Killing (or Maiming) a Sacred Cow: Home Mortgage Deductions
By Edward L. Glaeser
Edward L. Glaeser is an economics professor at Harvard.
The Great Depression provided an opportunity to rethink old policies in a major way. In the current morass, everything should, once again, be open for debate. One sacred cow that has long been in need of a good stockyard is the home mortgage interest deduction. So, in the spirit of libertarian progressivism, I suggest gradually reducing the upper limit on the deduction to loans of up to $300,000, and then refunding the tax revenues in a more productive manner.
The tax code allows homeowners to deduct the interest on loans used to buy, build or improve a home, for mortgage principals up to $1,000,000. (For mortgages used for other things – say, to finance the purchase of a car, or pay for college tuition – homeowners can deduct the interest they pay on loans of up to $100,000.)
A wide range of economists have long found fault with the deduction. Here are a few of the reasons:
Problem #1: Subsidizing interest payments encourages people to leverage themselves to the hilt to bet on housing markets. The size of the tax benefit is proportional to your debt. The deduction essentially encourages us to make leveraged bets on the swings of the housing market. That leverage means that housing price swings can easily wipe people out. We are currently experiencing the consequences of subsidizing gambles on housing.
Problem #2: The deduction pushes up prices in places where the supply of new homes is constrained, as it is in many coastal markets. Economics 101 teaches us that if we subsidize demand where supply is inelastic then the only effect is to make prices go up. Housing supply is pretty constrained in places like New York City because of land-use restrictions and lack of land. In these places, the deduction doesn’t make housing more affordable. It just transfers money from buyers to sellers, and that makes little sense.
Problem #3: The deduction is wildly regressive. The tax savings for households earning more than $250,000 is 10 times the tax savings for households earning between $40,000 and $75,000 a year, according to recent research by James Poterba and Todd Sinai.
If there ever was a case for small-government egalitarianism, then this is it. Eliminating the home mortgage deduction and replacing it with an across-the-board tax cut would equalize after-tax incomes without a single new government program.
Problem #4: The deduction encourages people to buy larger, single-family detached homes, and that increases carbon emissions and pushes people out of cities. The deduction encourages people to buy more expensive homes, which are generally bigger homes.
Bigger homes use more energy. The deduction is therefore implicitly urging Americans to run higher electricity bills and spend more on home heating. If global warming is a serious problem, then the government should be encouraging us to live in smaller, not bigger, dwellings.
Problem #5: The home mortgage interest deduction is poorly designed to encourage homeownership, which is, after all, the alleged desideratum. Much of the interest deduction’s benefits go to richer Americans who are likely to own homes in any case.
Poorer people who are on the margin of buying and renting often don’t even itemize. My own research in this area found that when the value of the interest deduction rose, during periods of high inflation, there was no observable increase in the homeownership rate.
If the goal of the deduction is just to increase homeownership, then it would make far more sense just to give a flat tax credit to people who buy homes. If the credit was independent of home value, then this would eliminate the incentive to buy bigger homes. If the credit was independent of borrowing, then this would decrease the incentive to over-borrow.
Now, I do understand that drastically reducing the cap on the mortgage interest rate now, in the midst of a housing crash, would be kicking the markets when they are down. Yet this crisis provides us with an opportunity to act that will be lost if we wait until housing prices rise again.
So here is my utterly quixotic proposal. Enact legislation now that will gradually decrease the cap on the mortgage principal for which homeowners can deduct interest payments by $100,000 a year over the next seven years until it hits $300,000.
The effect during the next two years should be sufficiently small that it will be unnoticeable in the current environment. Ending the madness of encouraging Americans to bet everything on housing, we can hopefully reduce the odds of a tragic repeat of the current boom-bust cycle.
