Is The Mortgage Interest Deduction Inequitable?

photo by Elana Centor

I have certainly thought so, as do many other housing policy types. Daniel Hemel and Kyle Rozema have a more nuanced view in their paper, Inequality and the Mortgage Interest Deduction, that was recently posted to SSRN. The abstract reads,

The mortgage interest deduction is often criticized for contributing to after-tax income inequality. Yet the effects of the mortgage interest deduction on income inequality are more nuanced than the conventional wisdom would suggest. We show that the mortgage interest deduction causes high-income households (i.e., those in the top 10% and top 1%) to bear a larger share of the total tax burden than they would if the deduction were repealed. We further show that the effect of the mortgage interest deduction on income inequality is highly sensitive to the alternative scenario against which the deduction is evaluated. These findings demonstrate that claims about the distributional effects of the mortgage interest deduction depend critically on the counterfactual to which the status quo is compared. We extend our analysis to the deduction for state and local taxes and the charitable contribution deduction. We conclude that the appropriate counterfactual for distributional claims is dependent upon political context — and, in particular, on the feasible set of politically acceptable reforms up for consideration.

To make this a bit more concrete, the authors offer a simple hypothetical:

to show how a provision of the tax code can provide a disproportionate share of dollar benefits to the rich while also causing the rich to bear a larger share of total tax liabilities. Imagine a society with two households—a rich household with pre-tax income of $100, and a poor household with pre-tax income of $50. Further imagine that the rich household pays $12 in mortgage interest and the poor household pays $9 in mortgage interest. Say that the tax system is structured such that the tax rate on the first $50 of income is 20% and the tax rate on all income above the $50 threshold is 40%.

If the tax system does not allow a deduction for mortgage interest, the rich household would pay a tax of $30 ($10 on the first $50 and $20 on the next $50), and the poor household would pay a tax of $10. Thus the government would collect a total of $40 in revenue; the rich household would bear 75% of the total tax burden ($30 divided by $40); and the poor household would bear the remaining 25%. If the tax system allows each household to deduct mortgage interest, the rich household would receive a benefit from the deduction of $4.80 ($12 times 40%), and the poor household would receive a benefit from the deduction of $1.80 ($9 times 20%). The benefit of the MID in dollar terms is clearly greater for the rich household than for the poor household. In percentage terms, the rich household received 72.7% of total MID benefits, while the poor household received 27.3% of total MID benefits. And yet the rich household now bears 75.45% of the total tax burden ($25.20 divided by $33.40), as compared to 75.0% before, while the poor household now bears 24.55% of the total tax burden ($8.20 divided by $33.40), as compared to 25.0% before. (Government revenue decreases from $40 without the MID to $33.40 with the MID.) (8, footnote omitted)

The authors conclude that their analysis “simultaneously confirms and challenges widespread beliefs regarding the effect of tax expenditures on inequality. The mortgage interest deduction does indeed appear to be inequality-increasing relative to a counterfactual in which the deduction is repealed and revenues are reallocated to all households on a equal basis; when the mortgage interest deduction is evaluated against other counterfactuals, however, the distributional effects are more nuanced.” (40)

Where does this leave us? It reminds us that we should be careful about promoting simple policy proposals without taking into account the likely context in which they might be implemented.

The Mortgage Interest Deduction: A Taxing Expenditure

The Congressional Budget Office has issued a report, The Distribution of Major Tax Expenditures in the Individual Income Tax System,  which evaluates the mortgage interest deduction and the state and local tax deduction among other tax expenditures.  It finds (consistent with all previous findings) that they accrue disproportionately — grossly so — to the wealthy.  The mortgage interest deduction has a budgetary effect of $70 billion and the state and local tax deduction has a budgetary effect of $77 billion. (6, Table 1) (to be clear, budgetary effect is not the same as lost revenue; read the report for an explanation of the difference)

Itemized deductions such as these “provide the largest benefits — in both absolute dollars and relative to income — to the highest-income taxpayers.  Those tax expenditures benefit only the roughly one-third of taxpayers who itemize their deductions, and lower-income taxpayers are much less likely than higher-income taxpayers to do so.” (17)  The CBO “estimates that the top quintile will receive almost three-quarters of the benefit of the deduction in 2013, including 15 percent accruing to the top percentile.” (18)

I and many, many others have argued that this is not a good state of affairs but the real estate industry are very well organized around this issue.  Real estate brokers are particularly focused on this because a reduction in these deductions would likely lead to a significant and permanent reduction in their income.  Smaller deductions would make owning a home less financially attractive and thereby push down prices.  Brokers typically get paid by a percentage commission of the sales price.  So they would suffer not just during a transition period (as sellers in the transition period would) but for all time.

So there is no reason to believe that we will see reform around these regressive tax expenditures in the near future, but it should always be kept on the table as part of a tax reform package, particularly if it is implemented in some incremental way (for example, capping the value of the deductions individually or as part of a basket of deductions).