Friday, May 13, 2011

“Just the facts” Friday: Mortgage Interest Deduction – Who Benefits, What Does It Cost, and Does It Work?

The U.S. is among a handful of countries with a tax deduction for mortgage interest (hereafter known as the MID). It’s part of the overall emphasis on home ownership that’s been part and parcel of U.S. public policy for decades. As such, it’s almost a “third rail” issue like Social Security or Medicare: most politicians won’t touch it for fear of being fried and ending up looking like Christopher Lloyd in Back to the Future. But how much does it cost and, most importantly, does it actually work?

How Much Does It Cost?

According to the Congressional Budget Office, the home mortgage interest deduction cost the government $97.3 billion in 2009. The CBO estimates, however, that it will cost $131 billion in 2012.

Another way to look at the cost is to consider what it cost the government to meet the goal of increasing home ownership. A recent paper determined that, from 1984 to 2007, it cost $53,390 for each new homeowner created.

It’s worth noting that the mortgage interest deduction is not the only benefit homeowners get from the tax code. They can also deduct residential property taxes ($20.9 billion in in 2009) and they’re exempt from the first $250,000 in capital gains on the sale of a house ($28.0 billion in 2009).

Who Benefits?

In 2008 (latest IRS data), 26.8% of tax filers claimed the home mortgage interest deduction. In spite of its image as a middle-class tax break, the benefits fall mostly to upper income taxpayers: 75% of the monetary benefits went to taxpayers earning over $100,000 per year. The Tax Policy Center found that the average benefit for those with incomes of $40,000 or less is only $91, rising to $$5,459 for those earning over $250,000.

Why is this?
  • Taxpayers have to itemize to get the deduction and most lower income taxpayers don’t itemize.
  • Lower-income taxpayers have lower rates of home ownership. And retired homeowners, who already have lower incomes anyway, often have no or low interest payments, and are receiving Social Security, which isn’t included in income.
  •  Upper income taxpayers tend to own more expensive homes and therefore pay more in mortgage interest.

Does It Work?

This is a difficult question to answer factually. Many articles and reports emphasize the fact that there is little difference in home ownership rates between countries with and without a mortgage interest deduction. The U.S. and Canada, for example, have virtually identical rates of home ownership (68% vs. 67%). However, there are many factors at play in determining rates of home ownership: history, patterns of land use, urban planning policies, family relationships, tax treatment for other types of investments, etc. A simplistic comparison doesn’t help.

There is a recent study, however, that notes virtually no statistical connection between a home mortgage interest deduction and rates of home ownership. To quote from the report: "[O]n average, the MID has no statistically significant impact on homeownership attainment," and the study’s authors therefore "conclude that the MID is a costly and ineffectual policy for boosting homeownership and social welfare."

Then What Does It Do?

Since the MID doesn’t really increase home ownership, what does it do?
  • Encourages more debt: Because mortgage interest is much higher in the early years of a mortgage, the deduction is larger at the beginning. People therefore often buy the home they can afford in the future, not the home they can afford now. They can also deduct interest on up to $100K in home equity loans, another incentive to borrow against a home’s equity and therefore decrease their equity in the property. This means that the MID was a big contributor to the recent financial crisis.
  • Increases income disparity: Sang-Wook (Stanley) Cho and Johanna L. Francis (from the University of New-South Wales and Fordham, respectively) published a study earlier this year that demonstrates a strong impact from the MID on the increasing and unsustainable level of income inequality in the U.S.
  • Increases housing price inflation: Numerous economists and policymakers (e.g. Sheila Bair, chair of the FDIC) have noted that the MID contributes to housing inflation by distorting the market (since people don’t buy the home they can afford now but the home they can afford when the MID declines).
  • Encourage waste: Finally, the MID encourages people to buy bigger homes and therefore get a bigger deduction, a factor in the ever-increasing size of the average U.S. home (up to 2436 sq. ft. in 2006 according to the U.S. Census, well above that 1400 sq. ft. average in 1970 in spite of shrinking family size).

The Bottom Line

The bottom line is simple: this is terrible crappy public policy that should be ditched as soon as possible.

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