Much of the discussion about raising tax revenues has been about cutting deductions and tax credits, rather than raising rates. One of the biggest of these is the mortgage interest deduction (MID).
I found the graph below to be very interesting. It shows the dollar amount of the benefit for different levels of taxable income versus the number of tax returns each group gets. The data comes from the Joint Committee on Taxation, and the graph was put together by Felix Salmon of Reuters (
I would have preferred that Mr. Salmon had used different colors on it rather than shades of purple, but it is still clear enough to see the key point. The vast majority of the benefit goes to the relatively affluent households. For 2009, the Committee indicates that the deduction resulted in $76.656 billion of lower revenues, and there were a total of 34.632 million returns filed. Just under 10% of the returns were from households earning over $200,000, yet they got 29.7% of the total benefit. Households earning between $100,000 and $200,000 were 32.3% of the total returns, but got 39.5% of the benefit. In contrast, households earning less than $40,000 also made up about 10% of the tax returns, yet they got just 2.5% of the benefit. Those earning between $40,000 and $75,000 were 30.4% of the tax returns but 15.2% of the benefit dollars. The average dollar amount of the benefit for those earning under $40,000 was $570, the average for those earning over $200,000 was $6,650.
Here is the graph of the average benefit by group that I put together using the underlying data.
The huge disparity is due to a number of reasons. First, we do on paper have a progressive tax code, where people with high incomes pay a higher tax rates. With the MID, if you are in the 35% tax bracket, and have a monthly mortgage payment of $2,000 per month (well actually the interest portion of the mortgage payment, which is the vast bulk of the payment in the early years after you take out the mortgage, but declines over the course of the mortgage term), then you save a total of $700 a month on your taxes.
If you are in the 10% tax bracket, and had the same size mortgage, your savings would only be $200 a month. Of course, people with incomes that put them in the 10% bracket don’t usually have $2000 a month mortgages. They tend to live in smaller, less expensive homes. The savings on a $400 a month mortgage would only be $40. Actually, people in the 10% bracket are far less likely to own a home at all, and there is no deduction for rental payments. The home ownership rate in 2009 for those earning less than $40,000 was 59.9%. Many of those people are the elderly who live on fixed incomes, but who have paid off their houses, or nearly done so, and thus are not paying a lot of mortgage interest. In contrast, the home ownership rate among those earning over $100,000 is 90.5%.
Also, people who earn less than $40,000 a year are far more likely to take the standard deduction, rather than itemize their returns. The MID only applies to those that itemize.
If we were designing the tax code from scratch, I don’t think we would include the mortgage interest deduction. It is very expensive, $76.7 billion a year is hardly chump change, and most of the benefit goes to the relatively affluent. Not the super wealthy, but to the high end of the upper middle class. It distorts the rent versus buy decision by inherently burdening those who rent. It means that to raise the same level of revenue, higher tax rates need to be applied. It is worth noting that Canada has no mortgage interest deduction, and people are still able to buy homes there. Their homeownership rate is almost as high as ours is. A quick check on Wikipedia shows that in 2002, the U.S. rate was 68% while the Canadian rate was 67%.
However, removing it abruptly would substantially weaken the already devastated housing market. It is not really all that clear as to how much the MID makes housing more affordable. The benefit gets capitalized into prices, and makes housing prices higher than they otherwise would be. Take it away and housing prices will fall, and that will push still more homeowners underwater on their mortgages. Being underwater is a necessary, but not sufficient, condition for a foreclosure to happen. The further underwater a homeowner is, the greater the likelihood of foreclosure. Suffice it to say that we have more than enough foreclosures already.
If the MID were removed, the mortgages would still be there and the rates and balances would not change. The fall in price would first hit the homeowners equity in their house, which is still a very substantial store of wealth for the middle class in this country. There are still a lot of homeowners who are not underwater. People tend to view that wealth as a key part of their long term financial plans for things like retirement and college for the kids. Destroy that wealth and people would have to cut back even more on current expenses to save for those things, or would have to do away with the idea that they will ever be able to retire or send the kids to college.
If we are going to remove the deduction, we will have to do it in a gradual fashion, and preferably in a way that removes it first for the more affluent. I would begin with a rapid phase out of the deductibility for second homes. Ownership of a ski chalet or a beach house does not have the same sort of social stability benefits that ownership of a principal residence does. Crime rates tend to be lower, for example, in areas where a high percentage of the residents are homeowners rather than renters. Homeowners tend to be more involved in their communities.
The next thing we might want to consider is to put a cap on the total amount of mortgage interest that is deductible. For example, if we put the cap at $2000 a month, or $24,000 a year, a homeowner with a $2500 a month mortgage would still be able to take up to $2000 deduction. It would hurt a bit, but not like doing away with it entirely. That limit could then slowly be lowered, or at least not be indexed for inflation. Those in the middle class living in ordinary neighborhoods would still get the full deduction, but those living in McMansions would feel the bite. Of course the slower the phase in, the less benefit in terms of higher tax revenues, and thus the less progress on the deficit. Still it is the long term deficit that is the big real economic worry, not the deficit in 2011 or 2012.
Realistically, we need to have more tax revenues. Spending cuts alone will not do the trick, not if we want to maintain any sort of social safety net and also have a military. Thus we will either have to raise tax rates, or make more of the income people have subject to taxation, rather than being deductible. High rates do have adverse incentive effects, so I would prefer the eliminating deductions route (although we will probably need a bit of both). If we go that route, we have to go after the big ones, and that means the MID. The only other one of comparable size is that what your employer pays for your health insurance is not taxable income to you. If you buy your own health insurance you have to do so with after tax dollars. Eliminating that one would have its own set of problems, but that will have to be the subject of another post.
Dirk Van Dijk is the Chief Equity Strategist for Zacks Investment Research. You can follow him at twitter.com/DirkHvanDijk.
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