As Congress wrestles with ways to raise revenue and trim spending, a hotly debated topic is the federal tax deduction for home mortgage interest. Not surprising, when you consider that the home interest deduction is estimated to cost the federal government $100 billion a year. Compare that to the $62 billion a year the government gained in revenue by hiking tax rates after last year's fiscal cliff fiasco, or to the highly publicized sequestration, which amounts to $85 billion in cuts.
But while the mortgage deduction would save a lot of money, the consequences of eliminating it entirely will be dire. According to the National Association of Home Builders, home purchases and the ancillary economic activity generated from home purchases account for nearly 20 percent of GDP. That's not insignificant.
An alternative for policy-makers to consider, however, is to adjust, rather than eliminate, the mortgage deduction. Capping the tax break will allow it to do what it is intended to do: stimulate home buying. A cap would continue to motivate individuals to purchase a home without giving them a benefit that lasts well beyond its usefulness to the economy.
My proposal would be to give the deduction five years of life: After reaping the benefits for half a decade, homeowners would no longer be entitled to deduct the interest on their mortgage, unless they purchased a new home, in which case they would have a new five-year period of deductability on the new mortgage. (Simply refinancing a mortgage after the five-year period would not qualify a homeowner for the deduction.) This would keep the incentive where we want it to be: fueling economic activity.
Crucially, a cap would preserve the mortgage interest deduction for first-time homebuyers who justify the step-up from a rent payment to a house payment with the tax deductability of their mortgage. Those first-time homebuyers are very important; they begin the buy-sell-buy chain reaction that helps current homeowners move up to their next home.
But limiting the duration of the incentive would increase the desire for everyone to move out and up.
As it is now, the mortgage-interest deduction reaches a point of diminishing returns. As individuals remain in the same home for years, the deduction becomes the "gift that keeps on giving," without spurring economic activity. Under a cap, these people would be incentivized to buy again.
What's more, a five-year cap would better protect against a housing slump should interest rates rise. Here's how: When a homeowner's mortgage interest deduction has expired, that homeowner could profit from a fresh five years of tax deductibility, thereby offsetting higher rates and fortifying the buy-sell-buy cycle.
Grandfathering my plan would make it easy to implement. Individuals with current mortgages will continue to claim the deduction for the next five years, giving people time to adapt to the change. First-time homebuyers would still have the incentive to purchase and experience no adverse effects from such a change.
A five-year mortgage interest deduction would favor housing without creating market distortions, while providing revenue to lower deficits. Rather than make a panicked decision to end a worthwhile tax break, Congress should consider a thorough and thoughtful solution that will spur the housing recovery and create jobs in the process.