Long live the mortgage interest deduction

[UPDATE 8 March 2010]: I got some things wrong in this post, mainly ignoring the time value of money in my "appeal to finance." It's only "twice the tax" if the owner's opportunity cost is zero. If the owner can consistently earn a return greater than his mortgage rate then financing actually results in less taxes than paying cash. When I eventually write a better post about the MID I'll link to this one, which I'll leave here unedited as a monument to my carelessness.

The Congressional Budget Office puts out a depressing publication called Budget Options. This year, option 7 (page 187) is "Reduce the Mortgage Interest Deduction or Replace It with a Tax Credit." What a terrible idea.

People that oppose the mortgage interest deduction (MID) like to call it a "subsidy" to homeowners. They claim it encourages society to invest too much capital in housing and not enough in growth sectors. They say it's not fair to renters. They decry inequity to homeowners with lower incomes who don't itemize deductions. They are wrong.

The term "subsidy" implies unfairness. Some special group is getting over on the rest of us. It's easy to show that the MID is no such thing. First, an appeal to history. When the income tax was first established, all interest was exempt for both businesses and individuals, and that is how things should have stayed. The Tax Reform Act of 1986 removed the deduction for credit card interest and other forms of personal interest. When you start out with full exemption for all and Congress strips some away, is what remains really a subsidy?

Not sold yet? How about an appeal to finance. Assume there is no MID and consider two individuals, Richie Rich and Mark Middleclass. Richie buys a $500,000 house with cash. He's paid tax on $500,000. Mark doesn't have that kind of cash so he puts $100,000 down for his similar house and borrows $400,000 at 6% for 30 years. He'll pay tax on $963,000. Mark will pay nearly twice the tax for the same house because he financed it. Is that fair? Should we force Richie to finance his house too and eliminate that "subsidy?" Should we prevent Mark from buying a house until he saves $500,000?. Maybe we could just let Mark deduct his interest expense.

The kind of people who think they can somehow know that 38 percent of net private domestic investment is too much investment in owner occupied housing and desire to fix it with the Tax Code are the same kind of people who think it's not a problem that the Tax Code is 7,500 pages long. They consider the MID a distortion, a source of economic inefficiency. It would be better in their view if more capital went to their preferred economic sectors. But we can finance the purchase of stocks and bonds by buying on margin, and we can deduct margin interest expense. So the only thing that's distorted is the superegos of these people.

The benefit that homeowners receive is called imputed rent. This is the rent they would have paid to rent their own place if they didn't own it, or would have received if they rented it to someone else. Rental income is taxable to a landlord, but this imputed income is not taxable to a homeowner. Unfair? Landlords can also deduct maintenance, depreciation, salaries, etc. Homeowners cannot. If the imputed rent should be taxable, then the expense—both real and imputed—of maintaining the home should be deductible. A more equitable basis for taxing homeowners would be a tax on imputed rental profit. In nearly every case this will be much less than the MID. There could even be an imputed loss. It's a difficult value to estimate, and might easily be gamed. If I can deduct my labor to caulk the tub and cut the grass, I can claim just enough labor to cancel my imputed rent. How do you audit that? In any case, eliminating the MID would cost homeowners a lot more than the present slight tax advantage over landlords.

Renters benefit from the MID because their landlords have lower costs. The portion of rent you pay to your landlord in excess of his costs is his profit. If you don't want to pay profit to a landlord, buy a home or find a non-profit landlord. Don't whine about the MID, because you receive it indirectly.

It's true that nearly half of homeowners with mortgages don't itemize and therefore don't receive the MID. Can we presume that they don't itemize because the standard deduction is greater than the total itemized deductions? These homeowners aren't losing the MID, they are opting instead for an even greater benefit. Say you go to the store and they offer you 5% off or 10% off, your choice. After you choose 10% do you have a right to complain because you didn't also get the 5%? How ridiculous arguments like this get into CBO publications amazes me.