Ending the Mortgage Interest Deduction?

August 23, 2005

As we've written before, the home mortgage interest deduction is almost uniformly condemned by economists as bad tax policy, since it distorts investment decisions and shrinks the tax base requiring higher tax rates.

Unfortunately, it survives thanks to entrenched and politically powerful interest groups—builders, home owners, realtors—who benefit from it at the expense of other taxpayers.

Thankfully, the Hartford Courant reports today that despite rumors that the deduction is politically "off the table," the President's Advisory Panel on Federal Tax Reform may consider reforming it:

The status of housing as the least taxed investment in the United States, which has helped fuel an eight-year boom in real estate values, may be in jeopardy as a presidential commission considers changes to the federal tax code...

Changes to housing-related tax incentives will also be considered, Jeffrey Kupfer, the panel's staff director, said. Economists say such policies would have the effect of eroding the relative advantage housing has enjoyed over other investments since 1997, when Congress effectively made most sales of primary residences tax-free...

The toughest issue to tackle may be the mortgage interest deduction, which has long been viewed as politically sacred, former Treasury Secretary James Baker III told the panel in March.

Former Treasury Department economist Eugene Steuerle says he does not believe that housing incentives, which are worth about $150 billion annually, are off-limits. "Politically, I think the case against making changes is exaggerated," said Steuerle, now a senior fellow at the Urban Institute, a nonpartisan research group.

Linda Goold, tax counsel for the National Association of Realtors, said it's possible that the tax panel may recommend replacing the interest deduction with a tax credit that would be more beneficial to lower-income Americans. They usually don't have enough deductions to justify itemizing, a prerequisite for taking advantage of the mortgage interest deduction.

The most likely reform—if any at all—would be to transform the deduction into a credit to eliminate its regressivity.

Unfortunately, that would make a bad tax policy worse by likely carving even more out of the federal tax base, requiring higher overall tax rates, and further entrenching its political support, all of which make fundamental tax reform even more difficult than it already is.

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