How to Eliminate the Mortgage Interest Subsidy Without Raising Taxes

Mortgage application
Mortgage application

President Barack Obama unveiled his $3.73 trillion spending blueprint today. It promises $1.1 trillion in deficit savings over the next decade through spending cuts and tax hikes, including slashing the mortgage interest deduction for Americans already paying the top tax rates.

It’s good that Obama has put the mortgage interest deduction on the table. This is a huge housing subsidy that severely distorts the economy. But Obama doesn't go far enough. The mortgage interest deduction should be eliminated altogether.

It’s quite well known that the mortgage interest deduction channels too much of our wealth into housing and housing finance. People essentially pay a tax penalty for not taking on a mortgage—renting or buying with cash—or limiting the size of their mortgages. It encourages people to buy bigger houses and take on more debt, instead of saving, investing or spending on goods other than housing.

The mortgage interest deduction not only over-incentivizes people to buy homes, it rewards them for buying a second home. That’s right, the interest payments on your second home are deductible. It also encourages taking on more additional debt, by allowing deductions for interest payments on home equity loans up to $100,000.

Unfortunately, Obama is approaching the mortgage deduction from the misguided view that it is a government expenditure that can be cut. It’s not a spending cut. It’s a tax hike. And the last thing our economy needs is a tax hike that takes more money out of the marketplace and delivers it into the hands of government bureaucracies.

Here’s a good test for whether something is a spending cut or a tax hike: does it result in someone paying higher taxes? If the “spending cut” is really just a way for the government to collect more in taxes, it is a tax hike. Real spending cuts mean that the government is spending less, not that it is collecting more.

Of course, our tax system is so laden with special interest giveaways that many subsidies and corporate welfare programs are structured so that their elimination would be a tax hike under my definition. That doesn’t mean we should preserve them just to eliminate hiking taxes. In fact, there’s a way to eliminate the economy-distorting mischief they make without raising taxes at all.

Here’s how to end the mortgage interest deduction without raising taxes—expand it beyond recognition.

Right now, the mortgage interest deduction is an exception to the general rule that you cannot deduct personal expenses from your income tax. In other words, it is a loophole. What we should do is stretch that loophole so that it covers everything else in the world.

Instead of only applying the interest payments on mortgages, the deduction should be available as an “imputed interest payment” to anyone who paid cash on their home or is renting. The concept of “imputed interest” is not really that complex—you just allow people who aren’t paying interest to deduct an amount from their taxes as if they were paying interest. In this way, it becomes a “dwelling deduction.”

If we wanted to go further, we could allow for deductions for expenses such as home improvements or durable goods purchased for the home. Make it a “household expense deduction.” Let that new boiler earn homeowners a tax break. A new oven could earn a renter a break.

We should probably push it even further. Even as a “household expense deduction” would create economic distortions by over-incentivizing spending on housing. It should be expanded to a general deduction that can cover up to a certain amount of spending regardless of the object of the spending. Instead of having the government in the business of rewarding spending for favored items, the government should be neutral toward what kind of spending consumers choose.

The “household and living expense deduction” still doesn’t go far enough, however. The government would still be rewarding people who chose to spend rather than save and invest. To eliminate this favoritism, we’d need to expand the deduction into a generalized personal income tax deduction.

The mortgage interest deduction currently excludes about $210 billion each year from the clutches of government tax collectors. The expansion of the housing subsidy into a new personal income tax deduction could be structured so that it would preserve this level of tax savings. The taxes of some people who right now enjoy a mortgage subsidy would go up, while the taxes of others would decline. But the overall effect wouldn’t be a tax hike or a cut—it would be a restoration of sane market discipline to an economy too-long distorted by this pernicious housing subsidy.


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