Will the Mortgage Interest Deduction Sacred Cow Finally Get Slaughtered?

The Washington Post reports that Congress and the president are considering abolishing the mortgage interest deduction as part of a deal to avoid the “fiscal cliff”:

Of all the deductions woven into the sprawling U.S. tax code, few have been more fiercely guarded than the enormous tax break that lets homeowners deduct the interest they pay on their mortgages.

But as Congress and the White House negotiate the first major rewrite of tax laws in decades, changing the generations-old mortgage-interest deduction — which costs the government roughly $100 billion a year — has gone from far-off possibility to part of the conversation….

Current law allows homeowners to deduct the interest paid on mortgage balances up to $1 million, including on second homes, as well as on $100,000 worth of home-equity loans. The deduction overwhelmingly benefits wealthier families, partly because they tend to have larger mortgages and pay more interest, and partly because most low- and middle-income Americans do not itemize deductions on their tax returns.

Most economists and property law scholars have long been critical of the deduction for reasons I summarized here. The deduction incentivizes overinvestment in land as opposed to other parts of the economy, and it skews people’s decisions towards homeownership and away from renting. Although homeownership has some benefits, it also has significant costs. On balance, government should be neutral between owning and renting, not try to favor one over the other.

As the Post points out, the deduction also overwhelmingly benefits the wealthy. The story quotes USC law professor Edward Kleinbard, as follows:

Edward Kleinbard, a tax expert and law professor at the University of Southern California, said the mortgage-interest deduction represents the kind of government “extravagance” that the country no longer can justify, given its fiscal troubles.

“We simply cannot afford wasteful government subsidy programs anymore, and this is one of the most important examples of that,” Kleinbard said. “It’s very much a subsidy to those Americans who need it least.”

I agree. However, as both the Post and Mark Edwards at PropertyProf Blog emphasize, the deduction still enjoys strong political support. Mortgage lenders and the real estate industry are among its powerful interest group backers, and it still enjoys considerable popularity with the general public, though many are willing to reduce it for higher-income homebuyers.

The deduction’s popularity and strong support from powerful interest groups have enabled it to survive previous attacks by would-be budget-cutters, not to mention years of criticism from scholars. It’s far from certain that its luck will run out this time. The sacred cow might yet wriggle its way off the fiscal cliff chopping block. But the severity of the fiscal crisis does make it more vulnerable than it was in the past.

In my view, the deduction should be abolished completely, not just for the wealthy. If we want to lower the tax burden for the poor or the lower-middle class, the best way to do so is to reduce their income or payroll tax rates across the board, not give them a deduction that only applies if they buy a particular product, thereby skewing their incentives.

It may be defensible to argue that abolition should be phased in gradually over a period of several years. That way, we can smooth the transition for homeowners who relied on the deduction when they took out mortgages they are currently still repaying. While the government is not legally obligated to protect such reliance interests, there may be a policy case for doing so. The word “may” is a crucial qualification here. I’m far from certain about whether and to what extent abolition should be phased in gradually as opposed to immediately. Regardless the reliance argument does not apply to new purchases that occur after the deduction has been abolished. For them, abolition can be immediate.

UPDATE: The Promethefeu blog criticizes my tentative suggestion that we do a gradual phaseout of the mortgage interest deduction for current mortgage-holders:

This is a mistake for several reasons. First, current homeowners do have a reliance interest in home-buyers benefiting from the deduction. If home-buyers can expect to get the deduction, they will be willing and able to pay more for houses. This is something that homeowners relied upon when they bought their houses. If the deduction is abolished, this could mean a significant hit to home values and whatever plans homeowners may have made relying upon that home value could be disrupted.

Second, and I think much more importantly, this would create a harmful discontinuity in the real estate market: If you currently have a mortgage, you would have an incentive to stay in your current house for longer than optimal in order to avoid giving up the deduction. Otherwise, you would have to settle for a cheaper place/dig into your capital/pay a higher mortgage.

On the first point, I agree that current homeowners may have some reliance interest in the effect of the mortgage interest deduction on the resale price of their houses. However, the reliance interest here is much smaller than that embedded in their payment plans for their current mortgage. Home prices fluctuate for a wide range of reasons, and we can reasonably expect people who purchase real estate to be aware of that. The diminution caused by eliminating the mortgage interest deduction is just one of many factors that could cause a substantial change in resale price.

The second point is valid. However, it is mitigated by the fact that I don’t propose to keep the deduction in place for current mortgages permanently. I would merely phase in its abolition over a period of a few years. That should greatly reduce the potential distortion in the real estate market.

That said, as I noted in my original post, I’m far from certain that a phased abolition of the deduction really is preferable to an immediate. It’s possible that we should slaughter the sacred cow all at once, rather than opt for a slow, lingering death.