Why Economists Don't Like the Mortgage Interest Deduction

Thinkstock/Brian A. Jackson/p>

Spring and summer are traditionally peak times for homebuying activity. Amid all the open houses, some buyers and sellers may also be considering the tax implications of homeownership—specifically, the fate of the home mortgage interest deduction.

While the 2017 Tax Cuts and Jobs Act did not eliminate the deduction, it did impose new limits: Effective for mortgages taken out after Dec. 15, 2017, qualifying joint filers can deduct interest on up to $750,000 of mortgage debt, down from the previous $1 million limit.Publication 936 (2017), “Home Mortgage Interest Deduction.” IRS.

In a recent Housing Market Perspectives article, St. Louis Fed economist Bill Emmons tackled the mortgage interest deduction, or MID for short. And he wrote something intriguing: “It’s rare to find a policy that’s both popular among the public and almost universally disliked by economists. But the MID is one such policy.”

Gauging Public Sentiment

In terms of popularity, an October 2017 opinion poll by Economist/YouGov found some people are unwilling to see the mortgage interest deduction go, even for an increase in the standard deduction. About 41 percent of all surveyed said they opposed eliminating the MID if Congress were to increase the standard deduction; that opposition rose to 66 percent among homeowners who itemize their taxes.

Even some folks who do not use the MID opposed its demise, according to the poll:

• 50 percent of homeowners who take the standard deduction said they’re against scrapping the MID.
• 28 percent of renters said they’re against eliminating the MID.

Emmons, who serves as lead economist for the St. Louis Fed’s Center for Household Financial Stability, acknowledges this poll. He notes that proponents may support the MID because they plan to someday use it, or because they feel it would raise homeownership rates and promote community welfare.

But Emmons goes on to explain why economists find shortcomings with the MID. Here are several biggies.

5 Reasons Why Economists Dislike the Mortgage Interest Deduction

1. It encourages larger houses

Emmons says the MID encourages the construction of bigger, more expensive homes; this can contribute to higher energy costs, urban sprawl and fewer funds deployed to non-housing business investment.

2. It’s regressive

The MID benefits high-income households the most, Emmons says. He cites Tax Policy Center estimates suggesting the Tax Cuts and Jobs Act will make the MID more regressive: Even though it’s a smaller pot of money, the 8 percent of taxpayers with annual incomes of $200,000 or more will get about 63 percent of the benefit, compared with about 54 percent of the benefit under the previous tax law.

3. It actually reduced the homeownership rate

Emmons says the MID can hurt low- and middle-income earners by driving up house prices and making homeownership less attainable. That’s because tax benefits like the mortgage interest deduction are “capitalized” into house prices, pushing them higher than they otherwise would be. Citing research published in the February 2018 American Economic Review, Emmons explores findings that the previous incarnation of the MID—before tax reform—did not encourage homeownership.

In fact, he says, it reduced the homeownership rate by about 5 percentage points. It raised house prices so much through the capitalization of tax benefits that homes became out of reach for some buyers, he explains.

4. It increases the likelihood of mortgage defaults

By enabling people to finance homes with debt, Emmons writes, the MID increases the likelihood of loan defaults when house prices drop, especially during economic downturns.

5. It’s inefficient

Emmons says that overall, economists view the MID as such because it distorts house prices and the mix of housing constructed, while encouraging greater mortgage borrowing.

What If the Mortgage Interest Deduction Went Away?

So, the 2017 tax reform imposed new limits on the mortgage interest deduction. What if it were eliminated entirely? Regarding this prospect, Emmons again points to the American Economic Review research, saying it could provide a new benchmark for evaluating the effects of tax policies on housing choice. Among other outcomes, the authors estimate that eliminating the MID would result in:

• A 5 percentage-point increase in the homeownership rate
• An approximate 4 percent dip in average home prices
• A more than 30 percent decline in the average mortgage balance

Emmons concludes: “While the new tax law makes a significant dent in a policy that many economists view as inefficient and regressive, a worthy goal for future tax reform may be a closer examination of the MID as a whole, particularly if the expected economic benefits from partial repeal of the MID materialize.”

Notes and References

¹ Publication 936 (2017), "Home Mortgage Interest Deduction." IRS.

Additional Resources

• Housing Market Perspectives: Fewer Tax Breaks for Homeowners: A Good Thing?
• Open Vault: Three Reasons Homeownership Can Hurt Building Wealth
• On the Economy: Standard vs. Itemized Deductions: How the New Tax Proposal Could Affect the Decision