TPC Looks at the Mortgage Interest Deduction

In a recent analysis of the second largest tax expenditure in the tax code--the mortgage interest deduction--the Tax Policy Center finds that most people would not see their tax burdens change much if lawmakers significantly reduced or restructured the deduction. Their findings may come as a surprise to many people who think of the mortgage interest deduction as a huge benefit for homeowners. In reality, its impact on individual homeowner tax burdens is much more limited than its budgetary impact of $120 billion per year would suggest.

Outright repeal, according to TPC, would increase the tax bills of all taxpayers, but by a higher percentage of income for upper-income taxpayers and by no more than $3,000 for any income group on average. Repealing the subsidy would raise a taxpayer's tax liability by no more than two percent of income for any average income group. As Howard Gleckman of TPC notes, this change is not as big a blow to incomes as the political intensity surrounding the deduction might lead someone to believe.

However, repeal of the MID faces political obstacles. Many proposals would tinker with it to reduce its size. Some proposals would limit the size of the mortgage eligible for the deduction (currently at $1.1 million), which would reduce the regressivity of the subsidy. The Fiscal Commission's illustrative tax plan would replace the deduction with a twelve percent non-refundable credit.

TPC found that by repealing the current deduction and replacing it with a twenty percent non-refundable credit, the tax bills of many middle-class taxpayers would actually be lower. Relative to current law, on average, the bottom three income quintiles (up to roughly $70,000 income) would all see tax cuts, while the top two quintiles would see their tax bills rise. Relative to current policy, the bottom four quintiles (up to about $120,000 income) would get tax cuts on average. In both cases, the tax increase that upper-income taxpayers would face on average would, again, be small as a percentage of their income, but enough to raise revenue overall.

Why would middle class taxpayers get a tax cut? It comes down to the difference between a deduction and a credit. The value of a deduction is determined by the tax bracket a person is in, while the value of a credit is not. Thus, a twenty percent credit would be worth more than a deduction for any taxpayer who is mostly in the 10 or 15 percent brackets. And the reason why more people get a tax cut under current policy is because the 2001/2003/2010 tax cuts push taxpayers down into lower marginal tax brackets. The result is a gain relative to those baselines.

CBO's Budget Options from 2009 estimate that replacing the mortgage interest deduction with a fifteen percent credit could raise about $400 billion over just seven years (since the policy would take effect in 2013). TPC has no specific revenue estimates for the twenty percent credit, but they do say it is intended to raise $30 billion in 2015 relative to current law.  Still, the point is clear: even a reform policy that cuts taxes for some people can raise a significant chunk of revenue.

These are the types of benefits we can see from reforming tax expenditures. This type of proposal could help correct the regressive nature of the mortgage interest deduction, while raising revenue and possibly stunting the growth of a housing bubble in the future, which is one of the biggest concerns with the MID currently.

This type of scenario is not just limited to the mortgage interest deduction. Many other tax expenditures distort economic incentives by providing open-ended benefits, often to the people who least need them. TPC's report demonstrates the essential role that reforming tax expenditures could play in the future of our economy and our budget.

For CRFB's suggestions on tax expenditures, see here.