Mortgage Interest Deduction: Good Social Policy?

Federal tax code permits taxpayers to deduct mortgage interest on loans of up to $1,000,000 and interest on home equity loans up to $100,000. On a home loan of around $180,000, that's about a $11,000 annual deduction. The proceeds from home equity loans don't even need to be spent on home improvements for the deduction.

The deductibility of loan interest began at the inception of the income tax, although the focus was not on increasing home ownership. In fact, the modern home mortgage did not take shape until the late 1930's and the 1940's under New Deal-era legislation. Previously, most mortgages were 3-5 years with large balloon payments that required constant rollover of debt (the bank failures of the Great Depression made that system unworkable). Instead, it seems likely that Congress intended the deduction to help foster business growth, since the deduction wasn't available for people with incomes below $3,000 (in other words, 99% of people in 1913 couldn't take the deduction).

As incomes grew and the availability of credit expanded with the use of credit cards, the interest deduction became very popular. In 1986, President Regan and Congress modified the exemption, removing everything except the deductibility of home mortgage interest. The cost of the mortgage exemption has grown significantly, from around $20 billion in 1981 to $72.6 billion in 2005. The tax benefits of home ownership are significant.

Although undeniably popular, there is significant criticism of the mortgage deduction. Critics contend that the deduction actually does little to encourage home ownership and is "remarkably unprogressive." Economist Edward Glaesar recently gave 5 reasons why we should kill the deduction:

1. It encourages people to take out larger mortgages to maximize the tax benefit.
2. It causes prices to increase in markets with inelastic housing demand (i.e. NYC, SF)
3. It's regressive.
4. It encourages purchase of expensive and larger homes.
5. It doesn't really increase home ownership.

To relate this issue to our textbook, it seems to function much like the reciprocal deductibility of state and federal taxes.

Would Congress and the President really act to kill such a popular deduction? Although killing it appeals to a wide range of ideological thinkers, it seems unlikely that the deduction would vanish without being part of a larger tax reform effort.