Mortgage Interest Deduction Research Articles

The Benefits of the Home Mortgage Interest Deduction

The home mortgage interest deduction creates incentives to buy more housing and to become a homeowner, and the case for the deduction rests on social benefits from housing consumption and homeownership. There is little evidence suggesting large externalities from the level of housing consumption, but there appear to be externalities from homeownership. Externalities from living around homeowners are far too small to justify the deduction. Externalities from homeownership are larger, but the home mortgage interest deduction is a particularly poor instrument for encouraging homeownership since it is targeted at the wealthy, who are almost always homeowners. The irrelevance of the deduction is supported by the time series which shows that the ownership subsidy moves with inflation and has changed significantly between 1960 and today, but the homeownership rate has been essentially constant.

Housing taxation and capital accumulation

This paper studies the impact of the preferential tax treatment of housing capital in a dynamic general equilibrium life-cycle economy populated by heterogeneous individuals. The model includes the main housing tax provisions currently in place in the U.S. and a minimum downpayment requirement upon purchasing non-divisible houses. The tax code makes the return on housing capital larger than that on business capital, which distorts the lifetime profile and composition of individuals’ savings. The wedge between the two rates of return emanates from the failure to tax imputed rents and is amplified by the presence of mortgage interest deductibility. Simulations show that individuals at all income levels would rather live in a world where imputed rents are taxed or one where mortgage interest payments are not deductible. Furthermore, distributional effects are much smaller than conventionally believed.

Dutch Personal Income Tax Reform 2001: An Exceptional Position for Owner-occupied Housing

This paper examines how personal income taxation has changed across countries and whether and how this has affected the taxation of owner-occupied dwellings. It presents a partial analysis as it focuses on imputed rent taxation and the mortgage interest deduction. Furthermore, the paper places housing taxation in a wider context by describing different benchmarks which could be used to assess the taxation of owner-occupied housing in different types of personal income tax. These international and theoretical points-of-departure are used to evaluate the taxation of owner-occupied housing in the Netherlands. The paper concludes that all along political arguments have conquered theoretical premises to the advantage of the owner occupier in comparison to the private landlord. It also concludes that the theoretical base in 2001 has become so weak that owner-occupied housing is in an exceptional position in comparison with other private wealth thus becoming an easy victim for future tax savings.

Household Debt and the Tax Reform Act of 1986

Prior to the Tax Reform Act of 1986 (TRA 86), interest paid on all types of household debt was deductible from income before the payment of taxes. In 1986, Congress changed the law to phase out the deductibility of interest over a five-year period.' Congress believed deductibility of interest an incentive to invest in durables rather than assets which produce taxable income and, therefore, an incentive to consume rather than save.... By phasing out the present deductibility of personal Congress intended to eliminate from the prior tax law a significant disincentive to (Joint Committee on Taxation [JCT], 1987 p. 263). The other goal of the provision was to raise $9.6 billion per year in tax revenue by 1991. Because Congress determined that encouraging home ownership is an important policy goal, achieved in part by providing a deduction for residential mortgage interest, it chose to retain the residential mortgage interest deduction (JCT, 1987 pp. 263-64). Thus, mortgage interest was fully deductible for interest paid on debt secured by a taxpayer's first or second residence up to his basis in the residence. The Omnibus Budget Reconciliation Act of 1987 (OBRA 87) changed the law so that interest paid was fully deductible on up to $1 million in acquisition debt and $100,000 in home equity debt.2 Debt is categorized as acquisition debt if it is used for the purchase or improvement of a home; home equity debt includes all other debt secured by a home. By keeping the mortgage interest deduction, Congress may have provided a loophole that some taxpayers could exploit. There was no restriction on the use of home equity debt, and taxpayers who owned homes could borrow against their home equity to pay for the same purchases they had previously funded with loans. Homeowners were given an incentive to shuffle their portfolios away from debt into mortgage debt. The widespread introduction of home equity lines of credit in the mid-1980's, which may have been spurred in part by the change in tax law, provided an inexpensive and flexible method for households to make this shift.3 Measuring the extent of portfolio shuffling is important for understanding whether households view mortgage and debt as close substitutes. Clearly the substitution of mortgage debt for debt undermines the goals of Congress to boost saving and increase revenue. Moreover, homeowners already have substantial tax preferences through the lack of taxes on the imputed income from housing and the preferential tax treatment of capital gains on their principal residence. The ability to use deductible mortgage debt to finance purchases provides homeowners another tax advantage relative to renters. Figure 1 plots the percentage change in * Putnam Investments, One Post Office Square, Bos on, MA 02109 (e-mail: dean_maki@putnaminv.com). This paper was completed while I was on the staff of the Board of Governors of the Federal Reserve System. Financial support from the Stanford Institute for Economic Policy Research and the Lynde and Harry Bradley Foundation is gratefully acknowledged. I would like to thank John Shoven, Orazio Attanasio, John Pencavel, Tim Bresnahan, Anne Royalty, Doug Bernheim, Al Teplin, Craig Furfine, Martha StarrMcCluer, Raphael Bostic, Len Burman, Julia Coronado, two anonymous referees, seminar participants, and the Financial Institutions Research Review Group for helpful comments. The views expressed in this paper are those of the author and do not necessarily reflect the views of Putnam Investments or the Federal Reserve Board or its staff. 1 In this paper, consumer interest refers to interest paid on loans that are not secured by a residence. 2 Under TRA 86, interest paid on qualified educational and medical debt secured by a home was also deductible, even if this debt exceeded the household's basis. This provision was not renewed in OBRA 87. Under OBRA 87, home equity debt also could not exceed the difference between the fair market value of the home and the amount of acquisition debt, even if this difference was less than $100,000. 3 Of course, homeowners can also increase their mortgage debt by taking out a traditional home equity loan, by taking cash out when refinancing their mortgage, or by taking out a larger mortgage when they Durchase a home.

