Crush That Mortgage Interest Deduction!

Writing from his huge villa on the hillside (three miles northwest of my 3400 square foot villa in the canyon) Hal Varian endorses the Tax Reform Commission's attempt to cut back on the home mortgage deduction. He is, of course, right:

Economic Scene: Certainly the panel's least popular suggestion is to limit the mortgage interest deduction. Under current law, homeowners can deduct interest on mortgages of up to $1.1 million... the panel proposed that this cap be significantly reduced and that the deduction be replaced with a 15 percent tax credit.

A change of this sort would probably have a significant impact on housing values.... But many economists would argue that the panel's proposal does not go far enough.... The truth of the matter is that housing is highly subsidized in this country and we would probably be better off if the tax treatment of housing were brought more into line with that of other assets. How is housing subsidized? Let me count the ways... the mortgage interest deduction... the deduction for property taxes... the capital gains exclusion... the deduction for points on mortgage loans... the deduction of up to $100,000 on home equity loans... home office deductions... homeowners are not taxed on the implicit rent they receive from their housing investment....

An excessive subsidy on one asset means that less will be invested in other assets. The money put into building those huge villas on the hillside could have been put into factories, office buildings and schools.... Given the huge subsidies to housing, it is likely that we as a country have overinvested in this area....

[T]his is unlikely to happen anytime soon.... The housing tax subsidy has been built into housing prices... cutting back could lead to painful capital losses on home values. If you give a lollipop to a baby, it may make him smile, but you will pay dearly for that smile if you try to take the candy away...

Comments

[Maynard Handley]

Margaret Thatcher dealt with this (as I understand it) by both freezing the level above which the interest deduction not longer kicked in (so that inflation would whither it away), and reducing some multiplier of the deduction in the tax code over 30 years.

I find it very very strange (perhaps a byproduct of the fact that politicians are absolutely completely innumerate) that this is not done routinely in legislation. If phasing out certain things we mostly all agree are bad would cause some people severe immediate harm, stick in some sort "depreciation" schedule into the legislation and kill the thing over five, ten, twenty, fifty years as appropriate.

[Richard Green]

Homeownership is in my view a good thing. But the dirty little secret is that the Mortgage Interest Deduction does little to encourage homeownership. Most at the margins of homeowning are not itemizers, and thus get little incentive to become owners. On the other hand, the MID encourages people like me (and Hal Varian and Brad)to buy bigger houses in more expensive neigborhoods than we otherwise would.

The interesting thing is that the MID is a vestige of the orginal income tax code, which allowed for the deductability of ALL consumer interest. With the tax reform act of 1986, the homebuilders, realtors and other real estate groups convinced congress that the mortgage interest deduction, unlike other interest deductions, should be retained to "encourage" homeownership. It is a very inefficient method for doing so.

The tax commission's recommendation allows the tax code to target homeowning--as opposed to housing consumption--much better, because it gives a credit whose size is independent of tax bracket, and because it allwos non-itemizers to take the credit. The five-year phase-in would reduce havoc in the housing market. It is proposing a remarkably sensible policy.

[dearieme]

The British score (and still we have a housing bubble):-
the mortgage interest deduction ..X
deduction for property taxes..X
the capital gains exclusion...still there the deduction for points on mortgage loans...eh? So presumably ..X
the deduction of up to $100,000 on home equity loans...ditto...X
home office deductions...small beer homeowners are not taxed on the implicit rent they receive from their housing investment....they were until late 50s or early 60s.

[Hari]

Limiting housing subsidies is a good idea (and I'm in California!)

In an ideal world, no one would have to pay taxes. But given the need for taxes, and to do it in the fairest and the most economically efficient manner possible, the proposal to limit mortgage deductions is a very good and timely one.

The current housing subsidies:

1) Encourage and reward those taking on the largest possible amounts of mortgage and home-equity debt, as early as possible.

2) Discourage saving in general, and saving for a home purchase in particular because the savings are at a heavy tax disadvantage. The savings also lose purchasing power rapidly because the home prices are inflated by cheap and tax-advantaged credit.

3) Contrary to popular belief, make housing less affordable by inflating home prices excessively.
The proper way to make housing affordable is not by pumping cheap credit into the system while endlessly inflating prices, but by keeping house prices low and increasing supply. This will also reward those that save more while making it easier for everyone to pay off the principal (what an alien concept!?) instead of encouraging overconsumption and outsized debts.

4) Distort the economy by channeling capital away from more productive investments.

These effects are very clearly seen today in abysmal personal savings rates, and a housing bubble that is pushing people into taking larger and riskier loans.

