Tuesday, March 23, 2010

The Case for Ending the Mortgage Deduction

Original posted in the New York Times by Agnes Crane:

Mortgages should be made less attractive. That’s one lesson of the recent housing bubble and bust. As long as borrowing seems like the easy road to riches, people will do too much of it. But right now in the United States, the tax code encourages many people to take out big mortgages. That’s why it’s a good idea to put the elimination of the tax deductibility of mortgage interest on the political agenda.

American homeowners can for tax purposes deduct interest on mortgages of up to $1 million. It’s a politically popular arrangement, and the lure of paying a bit less to the government has been an incentive to stretch housing budgets up to, or past, the limit. Even extra cash borrowed under home equity loans can share in the tax largess, whether or not the funds go to home improvement.

Take a married couple spending $400,000 on their home, a bit more than twice the $164,700 median price reported by the National Association of Realtors. The mortgage interest deduction, plus the deduction of property tax, is worth well over $20,000 a year, based on a 20 percent down payment, a 6 percent interest rate, and a 1 percent property tax. That’s an alternative to the $11,400 standard deduction the couple would otherwise be entitled to, but at a 28 percent tax rate, it would still reduce their annual taxes by some $3,000.

And the more the couple borrows, the more they save. A $900,000 home could reduce their taxes by nearly $13,000, assuming a 33 percent tax rate on income.

But not everyone benefits from the mortgage interest tax perk. The gross tax deduction for a married couple in a median home, as measured by the real estate agents’ association, would come to a bit more than $9,000, not enough on its own to make it worthwhile to forgo the standard deduction, which is available to every taxpayer.

The high income needed to take advantage of this tax benefit undercuts the claims of supporters that tax deductibility of mortgage interest promotes home ownership, which almost all Americans seem to assume is a good thing. In fact, it is a distortion in favor of those who need the least help.

The tax logic also encourages families to borrow rather than save. When the personal savings rate is a paltry 3 percent and policy makers are wringing their hands about global imbalances, this is the wrong message to send. Moreover, potential investment is skewed toward housing rather than, say, infrastructure, manufacturing and education.

Economists have been pointing out these distortions for years, but for politicians, advocating the elimination of this deduction is seen as suicidal. One problem is that an immediate elimination would probably pull down house prices, the last thing the already weak housing market needs.

The danger comes from the lower purchasing power that higher taxes would bring. For the couple who used to be able to afford a $400,000 home, the maximum purchase price would fall by 11 percent. The $900,000 home would have to drop about 21 percent in value to offset its owners’ higher tax payments. That sounds like an invitation to open another chapter of the financial crisis.

But even such a big change in tax policy could be phased in slowly enough to avoid disaster. Britain removed the tax advantages of home ownership over a period of 12 years. In the 1990s, the mortgage tax relief rate gradually fell from 25 percent to 10 percent before disappearing completely in 2000.

The British experience teaches another lesson besides the feasibility of a fairer approach to housing tax. Mortgage tax relief ended just as a housing bubble began. Far from slumping, the median British house price rose 145 percent from 2000 to the peak in 2007, according to the Halifax bank.

Higher taxes for mortgage borrowers would not prevent excesses in the United States housing market either. They would need to be complemented by careful controls on lending. But it would be a step in a good direction. As policy makers consider how to reshape this troubled sector of the economy — and the need to raise taxes to shrink an enormous deficit — getting rid of a poorly designed tax incentive is good place to start.

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