Death of the Mortgage Interest Deduction?

The feds are talking about ending the popular tax expenditure, which could be positive and negative for state and local economies.
by | September 21, 2011
 

As Congress continues to grapple with the budget deficit, one of the topics they keep revisiting is tax expenditures -- those often obscure and little understood tax breaks written into the tax code. Tax expenditure reform, in fact, was recently mentioned in President Obama's jobs speech as a means of helping to pay for the program. One of the biggest expenditures is the mortgage interest deduction, or MID.

Since it was first enacted in 1913, the MID has been sacrosanct. Who would dare touch the darling of middle-class homeowners? Still, there is talk of eliminating it gradually, turning it into a tax credit or setting other limits on it. The problem with that is that it could negatively impact the still fragile housing industry. After all, a housing recovery is integral to a local economy's recovery.

How would a change in the MID affect states and localities? I put that question to Doug Duncan, the chief economist for Fannie Mae; Kim Rueben, a senior fellow at the Urban-Brookings Tax Policy Center; David Merriman, an economics professor and associate director of the Institute of Government Public Affairs at the University of Illinois at Chicago; and Tracy Turner, an economics professor at Kansas State University. Their edited and condensed insights follow.

Doug Duncan: Very few low-income or first-time homebuyers deduct mortgage interest. For them, the standard deduction is worth more than the mortgage interest deduction. So, the MID is not an engine for homeownership. What it does do is encourage upper-middle income people to buy bigger houses. Studies I've seen suggest that if that deduction were curtailed or eliminated, people would adjust the demand for housing to a different size or attribute, but it wouldn't change the desire to own a home. People who own smaller homes on lower price points would see the benefit of appreciation because buyers would move down a price point and demand would rise.

There is an implication for property taxes to the extent there's a change in the average house price -- you'd have to know what would happen to the weighted average house price in a given market to figure out whether that is a net plus or net minus. For state and local revenue, there are both short-term and long-term considerations, positives and negatives related to it. If people are making a purchase in an unsubsidized way, then they are not dependent on political issues to determine the valuation of property or obligation. That may lead to behaviors that would be more sustainable. The credit-granting process would adjust to that and be positive. If there is no transition -- just suddenly a change -- it could be negative. It depends on the distribution of value in local jurisdictions and how policy changes are made. One size doesn't fit all. All real estate is local.

In the discussion of getting our national fiscal house in order, there are going to be impacts on state and local governments. The mortgage interest deduction is part of a broader discussion of the country's total fiscal view. It needs a good debate.

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Kim Rueben: There could be an effect on state income tax revenues, but only for those states that use the federal income tax form as their income base. If you limit deductions, it could have a positive effect on the base. If we go back to the tax reform under President Ronald Reagan, basically state and local income taxes grew because the revenue base they were keying off grew. The federal government lowered rates but broadened the base. States that use the same base as a starting point broadened their base. So, if there was a change in the deduction of mortgage interest, states and localities could see an increase in the amount of income tax revenue they get. Overall, only a quarter of homeowners would face a tax increase, and that would typically be higher income people itemizing deductions.

What is tough is figuring out what the "but-for" world would look like. It's likely we are not going to see reform of mortgage interest deduction in a vacuum. It's not clear that changing the mortgage interest deduction would have as big an effect on states and localities as getting rid of the deduction of state and local taxes or the tax exempt status of municipal bonds -- tax expenditures that are also up for discussion.

But if it were done and Congress didn't do anything else, it would broaden the base so states get more money but property taxes would be effected by a decline in house prices. So states might be better off but locals could be worse off.

David Merriman: It depends a lot on how states treat the change. In Illinois, it's not going to have any immediate effect on income taxes because we don't recognize the deduction -- it's not taken out of our tax base. Realistically, it's very unlikely that the MID will be eliminated. More likely, for very high-valued houses -- houses that sell for half a million or more -- those may get part of their MID taken away. For the wealthy or those on the East Coast or West Coast where housing values are very high, there will be a trimming back.

If the MID is reduced, that could be a hit to the economy. If the subsidy is reduced, that could hurt the construction industry. It might be a fairer tax system in the long run, but the short-term pressure is that it is not going to help the economy.

For people in state and local government, any major change in federal tax policy creates a disruption of tax policies. It makes it harder to plan. In general it causes uncertainty, which is of concern to those in state and local government.

Tracy Turner: In states that have high subsidy rates through this feature of the tax code -- 10 states as recently as 2008 had a subsidy exceeding 6 cents on the dollar -- housing prices will come down a little. Data I've seen suggests that even with declines in housing values, property taxes are stable. But if it makes homeowners feel poor, they'll spend less.

Changing the deduction to a credit would do more for local businesses and boost local economic systems. If it were a refundable credit, a homeowner who doesn't owe taxes would still get a credit back. Low-income people would spend that money more readily.

In terms of financial decisions we face right now, everything has to be up for consideration. So if we are going to cut programs, we should cut tax expenditures. They are programs put in place through the tax code without any oversight.

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