Bush's Tax Panel Has a Crazy Idea. Let's Go For It

Just how would the President's Advisory Panel on Federal Tax Reform trim the mortgage deduction?

The panel is expected to suggest replacing the home mortgage interest deduction with a new "home credit" of up to 15 percent of mortgage interest paid. That is, 15 percent of all interest paid on your mortgage would be credited against your federal tax liability.

But the panel is expected to recommend that the credit be limited to mortgage indebtedness equal to the Federal Housing Administration's loan limits in the homeowner's area. The limits range from $172,000 to a maximum of $312,000. Oh, and you would not get any tax break for second home mortgages or for home equity loans.

This should light up the switchboards on Capitol Hill. Right now, a couple can deduct from their income the interest paid on mortgages up to $1 million. Especially in the areas of the country with booming real estate markets like San Francisco, New York City, Boston and Washington, limiting that tax break would take political courage that is rarely seen in the tax policy world.

You would think from listening to the folks in the real estate, mortgage banking and home construction industries that the world will end if home mortgage interest deductions are reduced. There's no question that it would be essentially a tax hike for some Americans who got used to having their homes subsidized by other taxpayers. So, yes, the hyper-percolating real estate market might cool somewhat. That might be a good thing, anyway.

But in any case, the roof will not fall in if the home mortgage interest deduction is changed in the manner suggested by the president's panel.

The fact is that only one-third of taxpayers (46 million out of 130 million) itemize their returns. And only a tiny percentage of those deduct interest on mortgages of $300,000 or more. Earlier this year the Congressional Budget Office estimated that limiting the tax break to mortgages up to $500,000 would affect only 1 percent of all homeowners. So this would hardly be a broad-based tax increase. The wonderful thing about the progressive income tax is that it can be manipulated to raise revenue while protecting lower- and middle-income citizens quite easily.

There is simply no tax policy justification for allowing large home mortgage interest deductions. Both conservative and liberal public finance experts have long criticized the home mortgage interest deduction because it shrinks the tax base, thus requiring higher tax rates. That's right, you are paying higher tax rates because of the home mortgage interest deduction.

The mortgage deduction also distorts economic decision-making, effectively subsidizing ever-larger home purchases by making it cheaper to borrow money. (And at the moment, borrowing is already pretty cheap.) That, in turn, has fueled the out-of-control real estate market. People have been buying houses that they might not otherwise have been able to afford. Yet, really smart people since the time of Adam Smith have warned against using the tax laws to distort markets. Perhaps it is time we listened.

The purpose of the mortgage interest deduction was to encourage home ownership. Most Americans would agree that this is a worthwhile goal. But home ownership hovers around 70 percent. The other 30 percent of Americans for the most part don't earn enough money to take out $300,000 to $1 million loans for the starter home of their dreams. Maintaining tax benefits on home loans over $300,000 serves no purpose other than giving the best-off a break. Limiting those benefitswouldnot prevent anyone from basking in the joys of home ownership.

The only policy argument against reducing the amount of the mortgage tax benefit is that people who have already bought homes did so with the expectation that the deduction would continue. I agree that it would be unfair to change the rules after the fact. But transition rules can be designed to protect homeowners with such expectations.

There is even less justification for keeping the tax breaks for second home mortgages. These deductions also cost the federal government billions of dollars a year. The beach house may seem essential during the hot summers here, but we should recognize the tax break for what it is: a vacation subsidy.

The home equity interest deduction is even more absurd. We do not allow people to deduct interest on their credit card debt or unsecured bank loans. Why in the world do we allow them to deduct interest on their home equity loans? Those deductions are government subsidies for whatever the homeowner wants to buy. And the tax code makes no distinction between paying for good things, like college tuition, and frivolous ones, like European vacations.

In the end, the panel did the right thing by making these proposals. Members of Congress will be inundated with calls asserting that capping the benefits will hinder pursuit of the dream of home ownership. It will do no such thing. People do not buy houses because of the tax benefits. They buy houses so that they have a place to call home.

Author's e-mail:dbrunori@tax.org

David Brunori is vice president of Tax Analysts, Inc., a nonprofit publishing firm, and a research professor of public policy at George Washington University.