Last week, President Bush's critics interrupted their feeding frenzy about wars, floods, hurricanes, torture, and indictments to briefly savage his tax reform commission, particularly its proposal to scrap the mortgage-interest deduction.
The commission targeted the mortgage-interest deduction for several reasons. They say it is an unwarranted subsidy for housing that diverts capital from more productive uses in the business sector. The commission was also trying to find a way to limit the Alternative Minimum Tax from encroaching on middle-class families without raising income tax rates.
Outside economics departments, these arguments have been less than persuasive. The proposal has been savaged by critics who insist that scrapping the deduction would raise their taxes, lead to plunging house prices, and in the worst case, send the economy spiraling into recession. Some progressives even suggest that having failed to take away their Social Security benefits, the Bush administration is now trying to evict them from their homes.
Although the commission's two comprehensive tax-reform proposals should be rejected because they are costly and regressive, progressives should rush to embrace many of commission's specific ideas, particularly the mortgage proposal. That's because the plan will increase tax breaks for homeownership for the plurality of American families, likely increasing homeownership and making the tax system more fair.
One of the goals of our tax system is to encourage homeownership, based on the theory that homeownership has benefits that go beyond individual homeowners, making people into better citizens and better neighbors, reducing crime, and keeping neighborhoods cleaner. Whatever the merits of this view (and the evidence for important "externalities" for homeownership is uneven), our current tax system actually does an extremely bad job of encouraging homeownership.
This year the federal government is providing $200 billion in subsidies for housing, including $150 billion of tax breaks. The mortgage-interest deduction alone is $69 billion of that, making it one of our biggest government programs. Families get to take an itemized tax deduction on the interest from home mortgages of up to $1 million. The richer you are, the better the deal. For every $1,000 in deductions, a family in the 35-percent bracket would see its taxes go down by $350, while a family in the 15-percent bracket would see its taxes go down by only $150. And families taking the standard deduction wouldn't get any tax break at all.
As Gene Steuerle and his co-authors at the Urban Institute have documented, more than 80 percent of the major tax incentives for housing go to the top 20 percent of Americans (they get an average annual tax break exceeding $2,000) while less than 5 percent go to the bottom 60 percent (who get an average annual tax break of less than $50). Nearly half of all families with mortgages do not get any housing tax benefit at all.
This fact alone should be enough to give progressives pause when they tout the mortgage-interest deduction as a great boon to the average American. But it's worse: Only a small portion of this housing-tax break could conceivably be construed as supporting the goal of helping American families own their own homes. Since the mortgage cutoff is so much higher than the cost of buying a basic home, the bulk of the subsidies end up encouraging families who would have bought a home anyway to buy a larger house and/or to borrow more against it.
The commission proposes to scrap the mortgage-interest deduction and replace it with a "Home Credit" that allows families to reduce their taxes by 15 percent of mortgage interest on borrowing up to $227,000 to $412,000 (the limit is set at 125 percent of the median sales price for each county). Any family with $1,000 of mortgage interest would see its taxes go down by the same $150, regardless of their tax bracket. And the credit would be extended to nonitemizers who currently get no benefit.
Extending the mortgage-interest credit to all taxpayers would extend the tax benefits to all but 12 percent of families with mortgages, according to estimates by the commission. The fraction of typical families (those making $40,000 to $50,000) getting a tax break for their mortgage interest would jump from less than 50 percent under current law to more than 99 percent under the commission proposal. More than 20 million families would get a tax cut from the plan.