The mortgage interest deduction — considered by many to be the sacred cow of tax breaks — has joined the list of possible items on the chopping block in the growing debate between President Obama and Congress about the so-called “fiscal cliff.”
However, research coauthored by Wharton real estate professor Todd Sinai indicates that eliminating the deduction may not pay off. In a recent paper titled, “Revenue Costs and Incentive Effects of the Mortgage Interest Deduction for Owner-occupied Housing,” Sinai and James Poterba, a professor of economics from the Massachusetts Institute of Technology, examine consumer finance data to “analyze how changes in the income tax deduction for mortgage interest would affect loan-to-value ratios on owner-occupied homes, the distribution of income tax liabilities and the consumption of housing services.” (The paper was included as a chapter in the book, Economic Analysis of Tax Expenditures, published by the National Bureau of Economic Research last year.)
In light of the evolving budget talks in Congress, Knowledge at Wharton Today spoke with Sinai about his research, and what an elimination of the mortgage interest deduction would mean for consumers and the housing market.
Knowledge at Wharton Today: Why do you think the mortgage interest deduction has gone from being viewed as largely “untouchable” to being one possible area for cutting in the budget debate?
Todd Sinai: I am not sure it is any less “untouchable” than it was before. Instead, when Congress decides it needs more revenue, the two easiest ways to raise it are to increase tax rates or eliminate exceptions from the tax base, called “tax expenditures.” Tax expenditures are big-ticket items. The Office of Management and Budget estimates that over the five-year period spanning 2012-2016, the tax revenues foregone by allowing a deduction for mortgage interest will total $609 billion, the second largest tax expenditure (behind not taxing employer-paid medical insurance premiums as income, at $1.07 trillion). If the government needs revenue, it needs to look at these big-ticket items, and thus the mortgage interest deduction (MID) has surfaced in the debate about the fiscal cliff.
Nonetheless, “raising revenues” still means someone has to pay more taxes, so the political difficulty of eliminating the mortgage interest deduction remains. Not only will tax bills rise, but as my Wharton colleague Joe Gyourko and I found in earlier research, they will rise disproportionately in the major metropolitan areas of the Northeast (from Washington, D.C., to Boston), and along the West Coast. Residents of those metropolitan areas, who have high incomes and expensive houses, have the largest tax savings from the mortgage interest deduction and thus stand to lose the most if the deduction is capped or eliminated.
It seems politically difficult to reduce a tax expenditure that benefits a concentrated group of politically important citizens — the residents of these metro areas — but perhaps the fiscal cliff will create the political will to do so. Also, bundling a mortgage interest deduction reform with other tax changes that might offset some of the distributional impact, much in the way the Simpson-Bowles Commission had in mind, could perhaps help make a change in the mortgage interest deduction more politically palatable.
Knowledge at Wharton Today: Based on your research, what effect would eliminating this deduction have on the average consumer?
Sinai: If the deduction were eliminated completely, the average household’s annual tax bill would increase by a little more than $1,000. That number masks the real impact, however. Households earning less than $40,000 per year would see their tax bills rise by less than $110 on average — few of those households itemize on their tax returns and thus gain little benefit from the mortgage interest deduction, and those that do itemize tend to have relatively inexpensive houses. Households earning between $125,000 and $250,000, by contrast, would stand to lose nearly $2,700 in annual tax savings. And those making more than $250,000 — the ones subject to deduction caps under some tax reform proposals — currently save $5,400 per year on average from the mortgage deduction. It is worth noting that within any of those income groups, seniors (taxpayers age 65 or above) typically would face a much smaller tax increase than the average. By the time someone is age 65 or 70, they typically have paid off all, or nearly all, of their mortgage and thus have little interest to deduct.
Of course, households could mitigate the tax burden from the elimination of the mortgage interest deduction by using their savings to pay down their mortgages. They would have less mortgage debt, but they also would have less investment income and thus would owe less tax. However, many households are limited in their ability to do this reallocation. Households with a big mortgage typically don’t have a lot of investments that could be used to pay it off.
Knowledge at Wharton Today: What effect would an elimination of the deduction have on the housing market?
Sinai: For the homeownership rate, probably not much. Most research indicates that the mortgage interest deduction is not a particularly effective way of getting people to buy houses instead of renting. So, eliminating it would not deter many potential home buyers.
Rather, what the mortgage interest deduction is good at is encouraging households to spend more on housing once they decide to buy one. In the absence of the mortgage interest deduction, households would buy smaller or less fancy houses, or house prices would fall to partially compensate for home buyers’ having a higher after-tax interest rate. This effect would be largest in those metropolitan areas that currently gain the biggest tax savings from the mortgage interest deduction.
How much of an impact on existing home prices there would be from eliminating the MID is difficult to determine. The price effects are likely to be larger in the coastal and northeast corridor cities — not only do they have bigger subsidies, more of the subsidy is capitalized into house prices — but just how large is currently an unknown.
Knowledge at Wharton Today: Is there any upside to eliminating the deduction?
Sinai: Sure! There is a paucity of evidence that the mortgage interest deduction serves any useful economic purpose. While there are some arguments to be made that homeownership benefits communities and children, I’ve already noted that the MID is a poor mechanism for encouraging homeownership. If homeownership is our policy goal, we could eliminate the MID and redeploy the funds in a more effective way. Rather, since the MID mainly encourages housing consumption among people who would have bought houses anyway, we would be better off by eliminating the economic distortion that comes from subsidizing additional spending on that sector.
However, there are many factors at play besides the simple calculation of the economic inefficiency of a mortgage interest deduction. The MID has a large effect on the distribution of the tax burden across households of different incomes and ages, and some policymakers might view that as a positive. And, even if it would have been ideal to never have created a mortgage interest deduction in the first place, it does not follow that it is a good idea to eliminate or reduce the MID once it exists. Changing the mortgage interest deduction will likely reduce house prices in at least some vulnerable metropolitan areas, possibly leading to more foreclosures and certainly damaging the wealth of some older households who are counting on selling their houses to finance retirement. Reducing the value of the MID would have to be managed carefully to avoid collateral damage for individual households or the overall economy. Any plan would have to either be phased in slowly or use offsetting changes in the tax code to mitigate the risk of an excessive burden falling on any particular set of taxpayers.