On Wednesday, I published a piece arguing that the Republican tax plan would hurt home values by effectively killing off the mortgage interest deduction for middle-class families. A few readers have suggested that might not be such an awful policy move. So I want to elaborate on why it is.
To quickly review, the Republican tax blueprint that Paul Ryan rolled out this past summer calls for simplifying the IRS code by eliminating a number of breaks and nearly doubling the standard deduction to $24,000 for joint filers. Technically, the plan would keep the mortgage interest deduction in place. But with such a high standard deduction, very few people would choose to itemize. That would kill the tax advantage of having a mortgage, leading home prices to fall. People who paid more than $24,000 a year in mortgage interest would still get some benefit from the deduction, meaning that the luxury housing market would be comparatively unaffected.
I find this pretty terribly misguided. The mortgage interest deduction is a deeply flawed piece of policy that has inflated housing prices without expanding ownership much if at all and should be reformed. But doing it in a way that swiftly penalizes middle- and upper-middle-income homeowners while leaving the wealthy relatively unscathed isn't the way to approach the task.
I've seen a few points raised in response. I'd like to address three in particular.
First, some people have suggested that the House plan would still be a net positive to homeowners. If house prices drop, but middle-class families get a tax cut from the higher standard deduction, aren't they better off?
Not necessarily. The Tax Policy Center estimates that under the comprehensive House plan—which, to be fair, is just a preliminary sketch—the bottom 80 percent of households would see a less than 1 percent increase in their after-tax income. For a family in the fourth quintile, you're talking about a $410 annual bump.
Now, let's say a family in that income bracket owned a $200,000 house, which would be well below the median new home price of $305,000. As I mentioned in my earlier piece, a recent analysis from a Federal Reserve Board economist suggested that killing the mortgage interest deduction entirely could cause a 6.9 percent average drop in home prices. Let's say they fell less than half that much, by 3 percent. That would mean a $6,000 property value loss, equal to about 14 years' worth of the tax break they'd receive under the Ryan plan.
It gets worse, though. Houses tend to be heavily leveraged assets, so a small drop in value can erase a good chunk of a homeowner's equity. Let's say our hypothetical family owned 30 percent of their house, or had $60,000 in equity, with $140,000 on their mortgage. That 3 percent price drop would leave them with a $140,000 mortgage and $54,000 in equity—a 10 percent home-equity loss, all in exchange for a pretty meager tax cut.
That could have consequences for the rest of us, by the way. Economists have found a pretty strong “wealth effect” associated with housing: When prices go up, homeowners spend more; when prices drop, they spend less. A sudden contraction in the housing market can cause the whole economy to clam up.
The upshot: A bunch of middle-class homeowners would come out poorer in this bargain, and the broader country might pay a price for it.
Now, point two. Some have suggested that lowering home prices a bit would be a good thing, especially for young buyers, since housing costs are absolutely insane in many parts of the country.
I think that's a bit optimistic. Falling home values might make down payments more affordable. But the Fed Board analysis I pointed to earlier suggests that if the mortgage deduction goes, first-time homebuyers will be hurt more long-term by the higher borrowing costs than they’ll be helped by lower prices—even in places like San Francisco and New York.*
Finally, there are those like the Washington Examiner's Tim Carney, who allows that, yeah, there might be losers in this bargain, but their misfortune is worth the cost of a simpler tax code that lowers the burden for many and gets rid of distortions in housing prices.
But that's missing my point. We should reform the mortgage interest deduction, or maybe phase it out entirely. And I'm not necessarily against tax relief for lower earners; raising the standard deduction may even be a smart, simple way to offer it. But we need to do those things while minimizing the harm to homeowners who've made major financial decisions based on the current tax code. (Disclosure: I own my apartment. So do many people who'd be writing on this subject.) Congress could accomplish that by raising the standard deduction while turning the mortgage interest deduction into a set tax credit anybody could get whether or not they itemized. That would better target the policy's benefits at working-class homeowners without instantly yanking them away from slightly wealthier families and severely disrupting the market. You could then choose to sunset that credit over a decade or two—as Britain did with its mortgage subsidies—or keep it around. That approach would certainly be expensive. But we might be able to afford it if Congress wasn't contemplating a tax plan that slashed rates on millionaires and billionaires.
*Correction, Jan. 9, 2017: Because I goofed up reading the Fed paper, I originally reported that its author had concluded that eliminating the mortgage interest deduction entirely would cause home values to fall less in metro areas where housing supply is almost always tight, like San Francisco, than in more flexible markets, like Alexandria, Louisiana. The study basically says the opposite—in metro areas with greater price elasticity of housing supply, values fall less. Thankfully, for my dignity at least, other conclusions in the study support the broader point I was trying to make, which was that pushing down house prices by killing the mortgage interest deduction might not be that much of a boon to young homebuyers.