The Mortgage Deduction Should Be Done Away With--But It Won't

Having recently entered into homeownership, I am now in the unhappy state of having to advocate against my own interest. As someone whose freelance expenses make it worthwhile to itemize, I plan to take the mortgage interest tax deduction until they phase the damn thing out, or I pay off the house, whichever comes first.  But as an economics journalist, I retain my deep hatred for the thing.

The idea behind the tax deduction is . . . well, actually, scratch that.  There is no idea behind the tax deduction.  The reason that we have a special deduction for mortgage interest is not that politicians sat down and calmly, reasonably, worked out a way to reach certain social goals they thought were desirable.  The mortgage interest deduction is an artifact of changes to the tax code in the 1980s.

The reason we have a mortgage interest tax deduction is that all interest used to be deductible, because way back when the income tax was invented, consumer credit wasn't really much of a concept, so interest on loans was much more likely to be a business expense incurred in the acquisition of an income-producing asset, rather than a personal expense incurred in the acquisition of a 60-inch flat panel television with built-in Blu-ray player.

Seventy years later, the tax code had accumulated a huge number of special tax deductions, which meant that the marginal rates had to be very high in order to collect any revenue at all.  Some economists pointed out that it was not actually a good idea to have a tax code with more holes than a really enormous Swiss cheese, and the Reagan administration embarked upon its great and noble mission to eliminate the years of accumulated loopyness, allowing us to have lower marginal rates on a much broader base.

During that process, the people writing the new legislation noticed that most consumers had accumulated mortgage and credit card debt, and maybe some auto loans and a student loan or too, plus a personal loan down at the credit union for the time their brother in law got drunk and slugged a cop and had to be bailed out even though payday was still a full week off.  

It was fairly obvious that, with the possible exception of the student loans, none of this debt had any connection to an income-producing asset.  So they pencilled out the deductibility of interest payments.  Then they realized what this would do to housing prices, and the mood of taxpayers who had just lost their largest deduction, and pencilled it right back in.

That, my little chickadees, is why we have a special mortgage interest deduction.  The arguments for keeping that deduction are several:

  1. Homeowners invest more in their homes, and in their neighborhoods, then renters do.
  2. Homeownership breeds middle class values about saving and civic engagement.
  3. Homeownership has been the primary vehicle for saving for several generations of Americans, and poor people who do not have access to this precious vehicle are shut out of the American dream
I must admit that since buying a home, I have become considerably more reluctant to, say, pad down to the corner store in my pajamas and an overcoat when we're out of milk--what would the neighbors think?  But in the wake of the housing bubble, these arguments nonetheless seem ludicrous.  For millions, houses were a route to excess, and eventually penury.  And I'm just talking about the mortgage brokers.  Don't even get me started on the poor homeowners who fell for this malarky.

The thing is, economists knew these arguments were high-test twaddle before the bubble popped.  Adam Ozimek summarizes a recent paper which outlines just how terrible a deduction the mortgage interest allowance is:

Using national data from 1984 to 2007 they found that the MID did not increase overall homeownership. In areas with light land use regulation they found that homeownership among higher income families was increased, and in tightly regulated housing markets homeownership was decreased for all income groups except the lowest. The effects, both positive and negative, generally range from 3% to 5%. Regardless of the regulatory environment, homeownership among the lowest income group was not affected at all by the MID.

The authors estimate that it each additional homeowner created by the mortgage interest deduction costs the government $53,590, a number they rightly call "staggering".

An important implication of the findings is that in urban areas, where land use regulations are typically more restrictive, homeownership is likely to be negatively impacted.

We spend around $100 billion a year on this subsidy, and to the extent that it's defenders are correct and homeownership does have positive externalities, it is actually making urban areas worse off.

The problem is that while homeownership wouldn't be affected by getting rid of the deduction, homeowners would be.  Some people who relied on the deduction to make their house affordable would be caught in a budget squeeze--though you can solve this problem pretty easily by grandfathering in existing homeowners, or sunseting the deduction after five or ten years.

However, this would still have a pretty nasty effect on housing prices.  Even people with little or no mortgage would be adversely affected by a price drop in their largest asset.

Of course, I will still support, even cheer, politicians who do away with it.  But I am a crazy ideologue.  Polling seems to show that most people will freak out, especially in a soft housing market, though to be fair most of that polling seems to be done by, like, the National Association of Homebuilders.

Self interested though the polling may be, this does seem to broadly comport with what I see on television, read on internet comment boards, and hear from friends and relatives.  Which is why I expect the deduction will stick around, even though there is a lot of hopeful talk from the DC wonketariat, and a few political types.  The deduction's sort of like a giant McMansion in an undesirable exurb with a whacking great underwater mortgage:  no matter how terrible it is, no matter how much we hate it, we're probably stuck with it for the foreseeable future.