Tax‐Induced Portfolio Reshuffling: The Case of the Mortgage Interest Deduction

Several provisions of the Tax Reform Act of 1986 had an indirect impact upon the demand for home mortgage debt. These include the elimination of the deductibility of interest on consumer credit, the increase in the standard deduction, and the reduction in the number of expenses that can be itemized. These provisions and the 1983–1989 panel sample of the Survey of Consumer Finances provide an opportunity to study the responsiveness of the demand for home mortgage debt to its tax status relative to the tax treatment of equity‐financed investments in housing and consumer credit. The results are strongly supportive of a highly elastic demand for mortgage debt with respect to its tax price. The best point estimate of this elasticity is –1, but substantial variation is found among certain groups. More generally, the results provide strong support for the phenomenon of portfolio reshuffling.

The Policy Implications of Portfolio Choice in Underserved Mortgage Markets

Home ownership increases the incentive to maintain property and neighborhood, as well as decreasing the outflow of rents from low-income zones. However, these benefits are not costless to homeowners. With a mortgage comes the possibility of default, the financial demands of maintenance, a reduction in alternate investment opportunities, an increased exposure to fluctuations in local economic conditions, and a drastic reduction in the liquidity of personal wealth. Recently, policy makers have sought to increase mortgage lending in traditionally underserved markets. In this paper we consider the effects of this policy in light of the risk and return of housing and the current tax treatment of the home mortgage deduction. We find housing to be a relatively poor asset class in which to invest the bulk of family wealth. Trends in housing suggest that a large percentage of homeowners who bought and sold within a five year horizon in the United States over the last twenty years lost money on the investment. Lowering the equity required to purchase a home does little to alleviate the problem. We show that the current tax code - if anything - encourages renting over buying and gentrification of low income housing markets. If the government wishes to encourage home ownership among low income families despite the risks, then we argue that government agencies should share information about the risk and return of home ownership with its citizens. In addition, a direct subsidy through a tax credit may be both warranted and necessary to achieve the desired result.

Evidence on the Demand for Mortgage Debt by Owner-Occupants

This paper explores the relationship between household mortgage debt burdens and housing consumption, periodic income, nonhousing wealth, the income tax position of the household, expected mobility, and other micro-level characteristics that proxy for household risk preferences and life cycle effects. We use 1985 and 1989 American Housing Survey data to estimate mortgage debt level equations simultaneous with house value equations, controlling for the contemporaneous nature of these two choices. We find that larger debt levels are positively associated with greater value residences and with the level of household income. Numerous household level demographic characteristics are also systematically related to mortgage demand. Of particular interest are our findings that the use of mortgage debt is affected significantly by the rate of tax savings on mortgage interest deductions and by the expected mobility of the household.

The False Messiah of Tax Policy: What Elimination of the Home Mortgage Interest Deduction Promises and a Careful Look at What It Delivers

This article explores the potential effects of eliminating the home mortgage interest deduction. Estimatesof the tax expenditures generated by the home mortgage deduction usually exceed $40 billion,which give the impression that much additional tax revenue can be obtained by eliminating it. Weargue otherwise. Many households, especially wealthy households, would change the way they financetheir homes if the mortgage interest deduction were eliminated; they would rely less on mortgage debtand more on their own assets.Roughly $10 billion in additional tax revenue is generated by eliminating the mortgage interest deductionwhen such portfolio reshuffling is taken into account. Those hardest hit would be younger,upper-middle-income households. Wealthy households, low-income households, and many elderlyhouseholds would be less affected.

