Reconsider the mortgage interest tax deduction

One aspect of this economic crisis that does not receive the attention it deserves is the skewness of our country’s policies in favor of home owners.  Disparate sections of America – our transportation policy (low gas taxes, abundant roads, low automobile taxes), political rhetoric (America is a homeowner society), and popular culture – glamorize home ownership.  This reverence of home ownership is codified in our tax law, which allows a homeowner to deduct the interest on the loan (up to a $1,000,000 secured mortgage) from their annual income when taxes are calculated.  This deduction effectively lowers the cost of home ownership, expanding the potential pool of buyers.  A larger pool of buyers means a larger demand for mortgages, which means a larger demand to securitize the mortgages.  Attracted by the returns and apparent safety of mortgage-backed securities, investors started to ask for more of the same, and supply eventually begat its own demand.  Voila the subprime crisis (and exurbs).

My explanation is of course simplistic and does not capture other factors at play in the crisis (low interest rates, increased inequality, stagnating income, flawed compensation structure on Wall Street, deification of the market, underpowered regulators, co-opted regulators, dominance of quants, etc.). The Tax Policy Center, which is affiliated with Brookings Institution and the Urban Institute, agrees that our tax code needs to be rexamined, explaining:

Many of these perverse incentives for overleverage are embedded in our Tax Code.   Corporate debt is favored over equity.  Mergers and acquisitions and divestitures are often highly-leveraged up front, with juice coming from the tax saving. Commercial real estate is still collapsing, caused in no small part by the ability of most real estate partnerships to avoid income tax in both good times and bad.  They simply remain highly leveraged, which allows them to deduct interest payments at a higher tax rate than their capital gain returns are taxed.  For every $1,000 of interest expense (deductible at a 35 percent tax rate) and $1,000 of capital gain (taxable at a 15 percent tax rate), there is net income of zero, but the tax code still provides a subsidy of $200 (the 20 percentage point difference in tax rates times the $1,000 at stake).  Mind you, that is $200 for wasting society’s resources in extra transactions and playing with others’ money.  Of course, when the capital gains go negative, then some of these firms go bankrupt.

Households can play this game too.  After all, we are encouraged to keep our homes highly mortgaged while at the same time putting money into 401(k) plans and Individual Retirement Accounts (IRAs).  Deduct $1,000 of interest expense and earn $1,000 in those accounts, and we, too, generate tax saving for leveraging up the economy while producing negative growth because we, too, employ people to generate tax saving rather than perform more productive tasks.

Except for the occasional entrepreneur in Silicon Valley, houses aren’t productive investments.