Over the long run, limiting these housing subsidies will have a very positive effect because saving and investment will be increased, housing will be cheaper, and the economy will become more efficient and productive.

In the short run of course, there will be huge resistance to these proposals from those who stand to lose the most. Home owners have seen huge un-earned increases in their wealth in the recent past. These increases are largely a transfer of wealth from current and future homebuyers, and other taxpayers. The prospect of these unexpected wealth gains slowing down or reversing is not a compelling reason to avoid implementing a better and more equitable tax code.

Also, most opinions in the media seem to assume that rising home prices are a "good thing" to be cheered, while advocating reduced home prices is somehow completely unacceptable and almost sacrilegious. The past several years have seen enormous inflation in home prices with little income or job growth, primarily fueled by explosion of credit, tax subsidies and speculation. After 100% or more increase in home prices, if the prices are scaled back 20 or 30%, is it not something that should be welcomed? Are unlimited wealth gains for every homeowner and real-estate speculator part of a social contract that needs to be underwritten by future homebuyers, savers and other taxpayers?

Transitions can be tricky and specific measures might be looked into to ease the pain, but there is nothing more important for long run US economic health than to encourage saving and investment. These changes to the tax code are a step in the right direction.

[Crales]

Let me give you my "general equilibrium" take on the mortgage interest deduction. I haven't seen this little bit of economic analysis anywhere, but it seems pretty important to me.

The mortgage interest deduction is useless. It is worse than useless. But getting rid of it is a tricky business.

It is useless because prices have risen to almost exactly compensate for the supposed benefit of the deduction. This is, after all, a seller's market. Since everyone involved can compute the true price being paid by buyers (that is, factoring in the deduction), prices simply move up to this point in equilibrium (again, true because it is a seller's market).

It is worse than useless because this means that what the mortgage deduction has done is cause a giant wealth transfer from the federal government (who collect less in taxes) to "lucky" homeowners who managed to cash in on this bonanza before the prices re-equilibriated. The government collects less in taxes year after year so that some random individuals could get rich.

However, fixing this problem is going to be very difficult. The only people who will really be hit by this will be _current_ home owners, who, even if they are grandfathered in and won't lose their deduction, will take a huge hit in their home equity. New buyers won't suffer much at all -- prices will simply fall to match the new "true" price. OK, this might not happen all at once, but it will happen. Unless this is handled correctly, it could be a catastrophe for the housing market, because a) we are already in a bubble and we don't need a price shock like this and b) if prices only adjust slowly everyone will be anticipated falling housing prices for years, which is just what we need to totally stall the economy.

Any thoughts on this? Can we somehow design a way to compensate current owners that gets us out of this nightmare? Is doing it slowly, as a previous poster suggested, really enough?

[sean]

I don't get the idea of implicit rent at all.

If I buy a DVD, am I realizing implicit rent every time I watch it? (That should be taxed separately from the value of DVD itself when I purchased it?)

If I buy a tuxedo, am I realizing implicit rent every time I wear it?
(That should be taxed separately from the value of tuxedo itself when I purchased it?)

If I buy a car, am I realizing implicit rent every day that I drive to work? (That should be taxed separately from the value of car itself when I purchased it?)

Are there any ongoing realization events in any of these scenarios (or in the homeownership example)? The benefit is realized when you BOUGHT the fucking thing. And any taxes should accrue (and do!) at the time of purchase.

Implicit rent is fine as a way of comparing the relative value of buying versus renting (i.e., what would it cost you to rent rather than buy this place?), but isn't it nuts to suggest that in addition to buying your house, you should pay taxes on the amount that don't have to pay to rent it as well?

[sean]

To paraphrase the linked story:

"If you rent the [tuxedo] out to someone else, you owe tax on the rental payments you receive. If you [use] the [tuxedo], you are effectively renting it to yourself, but no taxes are due on the transaction. Put another way, if you invest $[500] in the bank, you have to pay taxes on the interest you earn. But if you invest $[500] in a [tuxedo], which you [use], you don't have to pay taxes on the rent you save."

Yeah, doesn't it make sense that you don't owe taxes on rents you DON'T pay because you decided to buy instead. (BTW, the effect of property taxes should be neutral since they are factored into cost calculations by owners and price calculations by rental owners.)

[a]

"We could trade the mortgage interest deduction for AMT relief."

Now wouldn't that be sane? So my money's against...

[liberal]

Brad DeLong wrote, "Hal Varian endorses the Tax Reform Commission's attempt to cut back on the home mortgage deduction."

