The Adverse Effects of Reducing the Mortgage Interest Deduction

Tax reform is on the table, again. The mortgage-interest deduction (MID), as expected, continues to be a contentious issue for policymakers. In his latest proposal, Rep. Dave Camp (R-MI) calls to reduce the limit on qualified home mortgages for MID to $500,000 of principal from the current level of $1 million. While the prospects for a complete overhaul of the tax system are unlikely before the 2014 midterm elections, understanding issues like the MID are important for future debates.

The Wall Street Journal’s recent piece on the MID helps explain the divergent policy perspectives on the deduction as a policy instrument. The Brookings Institution argues that the MID needs to be revamped or replaced. Brookings argues that homeownership in the U.S. is not higher than those in other developed countries who do not have the MID. On the opposite side, the Hudson Institute provides another perspective that supports the benefits of the MID. The Hudson Institute points out that it’s incomplete to just compare the MID in the U.S. and other developed economies to analyze the homeownership. For example, while the United Kingdom and Canada do not specifically have the MID, they do have specific policies that encourage overall homeownership.

While the jury is still out on the magnitude of the impacts of the MID, the elimination or reduction of the MID will affect the real estate markets, millions of American homeowners and renters, and ultimately the health of the U.S. economy. The elimination or reduction of the MID is an equivalence of a tax hike policy that will affect the purchasing power of homeowners and renters negatively. When the component of housing expenditure increases, the negative income effects will reduce purchases of other items across all income groups.

Since housing expenditures make up a larger share of total household expenditures of the middle-income than higher-income groups, the relative values of the MID are in fact larger for the middle-income groups. Under the current U.S. tax code, the MID can only be claimed if a taxpayer itemizes their deductions. The limit of the mortgage principal might need to be expanded, and not reduced, to benefit the lower-income groups who do not itemize their tax filings. Policymakers must understand and measure the potential short- and long-term impacts of the elimination of the MID on the housing market and broader economy before tax reform passes through Congress.