Arnold Kling  

The Politics of the Mortgage Interest Deduction

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Ed Glaeser is naive. He writes,

Wyden-Gregg option is to limit the mortgage deduction to exclude second homes, home equity lines, and mortgages over $500,000. Lowering the upper limit on the home mortgage interest deduction should appeal to progressives, who want less largess for the wealthy, and to small-government conservatives, who dislike public paternalism. Unfortunately, the demons of discord seem to have prevented either group from embracing the reform.

Pointer from Mark Thoma.

Glaeser sees the opposition to this reform in very superficial terms, as Democrats wrongly defending the "middle class" and Republicans wrongly opposing any tax increase. Glaeser ignores the elephant in the room, which is the housing lobby, and how lobbying works in general. If you are a lobbyist for the real estate industry, AARP, or public sector unions, you believe that any policy that could be construed as a defeat for your lobby must be killed.

For the real estate industry, the problem with giving in to Wyden-Gregg is that it would show weakness. Once we have been defeated once, the thinking goes, we can be defeated again. If our goal is to maintain the mortgage interest deduction, we must show that any attempt to trim the deduction, no matter how sensible and narrow, will result in devastating electoral punishment from the housing lobby.

What looks like a small, sensible reform to someone not involved in lobbying takes on enormous significance to the lobbying group. Thus, seemingly sensible reforms that both parties might support can be as difficult to enact as more comprehensive measures. Again, this is also true for trying to trim public sector employee compensation or for trying to reform entitlements. The lobbyists fight small reforms just as vigorously as they fight larger changes.

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COMMENTS (15 to date)
aaron writes:

Shift the deduction to principal payments.

Here's what I'd like to see in short term.

I'm not so sure QE is "bad" itself, rather that it will be bad if done before structural problems are fixed first. We need to prevent the money from going into commodities (reduce constraints on supply, increase investment in supply).

We also need to create policy to reduce peoples debt levels. That means putting policy in place to facilitate, and encourage banks to institute, a Moratorium on Bubble Mortage Interest. That is, interest should be applied to principal for bubble mortgages that are in good standing and the homeowner should be able to deduct that principal on their taxes for a while. It would be nearly costless.

Effects of the Bubble Mortgage Interest Moratorium are:

Government, losses some tax revenue in the short run due to lower bank profits.

Banks, Cash flows improve as people have greater incentive to make their payments. Balance sheets improve and less taxes are paid (lower profits during moratorium). Reduced foreclosures and short-sales. House values are less likely to fall.

Banks, lose some profit if people are able to refinance at lower rates sooner. Banks also lose at the end of mortgage, as it is payed off earlier; these losses are very small and very far in the future. Banks can also lose at sale the amount above principal, up to the amount of scheduled interest during the moratorium, that the home sells for. Again this would occur in the future so the loss would be discounted.

Homeowners balance sheets improve. Uncertainty diminishes.

Homeowners who are ultimately insolvent may be given false hope and make payments they shouldn't.

Fed, value returns to some toxic assets, since many of the instruments were created under the assumption of prepayment of principal and non-payment of interest (the operating model was that people moved frequently and bought houses to invest in and sell). This will offset some of the lost tax revenue.

A policy to prevent over speculation in higher commodities prices might be an oil tax that is progressive, increasing as the price of oil increases. Starting at $65 a barrel it may be 10%, increasing as prices rise to 50% at $100/bbl. Or, a similar tax on transactions that don't result in physical receipt.

Lord writes:

It probably has less to do with that than congress people owning second homes which are frequently more expensive than that. Lobbies are far more effective when they support your personal interest.

Les Cargill writes:

In order for people to understand that the mortgage interest deduction is Bad, they must understand that it has the effect of making housing more expensive.

Since they think they get something for nothing, this will not happen. I can't tell you how many supposedly educated people I have encountered who justified twice to three times the house they could *really* afford by this deduction.

You don't have to resort to lobbies - this is perceived as a subsidy to every homeowner, even if it isn't necessarily.

GU writes:
"Shift the deduction to principal payments."

No, end the mortgage interest deduction and don't replace it with anything. The tax code is not supposed to give deductions for personal expenses, also known as consumption. If we allowed people to deduct their personal "expenses" the only people who would pay tax would be people who don't consume all of their income during the year (i.e. savers). This would obviously destroy the tax base.

It would only make sense to give a mortgage interest deduction for personal residences if we taxed the imputed rental income homeowners receive from living in their houses rent-free. Since we don't tax imputed income, individuals shouldn't get to write off expenses associated with the tax-free asset. This is tax policy 101.

GU writes:

"In order for people to understand that the mortgage interest deduction is Bad, they must understand that it has the effect of making housing more expensive."

