A tax loophole we love too much to lose.

A tax loophole we love too much to lose.

A tax loophole we love too much to lose.

Commentary about business and finance.
April 14 2005 5:55 PM

Location, Location—Deduction

The mortgage-interest deduction costs taxpayers billions, but it won't go away anytime soon.

Illustration by Robert Neubecker

There's a cancer at the heart of our increasingly complex tax code. A special deduction that disproportionately benefits the wealthy and distorts economic activity has grown rapidly in size and could cost taxpayers nearly $100 billion annually by 2009. Eliminating it would allow us to reduce levies on income and rationalize the system. According to Martin Sullivan, a contributing editor of Tax Notes, its existence "means the economy has less business capital, lower productivity, lower real wages, and a lower standard of living."


Who wouldn't want to excise such a tumor from the mighty American economy? President Bush, Congress, oh, and you, too.

We're talking about the home-mortgage-interest deduction, which has become too successful to be killed and perhaps a little too successful for our own good.

Every April, the fancy of policy wonks turns to reforming the expensive, capricious, and inadequate system of American taxation. This year, attention is being focused on the ravages of the Alternative Minimum Tax, which is clawing back a big chunk of the Bush tax cuts, and on the potential of the value-added tax. The center-right consensus in Washington and Wall Street holds as an article of faith that we have to engage in a broad consideration of tax reform.

And we probably should. The Internal Revenue Code routinely favors one kind of spending over another. For decades, legislators have been using tax deductions to provide incentives or effective subsidies for people and companies to purchase health care, to donate to charity, to invest in energy efficiency, or to save for retirement. The home mortgage deduction is among the single largest such incentives. Introduced along with the income tax in 1913, it wasn't widely used until the 1950s. In the last few decades, with the massive expansion of the home-finance and mortgage-backed-securities markets, housing debt has risen smartly. And so too has the home-mortgage deduction, from about $20 billion in 1981 to $38.8 billion in 2002 to nearly $70 billion in 2003, according to estimates from the Joint Committee on Taxation.


Today, individuals can deduct interest on up to $1 million in mortgage indebtedness, plus interest on another $100,000 in home equity loans. This year, the deduction will sap an estimated $72.6 billion from the Treasury. And the Joint Committee projects (scroll down to the 33rd page) that the deduction will total $434.2 billion over the next five years. As Cleveland State University College of Law professor Deborah Geier notes in a recent working paper, the home-mortgage deduction is the third-largest single "tax expenditure" behind the deductions companies take for contributions to pension plans and for health-care premiums.

Clearly, we've gotten some bang for all these bucks. The United States has an enviably high rate of home ownership and a highly developed infrastructure—secondary markets in mortgage-backed securities, online mortgage companies, etc.—that supports the construction and purchase of homes.

But the once-modest deduction has evolved into a very large and highly inefficient rent subsidy. The deduction plainly causes distortions. People are willing to pay more for houses and buy bigger houses than they otherwise would because they can deduct the interest from their taxes. "When Americans invest the bulk of their life savings in housing, that's a redistribution of capital from the productive business sector," said Sullivan.

What's more, the expansion of the deduction seems occasionally to have more to do with stimulating the financial-services industry than with allowing Americans to turn their homes into assets. Consider the growth of interest-only mortgages. With the deduction, the government is effectively subsidizing your monthly payment. But you're not building any equity, you're just paying rent. It's hard to say how an interest-only loan encourages home "ownership."


Then there are home-equity loans. The proceeds from home-equity loans can be used to pay for an addition or repairs, but also for a television or for a trip to Jamaica. And the taxpayer foots a portion of the bill. What does this have to do with encouraging homeownership?

What's more, it's remarkably unprogressive. One of the biggest obstacles to homeownership is the inability to come up with a down payment. The deduction doesn't help you there. Taxpayers who don't itemize deductions—generally people in the lower income brackets—don't receive any benefit from the home-mortgage deduction. And the more you borrow, and the higher your tax bracket, the more valuable the deduction becomes.

So, what would happen if the home-mortgage deduction were slowly phased out? For the sectors of the housing market where homeowners tend not to itemize deductions, the impact would probably be minimal. At the higher end, housing prices might be expected to adjust, but not to crash. Consider a home buyer in the 25 percent tax bracket with an 8 percent mortgage. Thanks to the interest deduction, he effectively pays 6 percent on the mortgage. Losing the deduction would have the same effect on his personal finances and mentality as a rise in mortgage rates from 6 percent to 8 percent would. A bummer? Certainly. But such moves have happened frequently without causing crises. And if the elimination of the deduction were accompanied by a reduction in rates elsewhere, it would be a wash for many homeowners. The real harm would come to the home-building industry.

And that's the real reason we shouldn't bet the house on eliminating or reducing the mortgage deduction. The home-building, home-selling, and home-buying industries, which claim to speak for homeowners, would bitterly oppose such a move. And so it's no surprise that earlier this year, when President Bush penned instructions to the advisory panel on tax reform, he told them to "recognize[e] the importance of homeownership."