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The Mortgage Interest Income Tax Deduction is Bad for America

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At first blush, the mortgage interest income tax deduction seems like a great thing. You get to deduct your mortgage interest from your income. This saves you money and encourages homeownership nationwide (believed to produce positive externalities such as crime reduction, community, etc.).

But beneath the surface, the mortgage tax deduction disproportionately benefits the wealthy and creates perverse incentives and market distortions that are plainly bad for America. I deal with these issues one by one:

Sadly subsidized(1) Good for the rich: since the US tax code allows the deduction of mortgage interest directly from your income, those that benefit the most are those with the most income. The very poor cannot afford to buy a home, so they do not benefit at all. Poor homeowners benefit very little because they do not pay much in income taxes. But the wealthy receive huge tax breaks from the interest on their jumbo McMansion mortgages.

(2) Perverse incentives: because of the huge mortgage interest tax break, high income earners are then encouraged (and subsidized) to buy ever more expensive mansions and borrow even more money through ever larger jumbo mortgages.

(3) Market distortions: by subsidizing the purchasing of homes and the taking on of mortgage debt, the mortgage tax deduction has increased the demand for homes (expensive homes, in particular) and reduced the effective rate of borrowing again homes. While the housing price bubble and over-leveraging of American was not caused by the mortgage interest tax deduction, certainly the previously (and still) inflated values of homes and over-borrowing of the US consumer cannot be disaggregated from this pernicious deduction.

What to Do Next

The rational policy choice would be to eliminate the mortgage tax deduction. The federal government can still encourage homeownership (distinguished from mansion-buying) by instituting a Housing Tax Credit. The credit could be cost-neutral and take the average cost per family of the current deduction, and give that amount out as a tax credit to any family or individual who wishes to purchase a home. A standard credit would make sure that regardless of a family’s income they would receive the same nominal incentive. This would provide more incentive for poor people to buy a home (the credit would likely be worth more to them than the current deduction) and waste less taxpayer money on subsidizing the mansions of the wealthy. Moreover, such a policy could potentially spur homeownership among lower-income families which could help us dig our way out of the housing crisis. Let’s hope the next president has the foresight to do something about this.

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About Jeremy Berman

  • http://www.associatedcontent.com/user/39420/joanne_huspek.html Joanne Huspek

    The very poor can afford to buy a home in Detroit. (Also in other depressed areas, such as Cleveland.) I’ve watched the market for starter houses fall from $40K to $1K in less than a year. Witness the fact that some woman recently bought a house for $1. If you have a steady job (tough to find in our area, but it can be done) with decent credit, even renters can make the transistion.

    This is a good time for anyone who wants home ownership to buy. Then the poor and middle class can take advantage of the interest break. Believe me, in my middle class bracket, the interest break doesn’t mean much. We are still going to pay a lot of city, state, federal and corporate taxes.

    The one thing holding them back is the current high foreclosure rate and mortgage debt of the banks. Before, anyone could get a loan; now potential buyers are scrutinized carefully before the banks will give the okay.

  • http://insolventinvestor.wordpress.com Nick First

    Joanne – I agree that banks’ reluctance to lend is a real problem. Unfortunately, this may not change soon, in large part because banks still see risk left in the housing market as well as the broader economy. It will likely take years for mortgage lending to significantly improve as housing markets sort themselves out.

  • bliffle

    It’s not only the poor who are walkng away from mortgages. A fellow I know explained it this way:

    “I bought my townhouse for $450k, putting $90 down, leaving a mortgage of $360. 2 years later, in the buying hysteria, I refinanced at a face value of $600k, a loan of $480 (which put me $30k ahead on paper) and took out $120k cash. I’ve already made any profit I’m ever going to make from this place, and any price under $480k is money out of my pocket. Why should I make any more payments to defend a price I may never see again?”

  • bliffle

    The mortgage interest rate deduction was premised on benefiting the middle-class, which was already pretty large and which economists wanted to make larger. And it worked. More people were able to join the middleclass, in particular blue-collar union workers, and low-level white-collar workers. the threshold cost of the middleclass was reduced and a decent incentive created.

    Yes, the deduction was too generous to the rich and too difficult for the poor. But the idea was to gain the support of the rich by their participation and to bring the lowest classes up into the middleclass and not predestine them to the lowerclass.

