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Is the Mortgage Interest Deduction a Wasted Incentive?
By Mel Miller

Bargains-113ad81bToday’s Congress is so focused on deficit reduction that many of the Great Society programs initiated by President Lyndon Johnson are facing major overhaul in an expense reduction effort.

The attitude of Congress has changed dramatically over the last fifty years. Gone is the desire to strengthen the policies of the Great Society programs that continue to touch the lives of most Americans. Medicare, Medicaid, Head Start, Higher Education Act, and Supplemental Nutritional Assistance Program—today called “Food Stamps”—just to name a few. All of these programs cost money. The benefits, however, are sometimes difficult to quantify, especially in dollar terms.

The key question is how we find the revenue to continue to fund or even strengthen the successful programs of the Great Society. As Congress does not appear inclined to raise taxes, deductions are coming under scrutiny. One such deduction now in the cross-hairs is the home mortgage-interest deduction.

Supporters of the mortgage-interest deduction say it encourages homeownership and a shot at long-term financial security. Conversely, opponents say it provides no benefit to the majority of American taxpayers and distorts a key market.

The first modern federal income tax was created in 1894. Early on, all forms of interest were deductible. However, the Supreme Court quickly ruled that an income tax was unconstitutional. In 1913, the Constitution was amended and the income tax was enacted. At that time there was no thought of a tax deduction for mortgage interest—the vast majority of homeowners in those days bought their homes with cash.

The Congress that enacted the income tax as we know it today probably viewed interest expense as a business deduction. The country was dominated by small proprietors and interest was considered an expense, just like other business expenses that needed to be netted out against revenue to arrive at taxable income. Home mortgage interest was intended to be treated the same as any other interest expense.

Was the unintended consequence an incentive for prospective middle class homebuyers?

No, according to A. Mechele Dickerson, a law professor at the University of Texas, and the author of Homeownership and America’s Financial Underclass: Flawed Premises, Broken Promises, New Prescriptions. Professor Dickerson points out that only 25% of all taxpayers deduct mortgage interest. The percentage varies by state, according to the Pew Center on the States. States with the highest average deduction are generally in the coastal states which have the highest home prices. Homeowners in North Dakota, West Virginia, Mississippi, South Dakota, and Arkansas claim the lowest average home mortgage deductions, averaging only 25% of the high average deductions claimed in Maryland, California, Virginia, Colorado, and Washington. Nearly two-thirds of all U.S. households take the “standard deduction” available to all taxpayers because it usually exceeds the amount of interest they pay on their mortgage loans.

Homeowners are allowed to deduct the interest on mortgages up to $1 million—even if the loan is used to buy a vacation home. The most recent data from the Joint Committee on Taxation shows 34.1 million homeowners claimed $68 billion in mortgage interest deduction benefits in 2012. This was down from $83 billion in 2010 when 33.6 million homeowners utilized the deduction. The report also noted that 77.3% of the total deduction went to individuals earning over $100,000.

In fact, the mortgage interest deduction could be viewed as an economic distortion. A report published by Center on Budget and Policy Priorities sites examples of the negative impact of the mortgage interest deduction. “The deduction lowers taxes on investment in owner-occupied housing relative to business investments, potentially skewing the allocation of capital across the economy.” The deduction is also “regressive” in nature, meaning that “there is an inverse relationship between the tax rate and the taxpayer's ability to pay.”

In summary, this is a useless tax benefit for most ordinary Americans. If anything, the deduction incentivizes higher-income individuals to purchase more expensive homes; it does not provide an incentive for middle-income taxpayers to purchase moderately priced homes.

So, is the mortgage interest deduction just a wasted incentive, or is it even more than that?

The International Monetary Fund published a report in 2009 titled Debt Bias and Other Distortions: Crisis-Related Issues in Tax Policies which examined all tax policies in an attempt to identify tax policy distortions that might have played a role in causing the Great Recession. The housing sector executive summary stated that “continued favorable treatment of housing in many countries has supported high housing prices, while mortgage interest relief—where it remains—may have encouraged heavy household leverage. The risks in distorting a market so central to financial stability reinforce long-standing efficiency and equity arguments for more neutral taxation.”

Politicians in the United States are beginning to pay attention to deduction distortions. Discussions are now taking place in Congress about a broad tax overhaul and the elimination of many deductions. Of course Congress always seems to be discussing tax policy, but lately both parties are becoming more vocal regarding deduction changes. President Obama and several congressional Republicans, including Rep. Dave Camp, chairman of the House Ways and Means Committee, have proposed limiting the value of the mortgage interest deduction.

Is the mortgage interest deduction a wasted incentive? And, if so, what are the chances of Congress eliminating it? While immaterial to most taxpayers it will likely be a tough political sell. Certainly, many taxpayers who currently do not benefit from this deduction aspire to a level of financial success where they would.

Mel Miller, CFA® is Chief Economist and a member of the Investment Committee for First Affirmative Financial Network. He monitors economic conditions and market movements, and keeps the firm and its network advisors current on economic issues.

First Affirmative Financial Network, LLC (http://www.firstaffirmative.com) is an independent Registered Investment Advisor (SEC File #801-56587) offering investment consulting and asset management services through a nationwide network of investment professionals who specialize in serving socially conscious investors. First Affirmative produces The SRI Conference (www.SRIconference.com).

Posted: July 24, 2015