The Case Against the Home Mortgage Interest Deduction

Despite the political popularity of the tax deduction for home mortgage interest, economists are basically united in their opposition to it.

What’s the economic case against it? Simple: by giving a tax subsidy to housing, it distorts investment decisions toward houses and away from assets like factories and equipment that are more productive at the margin. And that makes workers less productive, ultimately lowering wages and making society poorer.

A recent GAO primer on tax reform makes a clear and persuasive case against the mortgage interest deduction:

Tax Treatment of Owner-Occupied Housing Distorts Investment Choices and Lowers Wages
Compared to other types of investment, owner-occupied housing enjoys tax advantages primarily because the value that homeowners receive from housing services, which is a part of the return on their investment in housing, is excluded from taxation. Economists view these services, called imputed rent, as income in kind, which is valued at what the homeowner would receive as income if the house was rented.

Under a pure income tax, imputed rent net of such costs as mortgage interest would be taxed. This tax treatment would help insure that investment in housing is taxed as other investments are taxed. As the table below shows, the tax advantages under the current system lead to lower marginal effective tax rates (METR) for housing relative to other investments.

Marginal Effective Tax Rates on Capital, by Source, 2003

Owner-occupied housing: 2%

Noncorporate investment: 18%

Corporate investment: 32%

Source: Jane Gravelle, “The Corporate Tax: Where Has It Been and Where Is It Going?” National Tax Journal, vol. 57, no. 4 (2004): 903-23

Economists generally agree that the favorable treatment of owner-occupied housing, by lowering METR, distorts investment in the economy, resulting in too much investment in housing and too little business investment. The consequence of this is that businesses invest less in productivity-enhancing technology. This in turn results in employees receiving lower wages because increases in employee wages are generally tied to increases in productivity.

The resulting distortions from the tax-preferred treatment of owner-occupied housing lead to efficiency costs that have been estimated to be large. Gravelle’s summary of estimates reports that the efficiency costs of the tax-preferred treatment of owner-occupied housing could be as much as 0.1 to 1 percent of GDP.

That’s from a text box on page 39. Let’s hope Members of Congress—who may be taking on federal tax reform next year—are actually reading these excellent GAO reports. Read the full report here (PDF).