Economists Argue Over Mortgage Interest Deductibility

 (Editor's Note:  This is the second in a series of articles summarizing material in the latest edition of "Evidence Matters" the new digest of housing research first published in February by the Department of Housing and Urban Development (HUD).  The current issue is devoted to rental housing as it was discussed at the Next Generation Housing Policy Conference held in October 2010.) 

The Next Generation conference featured three presentations on the topic of the future of the mortgage interest tax deduction (MID).  This feature of the tax code allows homeowners to deduct interest paid on one or more mortgages on up to two homes and its elimination is suggested in current attempts to reduce the budget deficit.  It is, in fact, the only tax increase to have come under wide discussion. The three economists who made presentations were:

• Edward Glaeser, Ph.D., Fred and Eleanor Glimp Professor of Economics at Harvard University.
• Todd Sinai, Ph.D., Associate Professor of Real Estate and Business and Public Policy at the University of Pennsylvania's Wharton School, Visiting Scholar at the Federal Reserve Bank of Philadelphia and Faculty Research Fellow at the National Bureau of Economic Research.
• David Crowe, Ph.D., Chief Economist and Senior Vice President at the National Association of Home Builders (NAHB).

Two of the three speakers argued forcibly for curtailing the deduction although their reasons differed.  Only Crowe, speaking for an industry group which benefits from home ownership, favored its continuation. 

Glaeser called the deduction a regressive one that artificially distorts behavior, including pushing people toward single-family detached houses, while at the same time being poorly designed to actually promote homeownership. He maintained that the government should not be encouraging people to use leverage to gamble on "the vicissitudes of the housing market," particularly in the wake of a housing crisis.  

The deduction, he said, also encourages people to buy bigger homes and he believes that Americans already live in homes that are too big for their budgets or for the environment.  Homeownership is generally equated with single-family structures so, by encouraging ownership rather than rentals the government is pushing people away from multifamily dwellings and thus from urban areas where they are more common.  "We should not be bribing people to leave our economically productive urban cores," he said.

Homeownership, Glaeser said, has often been pushed as a path to middle-class prosperity, but in the wake of the housing boom he calls this "dubious."  It is also credited with other desirable social outcomes but the deduction is actually poorly designed to encourage homeownership because it disproportionately benefits the wealthy who are likely to own anyway.  Glaeser quoted research from James Poterba and Sinai that the MID is ten times more beneficial to upper income individuals than the family earning $40,000 to $75,000 and stated that many poorer households "on the margin between owning and renting do not even itemize."

Reform is needed but with the market still in distress eliminating the deduction all at once would be too extreme.  He suggested reducing the upper limit from $1 million to $300,000 over the next seven years.  "Eventually, policymakers could replace the deduction with a straight owner's credit that provided some incentive for ownership (if absolutely necessary) but did not encourage extra borrowing or larger homes."

Sinai opted for referring to the MID as a subsidy rather than a deduction and says it is only one component of the total tax subsidy for owner-occupied housing. "In an undistorted tax code, taxpayers would be allowed to deduct their expenses (mortgage interest) when they pay tax on their income (rent). Because the United States does not tax estimated rental income for owner-occupiers, the interest deduction should not be allowed." This constitutes a subsidy. "However, the tax code also does not permit many actions that could offset the effects of untaxed rental income, such as taxing the estimated return to equity invested in owner-occupied houses."

The deduction costs an estimated $93.8 billion in each year which constitutes nearly 9 percent of the 2011 budget deficit as projected by the Congressional Budget Office.  However, Sinai said that his and Poterba's research concluded that in 2004 the total tax subsidy for owner-occupied housing was $330 billion. The MID is just a subsidy that uses mortgage debt to finance home purchases. Curtailing it leaves behind a host of subsidies, the most important being a subsidy for using equity to buy a house.  "Many positive aspects of homeownership exist, but the inappropriate use of mortgage debt negated nearly all of them in the latest downturn."

Eliminating MID would not eliminate the tax subsidy for owner-occupied housing. High-income households might substitute equity finance for debt, allowing them to retain their housing subsidy. Older homeowners with little mortgage debt and low-income households that do not itemize do not benefit from MID, so curtailing it would have the biggest impact on middle-class families and would discourage wealthy households from using leverage. "Is a partial reduction in the housing subsidy worth these distortions to household capital allocation and progressivity? Because the government can change other parts of the tax code to restore progressivity, the answer is likely yes."

The solution depends on implementation; reducing MID requires corresponding reductions in the income tax burden and any changes must be phased in to mitigate an adverse impact on home prices.

Crowe outlined what he called the fundamental role of homeownership in American society including improved educational outcomes, better health, reduced crime, and in the long run, homeownership a path to wealth accumulation.  The net worth of the average homeowner, he said, is more than 45 times that of the average renter.

Homeownership for most is impossible without debt financing and the MID provides parity with the tax treatment of interest expense associated with other forms of debt-financed investment, including financial assets and rental housing and lowers the effective interest rate making homeownership accessible to more households.  "The MID is well justified as housing policy given the documented positive externalities associated with homeownership."

Crowe said that among the misleading or incorrect information used to attack the MID is that few homeowners actually benefit because they do not itemize on their tax returns.  In fact, Crowe said, 86 percent of all mortgage interest paid over the past decade was claimed as an itemized deduction.

He also argued that it is not regressive, citing a Congressional committee which estimated that about 70 percent of the benefits from MID go to households earning less than $200,000 and figures NAHB that show middle-class households earn the largest benefits as a share of income. That these benefits are greatest during the early years of a mortgage when most of a monthly payment is interest provides significant help to younger homebuyers when their household budgets are the tightest and wealth accumulation is beginning.

Another NAHB analysis indicates that families with children collect larger tax benefits so, rather than causing homebuyers to buy a larger home, the MID helps growing households finance the larger home they need.

Crow disputed that the MID played a role in the recent housing crisis as it has been part of the tax code since 1913 and widely used by the middle class since the 1940s, with no evidence of having created a housing bubble.  If the MID were responsible for recent problems, "you would expect a positive relationship between the use of the MID and foreclosures, but none exists."

"Given the macroeconomic damage that weakening the MID would cause," Crowe said, "the MID must retain its place as a cornerstone of U.S. housing policy."