WHAT CAN AMERICA LEARN FROM THE BRITISH TAX SYSTEM?

This paper examines elements of British tax policy and discusses their implications for the United States, where several recent proposals would mirror aspects of the British system. These include reducing filing requirements under the individual income tax, indexing capital gains for inflation, cutting mortgage interest deductions, enacting a value-added tax, and integrating the corporate and personal income taxes. The paper also discusses implications of the poll tax for tax reform. Britain and America have made different choices involving equity, efficiency, simplicity, and other goals. These choices offer the chance to help identify the impact of tax policy.

What Can America Learn from the British Tax System?

AbstractThis paper examines elements of British tax policy and discusses their implications for the US, where several recent proposals would mirror aspects of the British system. These include reducing filing requirements under the individual income tax, indexing capital gains for inflation, cutting mortgage interest deductions, enacting a value added tax, and integrating the corporate and personal income taxes. The paper also discusses implications of the poll tax for tax reform. Britain and America have made different choices involving equity, efficiency, simplicity and other goals. These choices offer the chance to help identify the impact of tax policy. JEL classification: H20.

The Design of a Tax Rule for Owner-Occuped Housing Under a Personal Consumption Tax

Abstract Analysts agree that designing a satisfactory tax rule for owner-occupied housingposes a senous challenge for the personal (cash flow) consumption tax that recently has been introduced in Congress by several senators. We compare tax rules for owner-occupied housing by performing numerical simulations for a person who begins as a renter, then becomes an owner-occupier, and ends as a renter. We show that the most commonly offered tax rule—prepayment with mortgage spreading— yields a time path for taxes over the person's life that is not fully satisfactory. We then show that this time path can be improved if the tax rule is modified so that prepayment with mortgage spreading is coupled with downpayment spreading, tax deferral, and capital gain or loss inclusion. Interestingly, a mortgage interest deduction, together with taxation of the nominal capital gain at sale, may represent an imperfect implementation of tax deferral.

PORTFOLIO SHUFFLING AND TAX REFORM

* Abstract - This paper analyzes the response of households to the provision in the Tax Reform Act of 1986 that phased out the deductibility of interest paid on consumer debt. The evidence suggests that the policy goals of the provision were frustrated because households shuffled their portfolios, substituting mortgage debt for con- sumer debt. High-income homeowners appear to have shuffled more of their debt and thus increased their share of the benefits of the mortgage interest deduction. One reason for this differ- ence in shuffling may be that high- income homeowners scored better on measures of financial sophistication, and better scores appear to predict greater shuffling. Policy options that would reduce the use of mortgage debt for nonhousing purchases are discussed.

On the equity effects of taxing imputed rent: Evidence from Australia

Abstract Taxation of net imputed rent from owner‐occupied housing (and mortgage interest deductibility) has been advocated in Australia on grounds of both efficiency and equity. The current tax system (no taxation or deductibility) favors owner‐occupied housing over business investments, and in the owner‐occupied sector it favors high‐income, low‐debt households over others. Nevertheless, imputed rent taxation has been criticized on the empirical grounds that its direct burden would fall more heavily on low‐income households than high‐income households. Using micro‐level data from the 1986 Income Distribution Survey, we show that the burden does not fall more heavily on low‐income households when net imputed rent is included in owners’ incomes and when life cycle effects are controlled for. Moreover, for married couples aged 25 to 54, the taxation of imputed rental income would be not only progressive, but more progressive than the taxation of other household income.

The preferential income tax treatment of owner‐occupied housing: Who really benefits?

Abstract This article uses a model that includes an explicit measure of net implicit rental income to examine the size and distribution of the tax expenditure to owner‐occupied housing across and within homeowner income classes. The model is derived from 1989 American Housing Survey data. The analysis leads to three major conclusions. First, on net, the inclusion of net implicit income in the measure of homeowner tax savings adds a substantial amount to the estimated tax expenditure given to owner‐occupied housing. Second, the interaction of changes in the standard deduction and in the tax treatment of itemized nonhousing expenses has rendered the mortgage interest deduction worthless for many low‐ and moderate‐income households. Third, although most of the expenditure is distributed to high‐income households, the distributional effects of eliminating the expenditure to owner‐occupied housing depend on the manner in which these savings are distributed.

A General Equilibrium Model of Housing, Taxes, and Portfolio Choice

We describe a model in which rental and owner housing are risky assets, tenure choice is endogenous, and each household is constrained to consume the same amount of owner housing that it has in its investment portfolio. At each iteration in the search for an equilibrium, we determine the new taxable income for each of 3,578 households (from the Survey of Consumer Finances), and we use statutory schedules to find the marginal rate and tax paid. Equilibrium net rates of return are major determinants of the amount of owner housing, but a logit model indicates that demographic factors are the main determinants of ownership rates. In our simulation, taxes on owner housing would raise welfare not only by reallocating capital but also by the government's taking part of the risk from individual properties and diversifying it away. Measures to disallow property tax or mortgage interest deductions do not help share this risk. Simulations of the 1986 tax reform indicate a small shift from rental to owner housing and welfare gains from reallocating risk.

