FEATURE ARTICLES
MID up for Debate
Published in DS News Magazine
Whenever the government is running short on funds, policymakers begin reexamining the tax code. So now, with federal deficits in the hundreds of billions of dollars, it's no surprise that tax reform is in the air. Such discussions inevitably turn to eliminating "tax loopholes"—an idea voters support, until it affects them. One person's loophole is another's justifiable, necessary deduction, and that's what makes reform so hard. Closing the deficit will mean slaughtering some sacred cows, and there is no cow more sacred than the mortgage interest deduction (MID). It's worth an estimated $100 billion a year to taxpayers—a large sum, even in Washington terms.
Proponents describe it as an essential bulwark of middle-class prosperity and mobility. Opponents call it inefficient and unfair. The strongest criticisms come from the political margins: on the left, because it disproportionately benefits higher income earners; on the libertarian right, because it's viewed as a needless government intrusion in the market. Politicians, whose fortunes rise and fall with public opinion, usually find it wise to ignore it.
As the debate rages, it's worth considering why we have a mortgage interest deduction in the first place. Contrary to popular belief, it wasn't invented to encourage homeownership. Described by some as the accidental deduction, the MID was imbedded in U.S. income tax law from the beginning.
A Different Time
The Sixteenth Amendment provided the constitutional framework for a federal income tax, and a few months later the Revenue Act of 1913 codified its provisions. Originally it was a modest ":class tax" affecting only the wealthy: The base rate of one percent applied to incomes above $3,000 ($4,000 for married couples) with an additional surtax up to six percent on incomes above $20,000. To understand that in today's terms, imagine paying no tax on income up to $65,000 ($85,000 for married couples), then one percent on income up to $500,000. On income above that, the top marginal rate would be six percent.
Along with business expenses, the Act allowed for the deduction of "all interest paid within the year by a taxable person on indebtedness." No distinction was made between business and personal interest—a quirk that became more important in subsequent years. Soon the rates increased drastically to finance U.S. involvement in World War One, and fluctuated between relatively high levels thereafter.
Developments around World War Two made the interest deduction more important than anyone could have foreseen: The income tax base was broadened to encompass a large swath of the middle class, while the New Deal had created a vast new apparatus for facilitating long-term mortgage loans. And with the introduction of the Diner's Club Card in 1950, a new age of consumer credit was dawning. For the first time it began to make sense for millions of middle-class taxpayers to itemize their deductions—including interest payments.
Tax reforms were enacted in 1969 and 1976, but the interest deduction was left untouched. By the 1980s a ballooning federal deficit put reform on the agenda again, and President Reagan directed the Treasury Department to formulate a proposal.
Eric Toder was an official in Treasury's Office of Tax Analysis at the time and recalls: "He (Reagan) made a speech in the spring of 1984 in which he promised that he would not take away the mortgage interest deduction. And that was the only direction that was given to Treasury staff. That was the only limit that was placed on the process—that we would leave the mortgage interest deduction alone." The MID, which began as a minor concession to a tiny fraction of wealthy taxpayers, was now a "symbol of the American dream," in Reagan's description.
But the Tax Reform Act of 1986 that emerged did make some major changes. Toder, now a Fellow at the Urban Institute, and Co-director of the Urban-Brookings Tax Policy Center, notes, "It eliminated all other personal interest deductions. So, you could no longer deduct credit card interest; you could no longer deduct interest on a car loan." The MID survived, though it was now limited to mortgage debt on first and second homes up to $1 million—with another $100,000 for home equity loans.
The Debate Continues
26 years later, the country faces a budget crisis that makes those days seem quaint, and a growing chorus of voices is calling for the abolition of the MID. One voice on the other side is Lawrence Yun, Chief Economist and Senior Vice President of Research for the National Association of Realtors®. He's particularly concerned about any change in policy now. "The housing market," he says, "is just trying to get its footing, and trying to recover in a sustainable way. And any tweaking or changes to the mortgage interest deduction would be a sudden, negative shock to the housing market recovery process. So, it would be the worst possible timing."
Yun acknowledges that the MID drives home prices up, but points out that this "capitalization effect" has created real wealth for millions of Americans, and removing it could deflate prices by 10 to 20 percent, indiscriminately. "Home value declines mean wealth destruction for all homeowners, independent of whether they are utilizing the mortgage interest deduction," he notes. "So, someone who bought their home 30 years ago, 15 years ago, 10 years ago—is it fair to somehow destroy their housing wealth by taking away the mortgage interest deduction going forward?"
Critics use the same data to argue that the MID has inflated home values artificially—to the benefit of a small group of affluent homeowners, and the detriment of those trying to enter the market. Their claim has some basis: In 2007, only 28.5 percent of tax filers took mortgage interest deductions, and almost 40 percent of those were in the $50-100,000 income bracket. Another 33 percent reported incomes over $100,000. Only 18.4 percent made less than $50,000. The reasons for that imbalance are found elsewhere in the tax code: the MID is only available to taxpayers who itemize deductions, and those are disproportionately higher-income earners.