That's all well and good. But will Hal Varian---and Brad DeLong---endorse land value taxation?

[liberal]

sean wrote, "I don't get the idea of implicit rent at all. ... The benefit is realized when you BOUGHT the fucking thing. And any taxes should accrue (and do!) at the time of purchase."

Yes, there are taxes at the time of purchase (I suppose you mean on the seller). But the appropriate comparison is to rentals, not tuxedos or DVDs.

Of course, the tax code is complicated (and in this case made more complicated because it's local, so varies over space). But, roughly speaking, these taxes can fall on residential property:
(1) Capital gains tax, at time of sale.
(2) Property tax.
(3) Income tax, if it's a rental.

(1)--(3) fall on rentals. Only (1)--(2) fall on owner-occupied housing. This introduces an economic distortion, a bias against rentals. (Not only is this an economic inefficiency; it's inequitable, because people who own are on average wealthier than people who rent.)

[john eckstein]

Never

Going

To

Happen.

So move on to the next idea.

[Robert]

While the MID IS a direct subsidy mostly to those who need it less, and IS distortionary from an efficiency point of view, isn't excessive liquidity resulting from negative real rates coupled with households/investors' probable errors in extrapolating the trends of "free" money and rising capital values ad infinitum, the more for more important distortionary issue?

[Matt]

Ain't gonna happen. The mortgage interest and property tax deduction and the third and fourth rail of American politics.

And how do you address the argument that millions made plans for their long-term future and bought their current homes based on the existence of (and anticipated future existence of) the mortgage interest and property tax deductions? Past policy has implications for future policy: one is not designing an ideal tax system ab initio.

[Randy]

If the concern is investment; there's a lot of money waiting for the next wave of innovation. Much of it is sitting in real estate. But there's no point in trying to move that money out of real estate and into "more productive investments" until said productive investment opportunities exist. And when they do exist, when the next wave of innovation occurs, the money will move on its own. The housing market will plateau - and it is good that the value being stored there is not being lost.

[ionides]

I agree with Sean on implicit rent. I think the whole concept of imputing economic value to non-market activities is questionable. Implicit rent is just one instance; another is including the value of home-makers' services to themselves as part of GDP.

I think the fundamental error here is to consider all productive activity economic. Most of living consists of productive activty. When I tie my shoes, should the GDP rise by the amount of labor services involved? After all, I could have hired someone else to tie my shoes. When I read a book, should I be taxed on the services of human captical I am consuming in the act of reading? After all, my skill in reading is an asset; again, I could have hired someone else to read to me. We need to define a domain of economic activity which is not co-extensive with life itself, a domain involving exchange of some sort between agents; perhaps the market only, or perhaps something broader, including charitable acts; defining a precise boundary would be interesting, but it should start from the proposition that economic activity is only a sub-set of behavior. George Reisman has an interesting and humorous commentary on this question in his book "Capitalism".

[tom n]

When would a government subsidy of a given behavior make sense?

I hope I don't mangle economic terms but I believe it would be when there are "extranalities" to society that would not necessarily figure into an individuals cost benefit analysis (which would be answered by the market)

Arguing or proving the extranalities in any case would take leghtnthy sort of enviromental impact sort approaches...

.but heres my basic agrumenent.

Renters whether rational or not, tend to take less interest on average in building the social fabric of a community. Sometimes that is because they are more only mentally short termere in a area, some of it might be the economic incentives home owners have in neighborhood effects on their investment, some of that is irrational bias people have to "fear of loss".

I would imagine a comparasion of renters with below market rent controlled appartments would start behaving more like home owners because they begin to have a vested "property interest" demonstrating that "ownership" could take different forms.

Much "evidence" would seem unscientifically annectdotal, but difficult at that might be to pin down some behaviorial economists are able to do so.

I can tell you that people "owning a home" are more likely, even with similar disposable income, to put up the holiday wreath or plant some marigolds in the spring, or call the police about suspicious behavior. Now certainly home ownership "selects" a class of people *on average* with their act "slightly more together" but I still think that if you take the same person and make them an owner of the place they rent you'll immediately change their behavior somewhat in ways that create positive extralities for society.

Can higher home ownsership rates reduce crime and number of criminals? Can a cleaner livinging environment caused by homeowners in a condo or a coop being more likely to pick up a piece of garbage or paint over graffiti lead to happier residents more likely to further education or less inclined to urban pathologies?

