Monday, May 2, 2011

Unindependence: The Case For Eliminating the Mortgage Interest Tax Deduction

There has been a recent call-to-action by the NAR and our state Realtor Association to fight against any actions that would eliminate the Mortgage Interest Tax Deduction (MID) that most homeowners presently enjoy.

As a full-time Realtor and the sole breadwinner in my home, it would make sense for me to parrot the talking points that it pays to support.  However, what is good for one special interest is not always good for everyone.  For many reasons, I believe the MID should be eliminated.

The history of the MID dates back to the institution of our income tax back in 1913.  Back then, most homeowners owned their homes outright.  They often built them from kits and purchased them with cash on hand.  Interest on debts were deductible because most loans at that time were business loans.  Businesses paid taxes on their revenues and therefore a tax deduction was allowed for the interest portion of loans incurred that enabled that business to create revenue.  Today, a person's private home is not a source of revenue that can be taxed.  Instead, it is a personal expense based on the person's willingness and ability the pay the price established in the market. In our day, that typically means borrowing a large portion of that purchase price.  Despite our homes coming with many enjoyable benefits like shelter, status, community, access to amenities, or even equity, it is still not a business nor a true investment per se.

Unfortunately, the government's manipulation of the tax code alters people's natural behavior and changes the fundamental dynamics of the housing market.  Ron Phipps, President of the NAR recently said: "....any changes to the MID now or in the future could critically erode home prices and the value of homes by as much as 15 percent, according to our research."  So, in other words, thanks to our government, housing is 15% more expensive than it should be.  These should be comforting words to first time homebuyers who want to purchase but simply cannot afford to do so.

The MID is basically a government subsidy of housing.  Will people go homeless without it?  No they will not.  However, some may opt to rent rather than own.  Is that so wrong?  I think not.  In a recent podcast Ron Phipps states that homeowners have an average net worth of $160,000 and renters have an average net worth of $4,000.  What is interesting about this statistic is that this is based on today's structure of subsidizing housing via the MID.  If somebody went from being a homeowner to choosing to be a renter instead, would that wipe out their net worth or their ability to make wise financial decisions?  I doubt it.  Interestingly, the NAR also states that the MID should be kept intact because 93% of people making less than $200,000 a year utilize the deduction.  That is because folks making more than $200,000 are likely paying cash for their homes.  I would argue that just because we created a system that makes a majority of the people dependent upon it doesn't mean we shouldn't work toward unwinding the system.

Another interesting aspect to consider is the natural balance that exists between owners vs. renters and, in a subsidy-free market, how these ratios gravitate to their normal levels.   

As you can see from this chart, home ownership percentages have been steadily declining since the burst of the housing bubble.  However, during the bubble, we were far above historical averages.  The cause: government (and Federal Reserve) intervention in housing.  What would this chart look like if government had had a laissez faire policy toward housing.  Would it be less volatile?   

Another reason the MID should be eliminated is the influence it has on household balance sheets.  Because of the tax deduction, many homeowners will justify taking on and maintaining debt on their balance sheets due to the deductible nature of the interest.  This defies the natural laws of economic prosperity that include frugality, thrift, and savings.  Adam Smith tells us the fastest way to opulence and wealth of a nation is for people to be employed so they can save.  Debt is a dead weight around the necks of those trying to obtain wealth.  For a government to create incentives to obtain and keep debt is folly.

Finally, eliminating the MID would create an incentive for more people to invest in real estate rather than purchase it for their own consumption as they see the comparative advantage of owning income property.  As a business asset, income properties are subject to 27.5 year straight line tax-deductible depreciation.  The rent is taxable income and therefore a tax deduction is given on the depreciation of the asset whose purchase made the generation of taxable income possible.  People would begin to treat their own homes as an expense rather than an asset and look at income properties as the true business assets that they are.  
The bottom line is that government intervention in markets has always resulted in unintended consequences.  I support a move away from the MID along with other government interference in the housing market.  Only then can we truly have a free market.


Jeremy said...

Thanks for this incredibly thoughtful policy discussion. I couldn't agree with you more. We need fewer attempts at social engineering in our tax code!

Clear Day Capital said...

I like your blog posting and agree with it in almost all respects. Here are a couple of exceptions:

1. There was not huge growth in home ownership. The graph shows it going from 62% to 68%. That's only 10% higher than historical rates. Show this on a graph with a scale starting at 0% and the increase is a blip.

2. You cannot correlate a 93% utilization of mortgage I interest deduction by sub-$200,000 earners with what the wealthy do. That makes no sense. Also, I know many people who earn that much or more and they generally do not pay cash for houses but they do pay them off faster.

Finally, I agree with you about eliminating the tax for new purchases. However, many people purchased a home based on affordability calculations that did include the interest deduction. Eliminating that now could cause another wave of defaults. I would suggest either a long term phase out (5-10 years) or permanent grandfather status.

Austin said...

Government gets involved in our lives due to greedy individuals who are left unchecked. Accountability is good and government is good. I don't trust the individual to be left unchecked in a free market system. Regarding MID, the gap between rich and poor is big. You remove the MID and, it is my opinion, the gap will only grow wider. It seems to me that you are saying that renting is good as well. What? The American dream is to own property and be free from payments after owning your own property.

Christie said...

Wonderful analysis. It is refreshing to read articles from someone who truly understands economics.