David R. Henderson  

Hugh Hewitt on the Interest Deduction

PRINT
Gruber on Romney and Obama... Deficits always matter...

In yesterday's Wall Street Journal, talk radio host Hugh Hewitt has an op/ed titled "Policy Purity is Bad Politics." In it, he argues against capping the mortgage interest deduction.

I'll comment on three things:
1. His economic analysis,
2. His political analysis,
3. My own puzzle about realtors' views on this.

1. His economic analysis.

Hewitt's economic analysis is approximately correct. He quotes the statement of economist Richard McKenzie, who has often written the Econlib Feature Article, to the effect that "the value of every home in America would decline by 10% to 15% the day after the deduction is capped." I don't know if he has quoted Richard correctly. My guess is that Richard was analyzing not a cap on the interest deduction but a complete elimination of the interest deduction. If the cap were a very low number, say, on the order of $5,000 per year (which would be the interest, at 4%, on a $125,000 loan), then Hewitt is roughly correct. If the cap is a high number, on the order of, say, $20,000 per year (the interest, at 4%, on a loan of $500,000), he's incorrect. The cap would hurt owners of higher-price homes but because the majority of homes are valued at under $600,000 (this allows for a loan of $500K and equity of $100K) they would not be much affected. And it probably wouldn't be the next day. House prices, unlike prices of widely paid stocks, are sticky. But it probably would happen within a year.

One major problem, though, is that Hewitt's argument could be used to argue against almost any major tax reform in which reduction of deductions is traded for lower tax rates. In fact, Hewitt, in this very article, proceeds to do that, arguing against limiting deductions for state and local taxes.

2. His political analysis.

Hewitt writes that Americans live:

in homes they bought at a value based on the existing deduction, in states whose taxes were partly offset through the federal code. Change those rules and what's left of the GOP in high-tax states will be gone.

But two of the highest tax states are California and New York, and there's little of the GOP there anyway. (Hewitt and I live in what is effectively a one-party state, California.) So a cap, say, of $20,000 on mortgage interest and a cap on the deductibility of state and local taxes (the latter include property taxes) would disproportionately hurt the owners of high-price homes. Where are those pricy homes disproportionately located? In coastal California and urban New York, which, as noted, is where the GOP is already very weak. So a cap would be seem to be potentially a smart political move, not a dumb one.

3. Why do realtors oppose the cap on mortgage interest deductibility?

Hewitt points out that after President-elect Trump announced Steven Mnuchin's nomination, Mnuchin said that the administration planned to "cap mortgage interest, but allow some deductibility." Hewitt writes, "That instantly energized the 1.2 million-strong National Association of Realtors against the tax reform."

I don't doubt Hewitt's statement. The NAR has always been one of the strongest defenders of the mortgage interest deduction.

What I wonder is: Why? You might say that it's because the 6% they get on sales of homes gives them a lower amount when the homes sell for a lower amount. Maybe that's it and end of discussion. But offsetting this factor is that the equilibrium of home ownership changes. People who find that the cap makes owning a home too expensive would try to sell. Other people who might buy are people wanting to pay a large down payment and take out a small loan. So there would be more buying and selling transactions. This means more commissions for realtors. It's not obvious to me that on net realtors would be hurt.

Of course, it's also true that many realtors buy houses and condos on their own accounts. I can think of a number of realtors in the Monterey area of whom that's true. So maybe much of the NAR opposition is due to the fact that many of them would take a capital loss. That might be one's first reaction. But probably almost all of these properties they buy on their now account are ones they rent. And when you rent, you get to deduct the mortgage interest and the property taxes from the rent. I doubt that Mnuchin's proposal would change that.

So I'm still left with a bit of a puzzle.

HT2 Mark Barbieri.


Comments and Sharing


CATEGORIES: Taxation




COMMENTS (19 to date)
Zeke5123 writes:

Adding to this complexity is renting. One thing the House tax bill puts forward is current expensing for business expenses. Thus, an apartment (or house) purchased for a ToB (i.e., rental) can be written off immediately. This makes homes purchased for lease a potentially lucrative investment. This could offset the price decrease based on the reduction of the mortgage interest deduction.

The group I think that would be against it is the banks / loan originators. People might try to equity finance more of their homes if they lose the mortgage interest deduction. This, coupled with the proposed elimination of interest deductions for businesses, could cripple banks. However, that could be a good thing (as debt-equity decisions should be driven by business risk).

Kevin Erdmann writes:

I think this makes the argument for eliminating corporate taxation even stronger than it already is. Homeowner exemptions from capital income tax (imputed rents and mortgage interest deduction) are highly regressive. Taken as a whole, removing all taxes (and tax exemptions) from capital income would be a progressive change.

Harry Watson writes:

Most itemized deductions are phased down already for high income tax payers. For joint returns income in 2017 that is over 313,000 the deduction is reduced by 3% of the amount of income over the threshold. The deduction cannot be reduced by more than 80%. Thus mortgage interest and sate and local taxes are already limited.

