Chipping Away at the Mortgage Deduction

A lesser-known benefit of the 2017 tax reform.

By William G. Gale. He is co-director of the Urban-Brookings Tax Policy Center. Excerpts:

"This is a welcome change. The mortgage-interest deduction has existed since the income tax was created in 1913, but it has never been easy to justify. Under classical economic theory, interest payments on an investment should be deductible, so that only profits—the income left over after expenses have been paid—are taxed. But the economic “income” from occupying a house—imputed rent—isn’t taxed in the first place, so there’s no reason the cost of earning that income should be deductible. 

The massive growth in the income tax during World War II led to a narrative that the mortgage-interest deduction encouraged homeownership. But study after study belies this claim. Canada, the United Kingdom, and Australia have no mortgage-debt subsidies, yet their homeownership rates are slightly higher than in the U.S. A large reduction in the mortgage-interest deduction in Denmark in 1987 had virtually no effect on homeownership rates.

Instead, the deduction encourages construction of larger, more expensive houses. This leads to higher energy costs and urban sprawl and reduces investment funds available for business. The resulting higher home prices may actually raise costs for first-time purchasers, most of whom don’t itemize or are in the 12% tax bracket and thus gain little or no direct benefit from the deduction anyway. By encouraging people to finance homes with high levels of debt, the deduction increased the likelihood of default when housing prices fell in the financial crisis."

"In 2018 almost 17% of the benefits will go to the top 1% of households, and 80% of the benefits will go to households in the top 20% of the income distribution. Only 4% will accrue to households in the middle income quintile."

"The mortgage-interest deduction has been expensive, reducing federal revenues by about $60 billion a year before the tax overhaul. That figure is now down to around $30 billion."