Is It Time to Kill the Mortgage Interest Tax Deduction?

With proposals from both President Obama and Republican leaders to broaden the tax base, it seems likely that some cherished income tax deductions may be reduced or even eliminated, and one leading candidate for the chopping block is the deduction for mortgage interest.

Though many economists argue the mortgage interest deduction doesn't work properly, most Americans don't agree. A poll by USA Today and Gallup published Friday showed that 61% of Americans oppose eliminating the mortgage interest tax deduction to either lower the overall tax rate or as a way to reduce the federal deficit. In fact, the poll showed that a majority of Americans were against eliminating any tax deductions.

But both the Obama deficit reduction plan and the plan put forward by U.S. Rep. Paul Ryan (R-Wisc.) would require some tax changes. "It's hard to imagine you could do a lot of base broadening while leaving the mortgage deduction completely untouched," says Alan D. Viard, a resident scholar at the American Enterprise Institute in Washington, D.C. "I think it is fair to say that each of them would end up having to do something with the mortgage deduction if they really wanted to carry through on what they are promising."

According to the Treasury Department, the budget for 2012 projects that the mortgage interest deduction will cost the budget around $100 billion. But Eric Toder, co-director of the Urban-Brookings Tax Policy Center in Washington, estimates that elimination of the deduction would only generate $70 billion to $80 billion, because some people would pay off their mortgages early if the law is changed.

"Most of the deduction is going to the people who are itemizing -- relatively high-income people who would be home owners anyway," Toder says. "People on the margin -- who might be thinking about renting or buying -- can't use the deduction."

AEI's Viard says the deduction actually "encourages people to own bigger homes or more expensive homes. It is hard to see the public purpose in that objective."

Who Gains the Most From the Deduction?

There is no dispute that the deduction benefits higher-income earners more than lower- and middle-income Americans. If you're in the 35% tax bracket, you get $35 of savings for every $100 of mortgage interest you pay, but if you're in the 15% tax bracket, you only get $15. So it's hard to claim that the deduction is targeted at people who are on the fence on the question of buying a home vs. renting.

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But a counter-argument comes from Robert Dietz, an economist with the National Association of Home Builders, who says that elimination of the mortgage deduction would have "a huge impact" on first-time home buyers.

In the early years of a 30-year, fixed-rate mortgage, Dietz notes, the largest part of each payment goes directly to interest -- only a little goes to paying down the loan's principal. As a result, he says, recent first-time buyers are the ones for whom interest makes up the largest share of the household budget, and it is they who would be hurt the most by an elimination of the mortgage interest deduction.

Dietz maintains that 70% of the benefits from the reduction in tax liability go to people earning between $50,000 and $200,000 a year. Eliminating the mortgage deduction "would have the effect of delaying the home ownership status of some people, as they would have to accumulate a larger down payment before they became home owners," he says.

Toder says he doubts that elimination of the deduction would divert potential homeowners into becoming renters. "I think what it would probably do is reduce the amount of money you would spend on a house," he says.

And, he notes, if there are no transition rules, current homeowners could get squeezed painfully if the deduction is eliminated while they have to carry on making the same old mortgage payments.

An Alternate Proposal

One plan that is gaining currency was suggested by President Obama's budget reform commission, which was headed by former Sen. Alan Simpson (R-Wyo.) and Erskine Bowles, former chief of staff to President Clinton.

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They proposed to eliminate the mortgage interest deduction and replace it with a 12% credit for interest paid. While that would be less than many taxpayers now receive for the current credit, lower-income earners such as seniors would be entitled to claim the new credit even if they don't file for itemized deductions.

The current limit for the proposed deduction is mortgages on $1 million homes. Viard says by making interest credit available to people who don't itemize deductions and placing a limit on the dollar value of the house, it wouldn't encourage people to buy more expensive houses.

"This credit is much more focused on what may be the legitimate goal of encouraging home ownership instead of this clearly illegitimate goal, which I am not sure anybody has identified, of encouraging bigger houses," Viard says.

Or perhaps we can eliminate mortgage interest from consideration altogether. After all, Canada and Britain don't allow it as a tax deduction, and the real estate markets are booming in both countries.