    It was thought that the middleclass would grow as more opportunites were made available to the lowerclass and the advantages of the rich declined. The middleclass would be wealthy, have good jobs, secure pensions and a stable economy. Upward mobility would solve a lot of problems.

    But, alas, we chose the opposite! We are dividing the middle class into winners and losers, sending a few up and sending many down. The middleclass is diminishing.

    Part of the economic problem is that we increased risk and the cost of risk for the middleclass, apparently to facilitate pushing them down. At the same time we increased the amount of risk that the middleclass must assume.

    Everybody knows about the huge increases in healthcare risk that individuals have been required to assume in the last few decades, but a more subtle risk situation was created in the housing market by the FHA. IIRC it was 1974 when the FHA changed a longstanding policy on two-income families. Previously they had only considered the high wage earner in the family, the second income was not considered permanent. But they changed that so lenders would consider the sum of both incomes so people with 2 incomes could buy more grand houses. The effect was to almost double house prices in the 70s.

    So what happened is that it almost REQUIRED 2 incomes to buy a house. This created an incipient risk since now if either partner lost their income the other could not sustain by themselves.

    We doubled the chance of failure. there was no more slack left in the home budget. The result was more losers.

    More risk was shifted to citizens as companies adopted the slogan “privatize the rewards and socialize the risk”, and the government joined in with “too big to fail” ideas, which we see manifested in numerous bailouts of companies which had produced large private profits.

    Whether you like it or not, you are coppering the bets of “Hedge” funds and numerous other companies. Also, as companies started to renege on their pension plans (which no one thought would happen) the government tried to cover it with the “Pension Benefits Gaaurantee Corporation”, which, though it only paid about 25% still cost 10s of billions.

    So to shift more risk to the middleclass the company didn’t even have to fail, it simply had to get greedy enough to cash out the pension plan.

    If your possible risks increase across the board, chances are you’re going to have a much higher chance of going broke due to circumstances beyond your control.

  • http://www.sitejabber.com Nick First

    It’s a grim picture, but it’s hard to disagree with. The income gap will likely grow in this downturn unless something unexpected occurs. Hedge fund managers will keep making 2 and 20, while the middle class and poor will lose their homes and their credit.

  • Surfer

    I wish we had the tax break on mortgage interest payments in Australia. You get it – in a round about kind of way – for an investment property, so that with rental income, it costs you zilch to pay off AND you get an income. This is to encourage people to buy properties that can be rented out, and eases pressure on a what is becoming a tightening rental market.

    However, there is no tax deduction on your primary place of residence, and worse, in Australia, unless you opt for a fixed-term, fixed rate mortgage when you buy a place (fixed term generally being, say, three to five years, when it reverts to a variable rate), all mortgage interest rates are variable and go up and down according to the market and the conditions dictated by the economy.

    In the past three years, they have been going up – so that my (already high) monthly repayment since February 2007 has now risen by more than $600 a month.

    Rates are set by the Reserve Bank of Australia (equivalent of the Fed), in this case in an attempt to slow down a “hot” economy driven by a mining boom exporting to Asia, and to put a brake on underlying inflation running at just over 4 per cent.

    Essentially, they seek to curtail growth by cutting household spending. However, because of the global credit crunch fallout from the US sub-prime collapse, the lending institutions have also been putting up rates independent of the RBA – the first time in my 50 years on this planet that I can recall this happening. None of their “problems” however have stopped them posting record profits.

    It’s had the desired effect up to a point. The Aussie dollar, which was at near parity with the greenback earlier this year, has now fallen back to between 80-90 cents (this is only really important when you are exchanging currency, say for a vacation, although purchasing-power parity is similar or better for the average punter as Australian wages are generally higher than US wages, because pretty much everything in this country is so much more expensive than it is in the US). But unlike many Americans, Australians realise that a currency lowered against the dollar and the euro is actually good, because it helps the export industries.

    Example of costs: expect to pay $30,000-plus here for a pretty standard, six-cylinder locally built Ford, while a $500,000 mortgage in Sydney isn’t regarded as a big mortgage. A wage of $A120,000 in Sydney (right now, that’s around $US100,000), isn’t regarded as a big wage.