The result is a subsidy for people who, arguably, don't need it. As Eric Toder explains, "The current deduction, the way it's structured, gives no benefit to the 65 percent of taxpayers that don't itemize their deductions. The incentive that it does give to itemizers is very variable, depending on your income. If you're in the 15 percent bracket, you get a 15 percent subsidy; if you're a higher income person, in the 35 percent bracket, you get a 35 percent subsidy. So, you're providing a kind of upside-down or backwards subsidy for homeownership—largely going to people who would be homeowners no matter what you did with the tax system. So instead, what you're doing is making it less expensive for them to buy bigger houses."
Proponents would argue that of course, tax carve-outs generally benefit the well-off, because they're the ones who pay taxes. And many moderate-income homeowners don’t deduct mortgage interest because they don't need to: The standard deduction is high enough that itemizing doesn't make sense.
Meanwhile, millions of renters receive no benefit at all.
At the macro level, some economists say the MID causes a misallocation of capital by encouraging overinvestment in real estate relative to other, more productive ventures. Yun disputes this, noting that investors aren't rushing to invest in housing, even with today's low prices. "The reality is that housing has never taken capital away from investment," he argues. If there were ever a time for that to happen, he points out, "Today would be a perfect opportunity, where one can see piles of cash sitting in company accounts."
Perhaps the most cogent argument for retaining the MID is simply that it exists—and as Yun likes to point out, millions of Americans have made financial decisions based on that. Even the most vocal opponents acknowledge that any changes would need to be phased in over a long period to minimize their impact on a fragile housing market.
In lieu of eliminating the deduction outright, various ideas have been proposed to limit its reach. The National Committee on Fiscal Responsibility and Reform, popularly known as the Simpson-Bowles Commission, issued a report in 2010 that included several suggestions: 1) Convert the deduction to a 12 percent non-refundable credit available to all taxpayers (not just those who itemize). 2) Cap the applicable mortgage debt at $500,000. 3) Eliminate the deduction for second homes and equity lines.
In 2011 the bipartisan group of senators known as the Gang of Six tackled the issue again, reviving the idea of a $500,000 cap, and the exclusion of second homes.
President Obama's 2013 budget does not address the MID directly, but calls for limiting itemized deductions to 28 percent for high income earners.
While these proposals have generally been ignored by lawmakers, they've generated strong pushback from the housing industry. Linda Goold is Tax Counsel for the National Association of Realtors. "When that million-dollar cap was put in place," she observes, "the median price of a house was $72,000. If that cap had been adjusted for inflation, it would be almost $2 million now. $1 million bought you a lot of house back in 1987. Now, the geographic unfairness of cutting the cap down from $1 million to $500,000 is just disastrous in any major urban area, and particularly on both coasts."
Even the deduction for second homes has a rationale, according to Goold. "A third of the counties in the country have at least one community where more than 15 percent of the housing stock is second homes," she says. "And in some counties, that goes up to as high as 40 and 50 percent. And so we can't see any good reason for eroding the value of property in those communities by taking away the deduction. And remember, not every second home is a ski chalet in Aspen." There are also laudable strategic plans behind many second-home purchases. As Goold notes, "For a fairly good part of the market, their second home is their anticipated retirement home."
What's Ahead?
The future of the MID will depend on the economic climate—and who's in power in 2013. Few observers expect any quick policy shifts. And few politicians would be rash enough to tip their hand on such a hot-button issue before an election.
Eric Toder says, "I would be surprised anything happened over the next year or two. But if you look at the longer picture in which the long-term budget is going into deeper deficit as the baby boomers retire, and the cost of retirement and health programs increase, there's going to need to be some adjustment in our fiscal position. It's not sustainable in the long run And since raising tax rates is an unattractive option, I think people are going to look harder at what are called tax expenditures. And, some of the things that were off-limits in the past may be reconsidered. But that's a long way from saying it's about to happen."
Linda Goold is equally guarded. "Congress is going to undertake tax reform," she says, but cautions, "If the goal of tax reform is to lower the rates, it's not clear to me that Congress can succeed, because the only way that they can lower the rates as much as they want to is to go after provisions that are of enormous benefit to the middle class. All of the money in these so-called tax expenditures is in mortgage interest, retirement savings, and employer-paid healthcare benefits. And I think that when push comes to shove, the public at large may be very unwilling to give up those provisions in order that a small class of richer people can have a tax cut."
And that sums up the status quo, which remains stubbornly resistant to reform of any sort. As often happens in Washington, this game could end in a stalemate.
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