THE FEDERAL TAX SUBSIDY TO HOUSING AND THE REDUCED VALUE OF THE MORTGAGE INTEREST DEDUCTION

This paper estimates the federal income tax subsidy and the associated deadweight loss to both owner-occupied and rental housing. We focus on the tax subsidy after passage of the Tax Reform Act of 1986 and add more detail than other work in this literature regarding the distribution of the subsidy among income classes and household types. Furthermore, attention is given to an aspect of the subsidy to owner-occupied housing that has received little attention: the value of the mortgage interest deduction and how its value is affected by the standard deduction and the amount of nonhousing itemized deductions. In particular, we demonstrate that TRA has introduced a substantial anti-mortgage debt bias, especially for low and moderate income households.

RESIDENTIAL MOBILITY AND HOUSING TAX REFORMS: Some Empirical Evidence*

The efficiency and equity implications of mortgage interest deductibility have been studied by a number of authors using models of housing demand that do not account for barriers to residential mobility. This paper examines how one's assessment of that proposed tax reform may differ based on models that do allow for such barriers, using data from Toronto, Canada. We find that earlier works tend to overstate the deadweight loss attributable to the introduction of mortgage interest deductibility, particularly in the short run.

GORING THE WRONG OX: A DEFENSE OF THE MORTGAGE INTEREST DEDUCTION

FOR many years the mortgage interest the mortgage interest deduction as a subdeduction was a sacrosanctpart of the sidy to homeownership, and that the true tax codedespite the frequently expressed advantage to owner-occupied housing lies opinion of many economists that it mis- in the different treatment of rental inallocatedresources in favor of housing and come to landlords (taxed) versus services was regressive besides. The inflation of of owner-occupied housing to homeownthe late 1970sdrove the revenue lossfrom ers (untaxed). We devote s6me attention the deduction relentlessly upward, mak- to the relationship between inflation and ing it an increasingly visible target for tax the cost of owning and renting. We show refonners, and finally the Tax Reform Act that under current tax law, inflation raises of 1986 imposed the first limitations. the cost of renting relative to owning for TRA86 restricted the deductibility of in- peoplein high tax brackets, but lowers the terest to mortgage interest, including in- cost of renting relative to owninglor peoterest on secondmortgages taken out for ple in the lowest brackets. Whether the worthy purposes such as home improve- cost of renting rises absolutely with inments, medical expenses and education. flation depends on whether nominal inThen the 1987 Budget Reconciliation im- terest rates adjust only for expected inposed a maximum of $1.1 million-$l flation or adjust sufficiently to keep the million of original mortgage debt plus after-tax real rate constant for those in $100,000additional home equity debt-as the highest brackets. the total amount of mortgage debt on The rent/own cost differential under

Mortgage Interest Deductions and the Consumption Theory of Land Rent

The internal structure of the city is in part determined by the nature of public institutions, including the manner in which governments tax households. Using the graphical consumption theory of land rent, it is demonstrated that the geography of the city differs between places where deductions are allowed and places where they are not allowed. Changes in mortgage interest payment deductions can offset changes in mortgage interest rates. Without countervailing planning policies, mortgage interest deductions may also provide an impetus for urban decay.La structure interne de la ville est partiellement déterminée par les institutions publiques, y compris la méthode utilisée par les gouvernements pour déterminer l'impôt sur le revenu. La théorie graphique de la consommation du loyer des terres démontre que la structure interne d'une ville est différente entre les lieux où les paiements d'intérêt d'hypothèque peuvent être déduits du revenu pour atteindre un revenu imposable réduit, et les lieux où telles déductions ne sont pas permises. Les changements du paiement des déductions d'intérêt d'hypothèque peuvent compenser pour les changements de taux d'intérêt d'hypothèque. Sans contrevaloir les prévisions d'organisation, les déductions d'intérêt d'hypothèque peuvent aussi fournir l'élan pour la décadence urbaine.

Welfare loss estimates from homeowner tax preferences: Inflation, mortgage interest deductibility, and capital gains treatment

A model of taxation is presented and used to estimate the welfare loss from distortive treatment between capital gains on housing and on non-housing in the US and the UK. Taxation of nominal capital gains produced by inflation is taken into account. Estimated welfare losses are on the order of 1% of GNP—much higher than that obtained by previous authors.