4 Problems With Mortgage Interest Deduction

By Daniel Indiviglio

I just complained about how the government does too much to prop up some industries. Perhaps the most obvious example of this over the past few years has been residential real estate. Washington bailed out Fannie and Freddie, offered a home buyer tax credit and spent billions to prevent foreclosures, to name just a few of numerous tactics used to prop up housing. Another way it has done this for nearly a hundred years is through mortgage interest deduction. By allowing taxpayers to deduct their mortgage interest from their taxable income, they have a greater incentive to buy a house. Is this a good idea?

An article by Agnes Crane from Reuters Breakingviews argues against this concept today, and I largely concur with her analysis. I don't see any compelling practical or even philosophical reason why home ownership should be encouraged by the government. There is neither shame in renting nor virtue in owning.

But when you look at the details of mortgage interest deduction up close, you begin to see how ugly it really is.

Arbitrary Taxation

First, think about what it means when a homeowner manages to pay less in taxes than a renter. Assuming they both had the same income and their other deductions were identical, the homeowner gets an additional tax break merely because she chose to purchase a home. How is that fair? That would be like if the government arbitrarily decided that the diamond industry was worth supporting, so it allowed anyone who happens to buy jewelry containing diamonds to deduct the expense from their taxes.

Encourages Greater Indebtedness

Oddly, the incentive increases with greater indebtedness. Generally, the bigger the mortgage, the more interest you pay and the more taxes you can write off. No wonder America loves debt so much.

Lowers Tax Revenue

Also, think about what it means when a homeowner pays less in taxes due to the credit. That lowers tax revenues. If we lived in a world where the government had an easy time paying for all of its spending, then that might not much matter. But that's the opposite of the world we live in. The government can't afford to allow people to have a tax break for purchasing a home as its own debt continues to expand.

Regressive Taxation

Finally, the deduction leads to regressive taxation. The richer you are, the bigger a mortgage you can afford. That will result in more interest deduction and a lower effective tax rate. Crane begins to make this point in her analysis:

The high income needed to take advantage of this tax benefit undercuts the claims of supporters that tax deductibility of mortgage interest promotes home ownership, which almost all Americans seem to assume is a good thing. In fact, it is a distortion in favor of those who need the least help.

Precisely right. And homeowners with smaller mortgages and lower incomes will likely end up taking the minimum deduction anyway, as the amount of interest they pay often won't exceed the $11,400 standard deduction for a married couple. So their effective tax rate will be unchanged while that of wealthier Americans could be lowered substantially through a hefty mortgage interest deduction.

Unfortunately, repealing the mortgage interest deduction is politically toxic. It isn't easy to tell the millions of homeowners who have enjoyed taking the credit each year for decades that it will suddenly disappear. This is also the wrong time to make home ownership less attractive, as the broader economic recovery will benefit in the near-term with a stabilized housing market.

But once the economy is fully healed and debt reduction eventually ramps up -- and it must -- the mortgage interest deduction seems a prime candidate for elimination. Doing so would bring in hundreds of billions of dollars in additional tax revenue each year.

This article available online at:

http://www.theatlantic.com/business/archive/2010/03/4-problems-with-mortgage-interest-deduction/37907/