Chart of the day: Where does the mortgage-interest deduction go?

By Felix Salmon
July 12, 2011
report on the way that household debt is treated for tax purposes.

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Check out page 44 of the Joint Committee on Taxation report on the way that household debt is treated for tax purposes. I’ve put the table into chart form, to make it easier to see what’s going on. Apologies for the rather weird y-axis on the chart: it’s serving a double purpose, counting total returns for the left-hand column and dollars for the right hand column. I would have done a dual axis, but I was having difficulty making that work in Excel.

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In any event, the big picture here is clear. Households earning more than $200,000 a year account for less than 10% of the returns, but get 30% of all the benefits. And households earning more than $100,000 a year get 69% of all the benefit. The mortgage-interest deduction might be a middle-class tax break, but realistically it’s an upper-middle-class tax break.

The JCT is also very clear on the two separate ways in which it’s fundamentally unfair, benefiting owners at the expense of renters:

The deduction for home mortgage interest reduces the after-tax cost of financing and maintaining a home. Because the Federal income tax allows taxpayers to deduct mortgage interest from their taxable income, but does not allow them to deduct rental payments, there is a financial incentive to buy rather than rent a home. Taxpayers are also allowed to exclude gains from the sale of their principal residences of up to $500,000 from gross income. There is no such exclusion for other types of investments, further reinforcing the financial incentive to buy rather than rent a home.

Homeowners also receive preferential treatment under U.S. tax law because the imputed rental income on owner-occupied housing (that is, the cost of rent which the taxpayer avoids by owning and occupying a home) is not taxed. Consider two taxpayers: one rents a home at a $1,000 monthly rate, and the other owns a home which carries a $1,000 monthly mortgage. All else equal, a renter pays taxes on a measure of income that includes the $1,000 used to pay rent and the homeowner pays taxes on a measure of income that does not include that same $1,000. If imputed rental income were included in income, it would be appropriate to allow a deduction for mortgage interest, property taxes, and depreciation as costs of earning that income. Because tax law allows taxpayers to deduct mortgage interest and property taxes to determine their taxable income but does not tax imputed rental income or allow them to deduct rental payment, it creates the incentive to buy rather than rent a home and to finance the acquisition with debt.

The mortgage-interest deduction should be abolished, of course — it’s a dreadful piece of public policy. Homeownership, especially during times of high unemployment, does more harm than good, and there’s not even any real evidence that the deduction actually increases homeownership, rather than just artificially making houses more expensive to buy.

But if we’re not going to abolish the mortgage-interest deduction, I like the idea that homeowners should be taxed on their imputed rental income. Think about it this way: I can give you a house, or I can give you the money to buy that house, or I can give you an income stream to pay the rent on that house. The tax consequences of the three are very different, and the last one is the worst: you have to pay income tax on the income stream, leaving you with less money for rent. But if you own a house, and get lots of valuable benefit from it every month, you don’t need to pay any tax on that benefit at all.

More realistically, however, we should just look at the $80 billion a year we’re spending on the mortgage-interest deduction and ask ourselves (a) whether we can afford it, and (b) whether it’s really the best possible way in which we could be spending $80 billion a year. The answer to both questions is clearly no. Especially since that money is going overwhelmingly to the richest households in America.

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