Andrew_FL writes:
One major problem, though, is that Hewitt's argument could be used to argue against almost any major tax reform in which reduction of deductions is traded for lower tax rates. In fact, Hewitt, in this very article, proceeds to do that, arguing against limiting deductions for state and local taxes.

Why is it a problem that an argument against a tax increase could be used to argue against other, similar forms of tax increase, also?

JFA writes:

David, you say, "But offsetting this factor is that the equilibrium of home ownership changes." Yes, the equilibrium ownership changes in that it decreases. Take a textbook lump-sum demand subsidy analysis (not exactly equivalent to the interest deduction, but it illuminates things). The subsidy increases quantity and price. But there is a difference in the price homeowners receive (higher than previous equilibrium) (this is what will determine the commission) and the price consumers pay (lower than the previous equilibrium). Take away the subsidy and the price homeowners receive decreases (going back to the original equilibrium and decreasing the size of realtors' commissions) and the quantity decreases (going back to the original equilibrium and decreasing the number of commissions realtors receive). Removing the mortgage interest deduction is a double whammy for realtors. They know where their bread is buttered.

Yes, you would get those few people who happen to have huge amounts of cash to put down on the purchase of a house, but my intuition tells me that those buyers are few and far between and that the vast majority of buyers are those for which the current interest deduction is a deciding factor (given current house prices).

Vivian Darkbloom writes:

@Harry Watson and Kevin Eerdman

The more significant existing cap on the mortgage interest deduction is that it is limited to interest on mortgage debt of less than $1.1 million. This tax deduction is effectively a middle class tax benefit. One should not speak of imposing a cap but of reducing the existing cap.

David R. Henderson writes:

@Harry Watson,
Good point.
@Andrew_FL,
Why is it a problem that an argument against a tax increase could be used to argue against other, similar forms of tax increase, also?
That’s not a problem. The problem is that an argument against a revenue-neutral change in taxes can be used against other similar revenue-neutral changes in taxes.

Peter H writes:

I want to just look at the question of the incentives faced by the NAR. I see a few factors.

1. In the long run, reducing the tax benefits of homeownership is likely to mean less capital is invested in homes. As such, it would imply the amount of money that realtors will make when the dust settles is reduced, since they're fighting for a slice of a smaller pie.

2. It will likely change the mix of buyers of residential real estate if it makes individual homeownership less desirable. If the housing mix goes to more rentals, that might be bad for realtors, who would be faced with a much more hard nosed clientele who may not use a realtor at all or who may negotiate hard for fees. And investors aren't as easily upsold on bigger houses than they really need.

3. There are marginal costs per sale made, and a new equilibrium of more sales at lower dollar figures is less profitable than fewer sales at higher dollar figures, all else being equal.

perfectlyGoodInk writes:

I think the reason realtors would oppose is that the increase in transactions would be a one-time blip until a new equilibrium was reached. However, this new equilibrium would be at a lower price level, resulting in a lower level of commissions.

Jim Glass writes:

Hewitt's economic analysis is approximately correct...

I dunno about that, even assuming "not a cap on the interest deduction but a complete elimination of the interest deduction".

"...He quotes the statement of economist Richard McKenzie ... to the effect that "the value of every home in America would decline by 10% to 15%..."

OK, quick and dirty: My trusty amortization table says that over the full term of a 30-year 4% mortgage interest payments will be just over 40% of total payment costs. Of course a lot of people sell their homes before then, if the average mortgage is in its 10th year (instead of 15th) interest is 55%.

IRS Statistics of Income gives the average marginal tax rate on itemized returns that deduct mortgage interest at 25%. Applied to 40%, the deduction saves 10% of carrying cost, applied to 55% it saves 13.75% (maybe boosted up to 15% for argument's sake). I presume this is where the Hewitt-McKenzie claim comes from.

But the solid majority of homeowners don't take the deduction. Census gives 74 million owner-occupied homes while IRS reports 33 million annual deductions, that's 44%.

Apply that to 10% or 13.75% and we get the deduction accounting for only 4.4% or 6% of total home values.

And that is an upper bound, assuming every home's value is 100% financed by a mortgage (no down payments or unfinanced appreciation) ... neglecting all the variable rate and shorter-term loans that carry a rate closer to 3%. ... and also the fact that the deduction is already capped at the interest on $1 million of purchase borrowing (plus $100k of home equity borrowing) so rich people like Trump already can't use it on their mansions. And even moderately rich people can't cover their McMansions and second homes with it. A whole lot more of home value is not giving any deduction there. Adjust the final figure down further for these items, accordingly.

Plus, of course, many decades of hard political experience have shown that even this resulting number will never be seen, this deduction will never be repealed outright -- and Mnuchin in using the word "capped" isn't pretending it will be here. If the already existing cap on the deduction is reduced from the current $1 million of borrowing to any politically survivable amount, the result will be negligible.

