The mortgage interest tax deduction is often justified as promoting homeownership among the middle class and supporting industries that employ middle-class workers. The deduction also has broad public support: a recent survey found that six out of ten Americans oppose its elimination.
But such support is misplaced. Over 64% of the MID tax benefits go to tax filers earning more than $100,000, according to our new study released through the Mercatus Center at George Mason University. While the upper middle class does benefit from the deduction, the vast majority of the dollar benefits go to higher-income taxpayers. Little to no dollar benefits go to low-income households that purchase a home.
Our study examines the economic effects of the mortgage interest deduction in addition to assessing the tax break’s policy effectiveness. We argue that, considering the political hurdles that full repeal might create, policymakers should instead seek to replace the MID with a fixed $900 credit for all taxpayers with a mortgage.
The purported public policy role of housing-related tax deductions and credits is to increase homeownership. But as currently structured, the MID fails to significantly increase homeownership among its intended beneficiaries, and it encourages greater debt among homeowners. In short, the MID is generally giving a tax break to households that would likely purchase homes anyway and enabling high-income households to buy homes that are roughly 10–20% larger than those they would otherwise buy.
Of the 65.2% of tax filers claiming to make less than $50,000, a mere one in ten claims the mortgage interest deduction. One reason that low-income and many middle-income taxpayers are unlikely to use the MID is that the standard deduction is likely greater than any itemized expenses. Unless annual mortgage interest expenses, combined with any other expenses that are allowed as itemized tax deductions, are greater than the standard deduction, a taxpayer will not opt to itemize deductions. According to data from the Internal Revenue Service, it is only after reaching $100,000 in income that three-fourths of tax filers use the MID.
Other countries also demonstrate an inconclusive relationship between the MID and homeownership. In the case of the United Kingdom, which phased out the MID between 1975 and 2000, the homeownership rate rose from 53% in 1974 to 68% in 2001. While the increase in homeownership may or may not be a direct result of phasing out the MID in the UK, at a minimum, the phase out did not decrease homeownership.
Much of the justification for owner-occupied housing subsidies focuses on encouraging individuals who would not otherwise have sufficient savings to acquire home equity. Yet as Yale economist Robert Shiller points out, other foreign countries such as Switzerland have higher rates of household saving even without high homeownership rates.
The MID could likely be eliminated with minimal effects on low- and middle-income taxpayers. Only a full repeal of tax-favorable housing policies in exchange for lower marginal tax rates for all taxpayers will eliminate economic inefficiencies. Elimination of the MID in exchange for lower marginal rates and a higher standard deduction would represent a general improvement in the standard of living for almost all low- and middle-income taxpayers.
This hypothesis has already been proven by the The Tax Reform Act of 1986, which significantly reduced the value of the MID by reducing marginal tax rates and increasing the standard deduction. The lower tax rates significantly diminished the use of the MID by lower-income households, although the reduction in use was not quite as great for high-income households.
Eliminating the MID may slightly decrease the demand for housing among some low-income households that actually have sufficient mortgage interest to itemize. But this decrease seems relatively small, given that the MID is used so infrequently by low-income households. The bulk of the decrease in the demand for mortgage debt would come from households with large loans that exceed the loan limits of Fannie Mae and Freddie Mac.
A cleaner tax code would also move the housing industry away from its current tax-driven overvaluation. Revenue-neutral tax reform that eliminated the tax bias toward housing might encourage higher-income households to shift some housing investments to more socially productive investments, such as stocks or bonds.
If tax-favored housing must exist, it should, at a minimum, promote homeownership among low-income and middle-income households. A successful tax-favored housing policy would be designed to encourage households at the margin to purchase a home—that is, those homeowners who would like to own homes but would not do so without a federal subsidy. For example, offering a fixed, nonrefundable $900 credit to people who have a mortgage could increase homeownership among low- and middle-income households by as much as 5%, while only decreasing homeownership rates among high-income households by 1%.
By reforming the MID from a deduction to a credit, the purported policy goals of supporting homeownership would be more properly aligned with actual outcomes. A cleaner, simpler tax code brings more equality to investment opportunities and is a step toward greater tax fairness.
Jason J. Fichtner is a senior research fellow with the Mercatus Center at George Mason University. Jacob Feldman is a research analyst with the Mercatus Center. They are coauthors of a recent working paper published by the Mercatus Center on "Reforming the Mortgage Interest Deduction."