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Earlier today, the White House released a budget proposal that included trimming the mortgage interest deduction for taxpayers in the top income tax brackets.

This is the first step in eliminating what many economists view as an expensive and inefficient housing subsidy.

Unfortunately, many of the critics of the mortgage interest deduction focus on its immediate costs. If it were eliminated, it might bring in more than $2 trillion of new revenue for the government or—as I proposed this morning—allow up to $2 trillion of new tax cuts for the American people.

Actually, I think getting rid of the housing subsidy could be an even better deal than that—providing it is done by expanding the deduction into a general tax cut instead of closing the “loophole” and raising taxes.

Over the years, government housing and banking policy has resulted in far too much wealth being directed into the housing sector. Too much funding got directed away from its economically most efficient uses and toward housing instead, thanks to the advantage of various tax and regulatory breaks.

Over a year ago, I explained the cost of the housing bubble in terms of human and financial capital:

This is all too obvious on Wall Street these days. Most financial firms, stung by the tech bust and investor fears of tech companies, shrank their operations in this sector while pouring talent and funds into housing related sectors. Many of the big names who might have mentored the next generation of tech oriented financial professionals were driven out by legal troubles stemming from the dot com bust or by the fact that their firm’s just weren’t interested in keeping them around.

The result is that most financial firms lack the in-house expertise to invest in innovative business ventures on any meaningful scale. The credit departments don’t know how to evaluate loans to these companies, the special executions groups don’t know how to make private equity investments, investment bankers stink at pitching acquisitions, and the capital markets desks do not know how to take companies public.

What’s more, there was so much money to be made in derivatives and credit—largely arising from the underlying housing boom—that many of the smartest people got drawn into these areas rather than tech innovation. Basically, we got lots of questionable financial innovation instead of technological, medical, or environmental innovation.

If all of this had worked out to make us fabulously wealthy, there might not be much to complain about. The tech, green and bio-tech communities would just sound like special interests complaining their favored projects weren’t capturing as much attention and wealth as the enthusiasts think is deserved.

But that’s not what happened. The dearth of technological innovation is largely attributable to government regulations and a loose money policy that led to massive malinvestment. Sectors of the economy unrelated to housing were deprived of needed capital and talent, while the great quicksand of the housing boom sucked down everything.

We’re now facing an historic opportunity to turn things around. If we eliminate the mortgage interest deduction, we can stop re-directing capital away from innovation. Working Americans will be free to spend, save, and invest according to their own perceptions of their needs and their sense of the future.

I expect that eliminating the government incentives for spending on housing would promote dramatic innovations, making Americans more productive and allowing the economy to grow with renewed vigor. Instead of building up a Ponzi-scheme illusion of bubble-dependent wealth, we can genuinely improve our lives by allowing wealth to flow to where individuals perceive it will be best used.

Scored dynamically, I think economists would find that eliminating the $200 billion a year income tax deduction, would result in economic growth that would return far more than $200 billion to the economy.

In short, let's unleash the genius of free markets on the capital of the American people simply by refusing to load the dice in favor of housing. Isn’t time to at least give the market a chance?

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