest politically-acceptable duration, whatever that is.

Tiny Island