    However, the drop in the dollar against the greenback means fuel costs are still soaring, as recent falls in the cost oil per barrel have been soaked up by the devalued currency – and as a result, grocery prices have gone up accordingly.

    So right now, I look at the US – even with all its current economic problems – and think: “If only”. I still prefer to live here, as I think the lifestyle’s better overall, and of course health care is free and there ARE tax breaks for those (like me, and many millions of others in a country of only 20 million) who choose to have private insurance as well.

    So all things considered, rather than being a bad thing, your tax break on your mortgage is an unbelievably generous bonus offered by your government.

    And you should count yourselves very lucky.

  • http://www.sitejabber.com Nick First

    To clarify on the mortgage deduction – the reason it’s bad is because of the way it’s structured in the US. Basically, the richer you are, the more you stand to benefit. What I’m suggesting is a tax credit instead of a tax deduction, such that lower income earners would receive the same nominal benefit as higher income earners.

  • Cindy D

    We should count ourselves “very lucky” that “our government” doesn’t bring back debtor’s prison.

  • Disagree a bit

    The IRS only allows you to deduct up to 1 million in interest of a mortgage , so yes while the upper middle class person is tempted to buy the 1 million home as opposed to a lower middle class person only being able to afford maybe a home in the 400k range , there are still limits. In escene it is the upper middle v. the lower middle class.

    It also depends on which state $1 million dollars in california is different from $1 milion dollars in texas.

  • http://www.sitejabber.com Nick First

    It’s true the mortgage deduction is capped at $1M, but I think there is a compelling argument that there are better uses of taxpayer dollars than subsidizing $1M mortgages, regardless of the state. The other issues is that someone who takes out a $1M mortgage will receive a tax deduction (in essence a subsidy) several times as large as someone who takes out a $50k mortgage. I am arguing what would be more equitable is a flat tax credit that is equal in size for anyone who buys a home as a primary residence.

  • Clavos

    I am arguing what would be more equitable is a flat tax credit that is equal in size for anyone who buys a home as a primary residence.

    Even more equitable would be a tax on consumption (as opposed to income), which takes into account (and compensates for) the necessity by the poor to have to spend a greater portion of their income on basics, as the FairTax does.

  • http://www.sitejabber.com Nick First

    My argument for a flat tax credit was meant more as a response to needed reform on the mortgage tax deduction than commentary on the broader US tax system. However, I do believe a properly structured consumption tax would be more economically efficient than our current income tax system (although is politically DOA at the moment). One of the most articulate commentators on this subject, in my view, is Greg Mankiw at Harvard.

  • Clavos

    A well structured consumption tax would eliminate ALL deductions, including the mortgage interest one, but I agree that such a tax is a dead issue for the foreseeable future.

    Pity.

  • http://www.sitejabber.com Nick First

    Yes, my friend, we sadly live in a political world where we must treasure small victories in the name of more efficient economics.

  • http://www.kanitz.com stephen

    This is why americans are the most leveraged people in the world. Tax code allows you deduct 100% of NOMINAL interest, say 6% , whicj is 300% od REAL interest, say 2% the rest is 4% inflation. This is the real cause of this global mess,second and third mortgages to be able to buy tax deductable SUV and so on. Great analysys

  • FALSE

    Just came accross this article (a bit late..I know), and REALLY feel the need to comment. The tax deduction is limited to the interest on a $1M loan. Any interest on a mortgage larger than that is NOT tax deductible. Therefore, your argument that “high income earners are then encouraged (and subsidized) to buy ever more expensive mansions and borrow even more money through ever larger jumbo mortgages” is just plain FALSE.

    Consequently, your argument about the rich getting the biggest benefit is flawed at its core, as the middle class and even the borderline poor who can afford to buy are able to take the full deduction for their mortgage interest, while the rich are only able to deduct a small fraction of the total mortgage interest actually paid. Maybe you should reconsider who is getting the short end of the stick with this one.

    The author of this article is incredibly ill-informed. It’s sad that he/she has a forum to spread his/her ignorance.

  • Charlotte Avery

    The interest on your home mortgage may be fully deductible as an itemized deduction. There is no dollar limit on the amount of interest you can deduct annually, but there are limits on the size of the mortgage on which the interest is claimed. The mortgage interest rules applies to both fixed and adjustable rate mortgages.