Mortgage interest deduction: Retain, modify or eliminate?

Editor’s note: Following is an abridged version of this report originally posted April 21 by Ethan Nobles at First Arkansas News. Nobles also works for a Realtors association in central Arkansas.

In December, it appeared a proposal to radically alter the mortgage interest deduction had failed.

It seems the issue is back on the table as President Barack Obama on April 13 raised the possibility of at least altering the deduction. The U.S. Treasury Department estimates the deduction will cost the federal budget around $100 billion in 2012. It’s no surprise that Obama is taking a look at the deduction as the aforementioned effort — a report generated by National Commission on Fiscal Responsibility and Reform — was a proposal setting out ways the government might save $4 trillion over the next decade.

The commission, a task force put together by Obama, looked at a number of cost cutting measures, including one that would eliminate the current mortgage interest deduction (or MID as it is known in some circles) and replace it with a flat, 12% credit available to all homeowners.

The commission didn’t net enough votes to send its report to Congress. That was in December and, clearly, the issue didn’t die there.

REALTORS’ OPPOSITION
The National Association of Realtors (NAR) has shown increasing alarm over the possibility of eliminating the deduction over the past months. Last year, the NAR declared eliminating the deduction would decrease home values by as much as 15%. The NAR also asked its 1.1 million members to contact their senators and congressmen and voice their concerns over the potential of eliminating or altering the deduction.

Preserving the mortgage interest deduction is a priority for the NAR, as evidenced by an April town meeting in which NAR officials explained the need for a dues increase in today’s political climate. Preserving the deduction was presented as a threat to the real estate industry and recovering housing markets, and the NAR says cash is necessary to defend the MID.

The NAR isn’t the only group worried about the federal government eliminating or altering the deduction. The National Home Builders Association, for example, has come out in support of keeping the deduction, declaring its elimination as an attack on middle class families. Last year the Home Builders launched a web site dedicated to preserving the MID.

ECONOMIST OPINION
In an attempt to present as much information about the mortgage interest deduction to our readers as possible, First Arkansas News sent an email to economists in the Natural State asking a simple question: Should the mortgage interest deduction be preserved?

It is our hope the majority of economists asked that question will respond so we can present a neutral discussion of the merits of the deduction.

Michael Pakko, chief economist and state economic forecaster at the University of Arkansas at Little Rock’s Institute for Economic Advancement, was the first respondent. Pakko said the deduction inflates home prices and decrease demand for rental property.

“There is no question that the home mortgage deduction distorts incentives and prices,” he said. “The deductibility of mortgage interest reduces the cost of home ownership, displacing the demand for rental housing. More importantly, by raising the relative after-tax return of housing relative to other forms of investment, it acts to reduce capital formation, economic growth and development.”

Pakko said whenever discussing the merits of any public policy, it is critical to ask one question — in the absence of the policy, what is the source of market failure? In other words, how does the policy correct for a distortion that the free market cannot address by itself?

“In this particular case, I would argue that there is no market failure, and therefore no economic justification for the policy,” he said. “The most common rationalization for the mortgage interest deduction is that it makes home ownership more affordable to low or middle-income families. But that doesn’t indicate a market failure, it only articulates a specific political favoritism.

HOME OWNERSHIP MYTH?
“One could argue that home ownership makes families more stable, so that by subsidizing ownership, the policy strengthens families. I’m not sure there is any evidence to support this idea, but even if it is true that there are social costs to families living in apartments rather than houses, it is not clear that the market under provides for home ownership.”

Pakko said it’s also important to consider whether the mortgage interest deduction is working as intended — does the deductibility of home mortgage interest make home ownership more affordable for low and middle-income families?

“That answer to this question seems to be ambiguous at best. … The mortgage interest deduction tends to favor higher-income families disproportionately,” he said. “In that sense, it represents a direct subsidy to those who would likely be home owners in the absence of the deduction.”

Pakko pointed to IRS data from 2003 (See table at end of story) as evidence of the fact the deduction favors those in higher income brackets.

According to the IRS data, then, the largest number of tax payers — those reported adjusted gross incomes of $20,000 or less — were the least likely to claim the deduction in 2003. The two groups most likely to claim the credit reported adjusted gross incomes of $100,000 to $199,999 and $200,000 or more. The $200,000 and over crowd — which represent the smallest percentage of tax payers — received an average deduction of $14,374 in 2003.

POSSIBLE PRICE INFLATION
Pakko said another consequence of the deduction is that it effectively inflates home prices. If the government makes home ownership less expensive through deductions, tax credits and other means, it stands to reason that the market value of something will increase accordingly. Pakko said that dynamic can effectively make home affordability a problem for lower and middle-income Americans.

Pakko said the final question to ask when considering the deduction is whether the deduction costs too much in light of the current budgetary crisis the federal government is facing.

“According to the GAO (U.S. Government Accountability Office), the policy resulted in a ‘tax expenditure’ of $61.5 billion in 2004 alone,” he said. “If this were a spending policy that sent checks directly to households (primarily those in the upper end of the income distribution), its worthiness would undoubtedly be questioned.

“But because it is a ‘tax break’ instead of direct expenditure and because it benefits ‘home ownership’ rather than ‘wealthy Americans,’ it is seen (by politicians) as being a worthy policy.”

In the final analysis, Pakko said there may be some short term pain associated with eliminating the deduction, but that act could pay off in the future.

“In the context of overall tax reform that reduces marginal tax rates and eliminates deductions and credits, there is no question that mortgage deductibility should be eliminated,” he said. “There are important questions to consider such as transitional issues. The elimination of the deduction would force a revaluation of residential housing relative to other forms of capital investment. That is, house prices would fall.

“Hence by changing the rules of the game, a change in policy would result in a loss of wealth for all homeowners. Some form of compensation for this loss might be necessary, or at least desirable. All else equal, a change would also tend to increase demand for rental housing and increase rent costs.

“Over time, new construction of rental units would lead to a new equilibrium, but the transition might be smoothed with temporary subsidies. Although the process of removing the mortgage interest deduction might be messy and costly in the short run, in the long run it would create conditions for a more efficient capital structure and enhanced economic growth.”