Home Mortgage Interest: the most over-rated deduction

My annual April op-ed piece on taxes, appearing in newspapers across Indiana...

It’s that time of the year again. Some people filed their 1040 tax forms last January, received their refunds and are excited that they let the government keep their money (interest-free) for months. Others have procrastinated and are filing their taxes at the last minute. Few taxpayers have noticed their “payroll tax” (FICA) - even though it probably takes more of their money (unless they earned a six-figure income). And most people believe that the world is a better place because of the Home Mortgage Interest Deduction (HMID).

Economists are interested in the distortions caused by subsidies in the tax code. Subsidies change incentives, so that people end up doing more of the activity being subsidized - whether it’s attending college, purchasing health insurance through one’s employer, or buying a bigger house. Such policies may be ultimately desirable. But they are “socially inefficient” - by definition - because they take resources from a more productive part of the economy and encourage people to do what has become “personally efficient.”

The HMID is projected to cost $132 billion next year. Even in years without budget concerns, that’s a lot of money. Now, some will say that this subsidy is important for the housing sector in particular and the economy in general. They point to the “multiplier effect” of jobs created by the housing sector - from construction workers to input suppliers, from those who earn the money to those who benefit when that money is saved, given away and spent on consumer goods.

But the same could be said of other ways to use $132 billion. For example, we could put the same money into infrastructure and create jobs, while improving roads and bridges. So, why would we think that spending the money for the HMID is better than alternative uses of the same money?

Aside from efficiency, there are also important questions of “equity” or fairness. One who receives a subsidy is likely to see that subsidy as “fair.” But if we’re trying to be more objective, what can be said about the fairness of the HMID?

Beyond its overall cost, the subsidy provides a disproportionate benefit to the wealthy. Intuitively, this is relatively easy to understand. One has to itemize deductions to get it. From there, the gain is only the amount of the itemized deduction over the standard deduction. In 2010, the standard deduction for married couples was $11,400. So, unless your mortgage interest and other deductions (most notably, charitable contributions, state-local income taxes and property taxes) exceed that amount, your mortgage interest does not reduce your taxable income at all.

For example, if a married couple has mortgage interest of $5,000 and total deductions of $12,000, then they only get the extra $600 over the $11,400 standard deduction. From there, you multiply the $600 reduction in taxable income by the relevant marginal tax rate (MTR). If they’re in the 15 percent tax bracket, then the extra $600 in deductions would be worth $90 in lower taxes. It’s difficult to get excited about saving $90 in taxes by giving a bank $5,000.

Both the amount of itemized deductions and the MTR typically increase with income. So it follows that the wealthier should be expected to benefit a lot, while the policy does little for the middle class and nothing for the poor.

Let’s look at the numbers. Some states benefit more than others. In 2008, 27 percent of Americans claimed the HMID for an average deduction of $3,279. But use of the HMID ranged between individual states, from Maryland’s 38 percent to North Dakota’s 15 percent. And average HMID deductions ranged from California’s $5,520 to North Dakota’s $1,222. (In Indiana, 33 percent claimed the HMID with an average deduction of $3,337.)

A recent study by the Urban Institute focused on the net tax benefit of the subsidy. Among Whites, 26.4 percent benefit from the HMID, by an average of $632. Among African-Americans, only 14 percent benefit from the subsidy, by an average of $277. Looking at income levels, the average annual benefit of the HMID is $4,466 for the top 5 percent of income earners; $2,639 for the top 20 percent; $215 for the middle 20 percent; and $2 for the lowest 20 percent.

It’s difficult to imagine why one would be really excited about this policy - rather than lower, overall taxes or lowering the deficit - unless one is wealthy and has a mortgage on an expensive home. But we should expect our politicians to rise above such selfish interest and to enact policies that are more efficient and more equitable.