So ISTM that Hewitt is pretty much blowing smoke at a straw man.

Jim Glass writes:

Hey, Vivian, good to see you. I missed your comment - you get the credit for bringing up the purchase price cap.
~~

One major problem, though, is that Hewitt's argument could be used to argue against almost any major tax reform in which reduction of deductions is traded for lower tax rates. In fact, Hewitt, in this very article, proceeds to do that.."

Good thing for him he wasn't around for the Tax Reform Act of 1986 -- the most successful US tax reform ever and one that in following years was emulated around the world. His head would have exploded!

Deductions were wiped out en masse. Those that survived lost near half their value for Hewitt's favorites as the top tax bracket was slashed from 50% to 28%. Even the favorable tax rate for long-term capital gains was totally eliminated! How many people counted on that?

The entire tax shelter industry was crushed (and we've never seen the like of it since). I mean, people didn't just lose the returns they expected and were relying on, entire major 'investment' firms went bust, and good friends of mine who worked at them wound up unemployed on the street.

Worst of all, it cost me a long string of very nice free lunches. I was a young puppy lawyer at the time and investment advisers from those firms regularly bought me lunch at the Plaza and other nice places to sell me on the merits of the sca^h^h, er, investments they were selling. (Buy me lunch and I'll be your friend.)

All gone with the stroke of a Presidential pen. How did the Republicans ever survive all that? I never voted for Reagan again.

Andrew_FL writes:

@David R. Henderson-

That’s not a problem. The problem is that an argument against a revenue-neutral change in taxes can be used against other similar revenue-neutral changes in taxes.

So you can inoculate any tax increase against this argument by putting it in the same piece of legislation as some tax decrease of allegedly identical magnitude?

David R. Henderson writes:

@Jim Glass,
Well done.

Vivian Darkbloom writes:

Jim,

Great comment, as usual.

I would add with respect to Reagan that the mortgage interest deduction was never mentioned in the tax code until the TRA of 1986. Until then, all interest was deductible. The special mention of the mortgage interest deduction was actually part of a much greater *restriction* in that it limited the deduction to mortgage interest (but was a major concession to the real estate lobby). But, the next year, in the 1987 OBRA, the further $1 million/$100k restriction was enacted. This did not seem much of a restriction at the time; however, the wily Reagan, who was famous for his observation about bracket creep on tax rates, did not index those caps. As a result, the effective cap has been reduced every year since and will continue to be further effectively restricted without doing anything!

Mr. Econotarian writes:

I have much empathy for people who benefit from the home mortgage interest deduction, but perhaps less so since I moved out of an underwater house which is now a "rental property" and no longer get it (of course I rent my new house with no way to sell my old one).

But it is inefficient, market-distorting, and reduces the flexibility of workers to move to areas of job growth.

The deduction should be phased out, not capped. The phase out should be slow to not be so painful, perhaps over 20 years.

Peter Gerdes writes:

Even if reducing the deduction results in more turnover it's far from clear that existing full time realtors would benefit substantially. The amount of time many people work is often quite sticky over the short term with little benefit provided by working fewer hours and perceived great cost to working more.

Thus, as in many other industries, it is entirely possible that the short term rise in activity will be absorbed by an influx of new realtors or part-time realtors moving to full time. While the views of the NAR are surely biased toward full time career realtors.

In either case the bump in activity will be short and, absent a change in fee structure, long term harmful to realtors.

Thaomas writes:

The failure to tax the imputed income from owner-occupied housing (presumably in pursuit of something or other) is a large tax subsidy to high consumption taxpayers. Capping the deduction might be an offset, but I'd prefer a partial tax credit so that a dollar of subsidy is worth as much to the low-consumption taxpayer as the high consumption tax-payer.

Mark H writes:

Your comment that it would be a politically smart move for the democrats to kill the mortgage interest deduction because of the predominance of Dems in NY & CA shows the disconnect between the Coastal-elite Democrats & the average person in this country and is a perfect indication of why Hillary lost the election.

You're correct that the uber-wealthy don't care about the current mortgage interest deduction (e.g., Mark Zuckerberg's $100,000,000 Hawaii property). With the current mortgage interest deduction capped at $1M of principal, what does he care about getting that deduction or no deduction at all (coupled with the 3% phase-out of itemized deductions previously mentioned, he really doesn't lose out if mortgage interest is not deductible). However, the current $1M cap on principal gets a mortgage interest deduction for the other 99% of American homeowners. As a California CPA that prepares taxes for plenty of Democrats & Republicans, believe me, it IS a big deal to lose that deduction.

David R. Henderson writes:

@Mark H,
As a California CPA that prepares taxes for plenty of Democrats & Republicans, believe me, it IS a big deal to lose that deduction.
Of course it’s a big deal. That doesn’t address my point, which is that the Republicans have little to lose by losing further votes in California and New York.

Comments for this entry have been closed
Return to top