President Obama’s bipartisan National Commission on Fiscal Responsibility and Reform (commonly referred to as the “Deficit Commission”) has called for terminating the mortgage interest deduction for homeowners, and a bipartisan “Gang of Six” senators, four of them members of the Deficit Commission, is now developing a budget plan that is likely to include that recommendation. The deduction is the second largest “tax expenditure” in the entire federal budget; repealing it would bring the federal government more than $100 billion annually. To a Commission trying to cut the deficit by almost $4 trillion over the next decade, it must have looked like a sitting duck.
Although this Commission proposal has been applauded by commentators across the political spectrum, it is bad economic policy.
Part of the rationale for the Commission’s recommendation is its desire to have a tax system that is as economically neutral as possible, a tax system that doesn’t push people to do something just for the tax advantage. This is a laudable objective and one that nearly every economist favors. Terminating the mortgage interest deduction, however, doesn’t help achieve that goal. Instead, it would create a new bias in the tax code, favoring renting rather than owning your own home.
Your house is an asset, an investment, as well as a place to live. A homeowner is both an investor and a consumer, both a landlord and a tenant—someone who owns a house and is renting it to himself or herself. Like any other business person, a landlord can deduct business expenses. For rental housing, these include interest on the mortgage, property taxes, maintenance expenditures, and depreciation on the property. At the same time, the landlord has to pay tax on the rent he or she receives, after deducting these business expenses. A homeowner/investor has the same business expenses, but can’t deduct all of them. The homeowner can deduct mortgage interest and property taxes, but not maintenance or depreciation. The homeowner also doesn’t have to pay taxes on the rental value of the home.
So homeowners have a tax advantage over landlords because owners don’t pay taxes on the rental value of their home; and landlords have tax advantages over homeowners because they can deduct maintenance and depreciation, and homeowners can’t. But homeowners and landlords are treated equally with respect to mortgage interest and property taxes. Both can deduct these expenses. The recommendation of the Commission takes away the deduction for homeowners, but leaves it in place for landlords.
The President’s budget for 2012 proposes to take a small but significant step in the same direction. The value of the deduction would be reduced for families with incomes above $250,000. These are the same taxpayers for whom Mr. Obama wanted to raise taxes back in December—“the rich.”
But the deduction isn’t a particular benefit for rich people. Taxpayers with incomes above $200,000 are about 5% of all households who pay income taxes – “the richest 5%.” They pay over half of all income taxes. But they only account for about 20% of all mortgage interest reported on tax returns, according to the IRS. That is much less than their share of other major deductions; they account for more than half of state and local income taxes, and almost half of charitable contributions.
Most of the benefit of the mortgage interest deduction goes to households who are not “rich,” households with incomes between $75,000 and $200,000. These are middle-class families, reasonably well off, but working, and working hard.
Terminating the mortgage interest deduction has other consequences. Homeownership has traditionally been an indicator of middle-class status and a path to financial security. For young families, their first two assets typically are a checking account and a car. Their next two are a home and a 401(k). Those are likely to be their most important assets over the rest of their working lives – particularly their home. For most middle-class families, the equity that they build up in their home is more important than all their financial assets combined. That’s also true for lower-income families. Not all of them are homeowners, but about half are, and for them their home is by far their most important asset. Financial assets, such as stocks, bonds, or mutual funds, are concentrated among the wealthiest part of the population. Homeownership and home equity are much more important for the middle class than they are for the rich.
The sooner young families can afford to buy a home, the more likely they are to enjoy an increase in the value of their home, and the greater that increase is likely to be. The mortgage interest deduction makes it easier for them to buy that home, unless they have been lucky enough to enjoy a comfortable inheritance. Most people haven’t; they have to work for a living, and work to pay a mortgage as well as their other expenses.
Repealing the mortgage interest deduction will make it harder for young families to become homeowners. Repealing the capital gains exclusion, another Commission recommendation, will make it harder for older families, when they want to move to a retirement home or move to be near their children and grandchildren.
Profiting when you sell your home may seem like a distant dream right now, when foreclosures are rampant and the homeownership rate is declining. Most of the time, however, families that have bought homes have gained financially when they decided to sell. That is the normal experience.
Surveys show that families want to be homeowners, even in today’s economy, and they are right. Homeownership has traditionally been an indicator of middle-class status and a path to financial security, and it still is.