Limiting the deduction of home mortgage interest is the most controversial proposal of President Bush’s Advisory Panel on Federal Tax Reform. It will be unpopular with much of the public. However, many economists — Republicans and Democrats alike — think it’s a good idea. While such disagreement is not unusual, this instance illustrates the knotty problems tax reformers must untangle.
People like the current mortgage-interest deduction because it visibly reduces the amount of tax they pay. Economists dislike it because it wastes resources, reduces economic growth and is increasingly unfair.
Why is mortgage interest deductible, when rent, food and clothing are not? Indeed, such deductibility is an anomaly if you compare our tax system to those of other wealthy countries. Only a few allow special treatment of mortgage interest. In no other country is such special treatment as open-ended as it is here.
The roots of deductibility lie with the 1913 introduction of the income tax. Before we entered World War I, the income tax was a tax on the rich. Fewer than 1 percent of the population owed anything.
Many of the wealthy subject to the tax had significant interest income. But they could net out any interest paid. Mortgage interest got no different treatment than other household interest paid. That remained true for more than 70 years.
In the 1980s, tax changes ended the deductibility of interest paid on credit cards, car loans, student loans or other household borrowing. Mortgage interest remained deductible, subject to some limitations on the size of mortgage relative to purchase price of the home.
This special treatment continues and is very popular with the public. However, economists dislike mortgage interest deductibility because it skews national savings and investment. It encourages households to overinvest in housing and underinvest in stocks, bonds or businesses.
We put more resources into building houses and fewer resources into new plants and equipment than we would if mortgage interest did not get special treatment. That makes the economy — and ultimately employment and family incomes — grow more slowly than it would otherwise.
This misallocation of resources is exacerbated by the fact that most of the increased value of homes is never treated as taxable income, while similar capital gains on stocks or bonds are taxed. This further biases the economy toward overinvestment in houses and underinvestment in factories.
Economists don’t like this inefficient use of resources. Many also object to the unfairness of special treatment for mortgage interest. If you own a home, the federal government effectively subsidizes your shelter, but if you rent you get no such aid. Higher income people are more likely to own and lower income people more likely to rent. Exempting mortgage interest makes after-tax incomes even less equally distributed.
Moreover, in the last two decades we have seen huge increases in home-equity loans or of rolling consumer debt into refinanced first mortgages. These practices effectively allow anyone with a home to deduct the interest of money borrowed for any purpose. This negates the effect of the 1986 change eliminating deduction of nonmortgage interest. Again, that only helps homeowners, not renters.
Moreover, in any income tax system with progressive rates, a deduction helps high-income people more than low-income people. If you are in a 15 percent tax bracket, $5,000 of mortgage interest cuts your taxes by $750. If you are in a 33 percent bracket, the benefit is $1,650.
Many economists see the panel’s recommended changes as good for two reasons. First, reducing the amount of interest subject to special treatment reduces the nation’s misallocation of resource away from production and into housing.
Second, converting from a deduction to a credit makes the remaining special treatment fairer. A tax credit of 15 percent of interest paid, as proposed by the panel, means that regardless of what tax bracket you fall into, you would get the same tax cut from $5,000 in mortgage interest.
The problem with any change is that millions of households already have made decisions about buying houses and taking out mortgages based on the assumption that the mortgage interest would be deductible. Changing the rules may increase productivity and be fairer to lower-income households and renters, but it inevitably would hurt some current homeowners.
Moreover, reducing deductibility of interest would reduce willingness to pay for housing and may reduce house prices. That would be unpopular with many.
For more on the tax reform proposal, see the article University of Michigan economist Joel Slemrod, formerly a professor at the University of Minnesota, wrote for a recent issue of the Journal of Economic Literature. The article is available at www.aeaweb.org/articles.php?doi=10.1257/002205105774431261.
© 2005 Edward Lotterman
Chanarambie Consulting, Inc.