A great, and also short (4 pages) and entertaining piece, on this topic was written by Boris Bittker and entitled Tax Shelters and Tax Capitalization, or, Does the Early Bird Get a Free Lunch?. It was originally published in the National Tax Journal in 1975, but has been reprinted in a few books since then.

It could convince a few people I would think.

David N writes:

That is the lamest argument against the MID you've made so far. "My 'sensible' idea is not deeply unpopular, it must be Big Housing..."

Everyone -- especially Ed Glaeser -- talks about the MID as if it was created specifically and nefariously to fuel the housing boom, when the opposite is true. All personal interest was deductible for 73 years. That was a simple, sensible policy. Why don't we go back to that?

When corporations can deduct interest expense and individuals can't, government has given corporations an artifical rent. Today, if you want to avoid paying tax on auto loan interest, lease your car. Tomorrow, if you want to avoid paying tax on mortgage interest, lease your house.

David N writes:

GU, homeowners aren't taxed on imputed rental income, but they also can't deduct real or imputed expenses in labor, materials, and depreciation. The actual benefit and appropriate taxable amount would be imputed rental profit, obviously a much smaller figure. And there's always the possibility of an imputed loss.

GU writes:
"All personal interest was deductible for 73 years. That was a simple, sensible policy. Why don't we go back to that?"

Because personal interest is best described as consumption, and income taxes are supposed to tax consumption (I = C + ∆W, where I is income, C is consumption, and ∆W is change in wealth). Allowing a person to deduct, say, his credit card interest, means taxes have to go up on someone else. This is usually accomplished through higher marginal rates, which undeniably causes deadweight loss. We're all better off with the broadest tax base and lowest marginal tax rates possible.

Sorry bub, "I want my taxes to be lower" is not a coherent public policy argument.

GU writes:
"homeowners aren't taxed on imputed rental income, but they also can't deduct real or imputed expenses in labor, materials, and depreciation. The actual benefit and appropriate taxable amount would be imputed rental profit, obviously a much smaller figure. And there's always the possibility of an imputed loss."

Insofar as the homeowners themselves do most of the labor and upkeep, they're again tax-exempt from their imputed labor income. So unless we start taxing housework, there should be no deduction for owner-performed labor. But your point holds re: the cost of materials and depreciation*, and I did not mean to imply that a more economically correct version of taxation would exempt those.

*True economic depreciation would be less generous than the current depreciation laws on the books. It is probably too onerous, however, in the real world to get a true depreciation measure because of valuation issues.

David N writes:

Allowing a person to deduct his credit card interest might result in that person carrying a higher balance, therefore paying more interest to the issuer, who in turn will pay more tax on that interest income.

At the risk of being so impertinent as to warrant being addressed as "bub," I have to insist that "I want my taxes to be lower" is a dishonest summary of my argument, even if it is true.

lxm writes:

Sure it's true that the housing industry will fight this reform, but let's not forget that rich folks will fight this reform as well. (Many in the housing industry qualify as rich, and the housing industry lobbyists are certainly in the rich category).

You can't blame the housing industry without also blaming the rich, even if you do not want to say it out loud.

But you can certainly try.

Get real.

Do you really think the rich need welfare? I know they think they deserve it. But is that what you favor as well?

GU writes:

David N.,

I regret the "bub" comment, and if I could edit the post I would erase it. Sorry.

[I could edit the post, but since you all have worked it out, it would make the conversation a bit hard to understand.--Econlib Ed.]

Simon K writes:

I think the mortgage deduction would be a lot less popular if more people did the arithmetic and figured out than in order to benefit from it, your mortgage has to be getting on for $300k at current interest rates. In expensive areas that's not much admittedly, but its way, way above the national average.

Thomas Esmond Knox writes:

Interest expense on a mortgage on one's home is not deductible in Australia.

I think this is a splendid rule. Among other things, it acts as an incentive to pay off your home loan, & a disincentive to use one's home as a "cash cow".

R Richard Schweitzer writes:

We are here dealing with taxation of something called "income," not taxation of transactions.

So, what is a "deduction?" How does it relate to defining "income" for purposes of taxation?

On the personal level, if there were NO deductions, would the tax not be simply a transaction tax on compensation received, proceeds of asset dispositions, and the like?

Why do we not tax the gross proceeds received from disposition of assets (no provision or deduction for what they cost)? By allowing recovery of cost, we are thus defining the income as gain (or loss).

The allowed "deductions" say: "This much of your money you may dispose of in this fashion, within these limits, for medical needs, charity, certain forms of interest expenses (presumably selected because they generate tax revenues elsewhere), etc." Thus we get to the "all else" that is taxable income.

Shall we now say that every transaction results in "Income." Let us now tax all transactions a la VAT.

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