Does enabling consumers to buy lead to market forces creating a better built environment even within the same location? Apartment towers built for ownership might have better sound proofing, storage light etc to meet users needs where non-neutral effects on consumer scrutiny, differences of Irr expectations of home owner and finacial investor might make incremental choices differently.

Opening the debate on how high a motgage subsidy, what sorts of housing to subsidize etc truly makes sense. (and transportation and water use subsidies and extranalitiy costs need to be considered perhaps even more)

But I think it would be a real danger to ignore the economics of the positive extalities that stem from having most people having ownership related interests in where they live.

A parting shot...the Cites in France. Had the residents of those Cites been given housing stipends of their pro-rata cost to the government how differently would integration happened? Had the stipend be allowed to be applied to individual ownership would some families have been able to move into the older more "mainstream" french cities? Even had the crummy buildings themselves been turned into ownership coops would say 15 or 20% of those developed stronger internal intiutions or pride or whatever that helped more of their youth into the job market ?(ok that might be stretching it because I seriously belive that the shape and texture of the towers actually breeds community ill will due to physical design)

[enfant terrible]

David Sucher:
"Here's another point. It seems to me that if we get rid of the home mortgage interest deduction we are disadvantaging buyers versus renters...unless we want to get rid of the deductibility of interest payments for business investments (e.g. an apartment buiilding) as well."

The issues are more complex than either side presents. Landlords get to deduct interest, but also pay income tax on rent (to the extent that it exceeds expenses) and capital gains tax on the value of the property. (There may also be local taxes on the rent transaction, but let's ignore that.) Homeowners now get all three breaks; if they lost interest deduction, they would lose the one break landlords get, but would still have the two breaks landlords don't have. It is not clear if the net subsidy would be to home ownership or to renting. It is clear, however, that now the subsidy is to ownership.

Also, a subsidy to ownership is not the same as a subsidy to owners. It may just be a subsidy to builders of houses that are meant to be owner-occupied.

Finally, the relative position of owners vs. renters is important for issues of social equity, but not for the misallocation of resources Varian mentioned. What matters for that are the subsidies to the housing sector as a whole.

[Peter]

The Tax Reform Act of 86 clobbered almost everyone who invested in real estate, and everyone who rented out real estate. One of the biggest changes in TRA86 was that it eliminated MID from properties 2+. I was renting from a company who was squeezed by TRA86 (my ex worked for them), and we got squeezed when they started doing things like taking 3 years to return deposits (and only because I pestered the bankruptcy court over errors and omissions).

I suspect that a similar change in mortgage deductability would end up with a lot more bankruptcies.

[enfant terrible]

tom n
"Renters whether rational or not, tend to take less interest on average in building the social fabric of a community."

Yes, and your point that there are positive externalities of home ownership, so that it may be worth subsidizing, is IMO correct and probably not very controversial.

However, a different point was mentioned before in this thread: the existing subsidies are very inefficient. It is unclear if they increase home ownership at all. Home ownership in Canada is only 4% lower than in the USA (63% vs 67%) - and they are equal in the below-50 age group - despite complete absence of MID and a more favorable tax treatment of renters in Canada. (http://www.dise.unisa.it/WP/wp44.pdf)
As the USA is somewhat wealthier and has much fewer immigrants (relative to total population), you would expect homeownership ratio to be higher here. Thus the tax subsidies to ownership seem to have no effect overall, and a negative effect on the younger families. (And your externalities come primarily from younger people's behavior.)

[ent lord]

Just some random thoughts: My grandfather, who made money during the Depression by buying properties on the courthouse steps, always told me to keep your home free and clear, no matter what.
However, the advent of home equity credit lines where the homeowner can write himself a check for $10,000 or $20,000 without having to explain it to the banker, is irresistable. Bankers love home equity lines because people will borrow against their homes for luxury items or nonessentials when they would not borrow the money, say from a credit card company.
The big selling point is the deductibility of the interest. Buy a car and mortgage your house so the interest is deductible again.
Common sense of the home equity line to buy a new car? Grandfather always told me, "Don't mortgage the mule to cover the crop, don't mortgage the farm to cover the mule, don't mortgage your home to cover the farm or you will lose mule, farm, and home." Advice from a man who started life as an orphan, passed from family to family, and ended dying in his own home, no mortgage.

[Firebug]

Stuff like this from economists drives me fucking crazy.

Tattoo it on your foreheads, fuckers: THERE ARE MORE IMPORTANT THINGS IN THE WORLD THAN ECONOMIC EFFICIENCY. We do many things that are economically efficient. If you go down this path you'll soon find yourself meeting laissez-faire nuts like Milton Friedman (and his even nuttier son David).

