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For True Tax Reform, Scale Back Mortgage Interest Deduction

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For True Tax Reform, Scale Back Mortgage Interest Deduction

July 26, 2017

Although tax reform has not received the headlines of healthcare reform,  top leaders in the Senate, the House, and the White House are meeting regularly to craft a new tax bill.  Many areas in the tax code introduce substantial distortions that are ripe for reform. One area is the mortgage interest deduction (MID), which allows claimants to deduct mortgage interest on their primary or secondary residences, up to a certain threshold.

The Joint Committee on Taxation estimates that the deduction for mortgage interest will reduce revenue by $72.4 billion this year, and by $234 billion through 2020, making it one of the most expensive tax expenditures in the tax code. Even at this magnitude, only about a quarter of tax filers claim the deduction, with the share varying by state.

The magnitude of per-capita MID benefits also varies widely by state, due to differences in home prices. Analysis from the Congressional Research Service estimates that in 2014 per capita MID tax expenditures in West Virginia were $86, compared to $436 in the District of Columbia. Per capita amounts in the ten largest beneficiary states were more than five times as much as the ten smallest states.

A new working paper analyzing the effects of the mortgage interest deduction in Denmark finds that it has no effect on homeownership rates in the long run, and it distorts decision-making about the size and price of which homes to buy. While the paper analyzes Denmark, it provides accords with other U.S. evidence that the MID does not even have the purported effect on homeownership, and the positive related externalities, that are often used to justify its existence.

In the paper, MIT professor Jonathan Gruber, Princeton professor Henrik Klevin, and University of Copenhagen professor Amalie Jensen use linked housing and tax records to analyze a major Danish reform to the mortgage interest deduction.  This natural experiment allowed them to analyze the effects of the deduction on housing decisions. The Danish reform increased the after-tax interest rate for the top tax bracket by 80 percent, for the middle bracket by about 30 percent, and left the rate mostly unchanged for the lowest bracket.

Over a long time-period, using a multitude of different strategies, the economists found no short- or long-run effects on home ownership.  

Source: Gruber, Klevin, and Jensen (2017).

The deduction did induce homeowners to increase homeowner borrowing to buy larger and more expensive homes. The deduction in Denmark introduces distortions to the size of homes purchased, but not to the decision to buy a home.

The working paper analyzes the case in Denmark, so there may be limitations on how applicable the findings would be to the United States.

Some past research has found that the MID has a modest effect on the homeownership rate. A 1980 paper from Princeton professor Harvey Rosen and University of California at Berkeley professor Kenneth Rosen (no relation) in the Journal of Political Economy estimated that if all personal income tax benefits of homeownership were eliminated, including the MID, the homeownership rate would decline by four percentage points. A later paper from those authors, along with then Princeton professor Douglas Holtz-Eakin (now president of the American Action Forum), found a more modest effect.

In a 2002 article for the National Bureau of Economic Research’s volume on Tax Policy and the Economy, Harvard University professors Edward Glaeser and Jesse M. Shapiro suggest that the MID “is a particularly poor instrument encouraging homeownership because it is targeted at the wealthy, who are almost always homeowners.” About 46 percent of the cost of the MID goes to households with income in excess of $200,000. Glaeser and Shapiro noted that homeownership rates had remained relatively constant from 1965 through 2000, although the value of the MID had fluctuated.

More recently, a paper for another NBER volume by Towson University associate professor Matthew Chambers, senior research economist at the Federal Reserve Bank of St. Louis Carlos Garriga, and economist in the Center for Household Financial Stability at the Federal Reserve Bank of St. Louis Don Schlagenhauf found that the effect of the elimination of the MID on homeownership depends in large part on what is done with the resulting change in revenue, and could “increase the ownership rate if the resulting increase in government revenue is rebated to households.”

The administration’s tax blueprint would eliminate most deductions but leave the MID in place. The standard deduction would increase substantially, from $12,700 for a married couple filing jointly to $24,000. With the higher deduction, the share of households filing itemized returns would decline from its current level of about 30 percent to 5 percent. As a result, more people would choose to itemize, and fewer filers would claim the MID.

Reforming the MID would be difficult politically. Realtors, construction companies, and consumer groups have always opposed reform. Scaling back or eliminating the MID could lower housing prices, which could harm existing homeowners. Reform efforts would also face staunch opposition from groups that benefit from the deduction’s upward pressure on demand for larger and more expensive homes.

Nevertheless, eliminating the mortgage interest deduction or capping the amount that could be claimed at a lower level, and using the revenue to reduce income tax rates, could limit the distortions. These changes would increase the efficiency of the tax code and should be considered by Congress and the administration in their deliberations.  

Charles Hughes is a policy analyst at the Manhattan Institute and author of the new report The Energy Bottleneck: Why America Needs More Pipelines. Follow him on twitter @CharlesHHughes

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