What to do about the Mortgage Interest Deduction? A Policy Proposal

The so-called fiscal cliff negotiations are underway, and a good many important policy decisions are at hand.  In play are a number of critical tax and spending issues, including whether to raise taxes on the wealthy and close various tax loopholes and deductions.  There is almost no tax deduction that is more popular than the mortgage interest deduction, which allows homeowners to deduct the monthly mortgage interest from their taxes.   Without eliminating this deduction, I propose some narrowly tailored reforms that are consistent with principles of equity and inclusion.

It is no secret that the mortgage interest deduction disproportionately benefits upper and upper-middle income earners.  You have to own a home to take advantage of the deduction.  The IRS claims that just one-quarter of tax filers claim this deduction.  From one point of view, and given limited resources, the deduction can be seen as government largesse or subsidy on behalf of the ‘haves’ at the expense of the have-nots’.

On the other hand, the purpose of the deduction is noble: to encourage homeownership.  Its defenders point to the fact that it reduces the cost of homeownership and that by encouraging homeownership, families can build wealth.   In other words, it allows millions of Americans to enter the middle class and enjoy the American dream of homeownership.

On the other hand, and this is much less appreciated, I would argue that the deduction has a distorting effect.  Although capped at $1.1 million on the principal of the home, the interest deduction encourages the wealthy to purchase more and more expensive homes.  The available empirical evidence supports this hypothesis.  This may contribute to residential income segregation

Sean Reardon recently published a study on the fact of growing income segregation in the United States. Between 1970 and 2009, income segregation grew dramatically in the vast majority of metropolitan regions.   Critically, mixed income neighborhoods have grown less common, while a­ffluent and poor neighborhoods have grown much more common. The share of the population in large and moderate-sized metropolitan areas who live in the poorest and most affl­uent neighborhoods has more than doubled since 1970, while the share of families living in middle-income neighborhoods dropped from 65 percent to 44 percent.   Professor Reardon also describes the racial impact of these facts, and the ways in which it may drive or exacerbate racial segregation as well.

In sum, wealthy and less well-off Americans are not living together anymore and they used to.   I would argue that the home mortgage interest deduction  plays a contributory causal role in that by generating wealthier and wealthier enclaves.

Here’s what we might do about it:  First, lower the principal cap to a firmly middle-class home price, somewhere under $350,000.   One way to do this is to set it at the annual median household price, or lower.  (If you wanted to be targeted about it, and since home prices vary by region, you could even define median prices by region.)

Second, and more importantly, I propose capping or eliminating the home mortgage interest deduction for individuals over a certain income level, somewhere between $100-200K per year.

Both of these proposals are narrowly tailored to the purpose for which the mortgage interest deduction exists: to encourage homeownership.  High wealth individuals need little incentive to purchase a home.  The deduction simply encourages them to purchase more expensive homes.   The home mortgage deduction should target tax filers at the margin: individuals and families for whom the deduction makes homeownership affordable.    Both an income and a principal cap are completely consistent with this goal.   This should not only help generate more revenue for our federal government, but should have a positive racial and socio-economic impact as well.

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