Look: We have a strong cultural tradition in this country, going back all the way to its founding, that land and home ownership on the part of the masses is a good thing. Consequently, we have, through our government, encouraged such ownership throughout American history. Once we did so via the Homestead Act and land grants, now we do so via FHA/VA mortgages and the mortgage interest deduction.

It is utterly, completely, totally irrelevant to say that the mortgage interest deduction on housing means we have "overinvested in this area". THAT'S THE FUCKING POINT. Why would we pass a subsidy like this if not to change people's behavior to something other than the jungle marketplace would dictate? Use your head. God, I swear economists are the stupidest fucking people on the face of the earth. (After Doug Feith.)

[Hal Varian]

To quote from the column:

"Sure, homeownership is a good thing from society's point of view....Even if one thinks that homeownership deserves some subsidy, does it really deserve as much as it gets?"

The cost of subsidizing one form of investment is that you get more money going into that type of investment and less into others. I think that there is a good case to be made that the huge subsidies handed out to housing have hurt capital formation in other sectors.

An earlier poster asked "What's difference between buying a car (and saving taxi fares) and buying a house (and saving rent)?" It's a good question, but the simple answer is: you can deduct the interest you pay on the loan to buy the house, but not the interest you pay on the loan to buy the car.

If you were taxed on the implicit rent for the housing services or the car services, then it would make perfect sense to have the mortgage interest deductible, just like an owner of an apartment building can deduct his mortgage interest. But if there is no tax on the consumption of housing services, then what is the rationale for making interest deductible? (Other than handing out goodies to voters...)

Another poster pointed out that what matters is that transactions that occur inside the household aren't taxed, which is quite right. If I hire a painter to paint a room, the transaction is taxed. If I do it myself, there is no taxation. It's no accident that the do-it-yourself sector is much larger in countries with high income tax rates!

It would be "less distortionary" to have my work and the painter's work taxed at the same rate. But it isn't practical to do so, meaning that more people do it themselves than is optimal, contributing to the deadweight loss from the tax.

[wkwillis]

tom n
That tax redistribution thing takes tax money away from Democratic voting areas in the metrocoastal zones and gives it to Republican voting areas in the inland areas of California. Which is why it was passed.

[Lord]

As these other more productive areas of investment can't even provide returns exceeding mortgage rates, I guess we will just have to designate them goverment charities.

[DuckedApe]

tom n

Re: France
In Clichy-sous-Bois, where the riots began, 44% of dwellings (mostly apartments) are owned by residents, same as in posh Neuilly-sur-Seine (where Sarkozy lives, and household income is over triple the national avg). Nationwide, the rate is 55%.

When I bought in the 80's, I had a capped deduction for the first seven years. That was reduced to five years, and then phased out: not applicable to loans contracted after 1998. People still buy, both to avoid "throwing away" their rent, and because the rental market is tight and demanding. Or because their landlord decides to sell their apartment...but that is another topic!

[Doug]

Prof. DeLong,

I was emailing with a friend over the mortgage deduction, spurred in part by Clive Crook's essay in the December, 2007 issue of The Atlantic. So I did a little googling, and came across a comment to one your blog posts from 2005. (I've posted this note on the blog post as a comment, for posterity.) Is the similarity in wording mere coincidence? Take a look:

The Atlantic, December 2007, Housebound, Clive Crook:

"The current deduction costs nearly $80 billion a year in forgone federal revenues. It is available only to the minority of households—typically affluent— that itemize their taxes. Households at the margin of choosing between renting and owning are not, for the most part, itemizers. The deduction has no effect on their choice, and thus does almost nothing to promote homeownership. What it does promote, studies show, is spending on housing—that is, people who would have been owners anyway pay more for their houses."

---

Richard Green, commenting on Brad DeLong's blog, November 17, 2005:
http://delong.typepad.com/sdj/2005/11/crush_that_mort.html

"But the dirty little secret is that the Mortgage Interest Deduction does little to encourage homeownership. Most at the margins of homeowning are not itemizers, and thus get little incentive to become owners. On the other hand, the MID encourages people like me (and Hal Varian and Brad)to buy bigger houses in more expensive neigborhoods than we otherwise would."

Again:

Clive Crook: "Households at the margin of choosing between renting and owning are not, for the most part, itemizers. The deduction has no effect on their choice, and thus does almost nothing to promote homeownership."

Richard Green: "Most at the margins of homeowning are not itemizers, and thus get little incentive to become owners."

So my question is:

Has The Atlantic's Clive Crook plagiarized one of your blog commenters?