This article first appeared in the San Francisco Chronicle on 10/28/2012
If Social Security is the third rail of American politics, then the home mortgage interest tax deduction is the space just above it – no instant electrocution, but still a very dangerous spot for any politician who dares play near the tracks.
Once the elections are over, however, Congress is likely to find itself in precisely that position. Trillions of dollars in Bush-era tax cuts are due to expire at year’s end, and hundreds of billions of dollars more in spending cuts are set to take effect at the same time unless lawmakers agree on a plan to cut the federal budget deficit.
In the scramble for savings, the home mortgage interest deduction is a tantalizing target simply because it’s so big.
This tax break for millions of middle- and upper-income taxpayers amounts to about $100 billion per year in lost revenue to the U.S. Treasury. That’s nearly twice as much as the deduction for charitable contributions, or, if you think of tax deductions as spending in disguise, more than twice as big as all other federal housing programs combined.
Faced with difficult choices, lawmakers might be smart to opt for one bold blow to an iconic piece of the tax code instead of enduring the political pain of making lesser cuts to hundreds of popular programs or tax breaks.
But there are better reasons to put the home mortgage interest deduction on the chopping block. It doesn’t increase homeownership, and most of the $100 billion goes to taxpayers who are already well off.
Although the home mortgage interest deduction is deeply embedded in the myth of the American Dream, its origins had nothing to do with either homeownership or housing policy. The original income tax, imposed a century ago, permitted deduction of any type of interest, including interest on mortgages.
Few people had mortgages, and credit cards were still a twinkle in a banker’s eye, so this mostly applied to small-business debt. In the post-World War II housing boom, home mortgages became a huge business for the new savings-and-loan industry, and the interest deduction helped people afford to go into debt to buy a home.
The advent of credit cards in the 1960s made household debt more common, however, and allowing that interest to be deductible started to get very expensive for the Treasury. By the mid-1970s, the deduction cost $5 billion per year. A decade later it was up to $15 billion.
In 1986, President Ronald Reagan and Congress agreed to a tax reform that eliminated deductions for interest on anything but home mortgages. Reagan, who understood the powerful symbolism of the deduction, declared publicly that it served an important function by promoting homeownership. Lawmakers were happy to concur and saddled it with a purpose it was never designed to serve.
The way the deduction works is fairly straightforward as tax policy goes: If you buy a house and have a mortgage, you can deduct the interest on that mortgage each year. But to do so, you have to itemize deductions on your tax return. For most American homeowners, whose mortgages are less than $200,000, that’s a lot of extra calculations for very little financial advantage.
They do just as well or better by opting for the standard deduction built into the tax rates. As many as half of the taxpayers with home mortgages don’t claim the deduction because it wouldn’t save them any money, and many who do claim it get only a very small benefit. According to the Center for American Progress, a liberal think tank in Washington, the average benefit for households making around the median income is $523. For people making more than $250,000, it’s 10 times that much.
In the Bay Area, however, houses are much pricier than the rest of the country: While nationwide the median home price is about $200,000, the average house in San Francisco sells for more than $700,000, which means an average mortgage of $560,000.
So, for that $560,000 mortgage with 5 percent interest, that homeowner is looking at a deduction of $28,000 that results in actual savings of $7,000. For the homeowner with a house priced at the national median of $200,000, the deduction would be only $8,000.
But don’t take off that green eyeshade just yet. The value of the home mortgage interest deduction to a taxpayer also depends on the taxpayer’s income tax bracket. The higher your tax bracket, the more the home mortgage interest deduction reduces your overall tax bill. That means that deductions are more lucrative in wealthy areas like San Francisco. As a result, three-quarters of the dollars from the mortgage interest deduction go to just three places: New York City, the Bay Area and Los Angeles.
So what should be done? Elimination of the deduction would have real consequences because its availability to taxpayers inflates home prices. The National Association of Realtors estimates that in some parts of the country, San Francisco among them, home prices could drop by as much as 15 percent.
Instead of eliminating it, lawmakers should say boldly what so many others in previous Congresses have said: A commission made us do it! In other words, they should follow the recommendations of the bipartisan debt-reduction commission headed by former Sen. Alan Simpson and former White House Chief of Staff Erskine Bowles.
Aside from giving everybody the political cover of bipartisanship, the Simpson-Bowles reform is good public policy. It would make the deduction live up to the promise of the political rhetoric that surrounds it and genuinely encourage homeownership. Instead of a deduction, Simpson-Bowles would make mortgage interest a refundable tax credit.
Taxpayers could claim 12 percent of the interest regardless of their tax bracket or whether they itemize deductions. That means more people could receive the deduction, particularly in the middle class. It would be simpler and fairer. The Simpson-Bowles proposal would save the federal government $20 billion a year, even as it makes the policy more effective. The deduction would be smaller for many people who receive it now, but twice as many households would benefit from it.
Some Bay Area homeowners might be reluctant to embrace a proposal that would cause them to pay higher taxes. Yet the reform would ensure that the deduction has a stronger base of support than before.
Social Security, after all, is untouchable because the benefits are so broad. The home mortgage deduction has much narrower benefits than most people realize, so it’s vulnerable – if not to this round of deficit reduction solutions, then inevitably to the next. And the alternative is probably not the status quo: We could see higher rates or the elimination of deductions like the one for state and local taxes, which Californians also hold dear.
The Simpson-Bowles reform is better than the alternatives, and would help millions of middle-class homeowners across the country. Either Mitt Romney or President Obama should be happy to embrace that notion.Alexei Painter is a master’s candidate at the Goldman School of Public Policy at UC Berkeley.