Eliminating Mortgage Interest Deductibility ... An Idea Whose Time Has Come

To have a realistic shot at fixing our nation's financial problems, we're going to need time and lots more economic growth.

We're also going to require less spending on entitlements, higher taxes and fewer tax deductions. Fewer deductions equal higher tax receipts. We may wish otherwise, and I do, but wishing and hoping isn't the answer. Reality is reality.

In simple terms, our entitlements spending can't be solved with taxes on the rich. If we want European type entitlements, we're going to have to pay much higher taxes than we do currently, and that very much includes the middle class. The math doesn't work otherwise.

But let's talk about a sacred cow today --- the deductibility of mortgage interest. And while we're at it, let's ask why government policies encourage individuals to take on what becomes excessive home related debt which often can't be repaid. We'll leave aside student debt for this discussion, but it's a very real issue too. Debt is debt, and it's not cheap, let alone free.

So why do government policies encourage individuals to be debtors? Is living the dream worth the risk of that dream turning into a nightmare? In other words, why does we incentivize people and especially home owners to take on onerous levels of debt by offering them deductions on their taxes for the debt assumed?

And why do government sponsored entities like the FHA, Fannie Mae and Freddie Mac guarantee the repayment of this mortgage debt to lenders who initially loan up to 97% of the amount of the home purchase price?

I don't get it, but builders, developers, realtors and mortgage lenders obviously do. They all have a "special interest" in the prices of homes and the sales volumes of homes, too. They are one huge lobby in Washington and clearly know their way around the halls of Congress. As a result, government policies have long heavily encouraged home ownership, even for those buyers who realistically can't afford to own a home.

But wait, maybe things are about to change in Washington. Let's hope so.

There's a report just out that says the home mortgage interest loan deductibility tax benefit is in real jeopardy as part of the fiscal cliff negotiations. Although it admittedly may be an unpopular position, I for one hope the deduction, at least for high income individuals, is soon eliminated. And in any event, its fate will tell us a lot about the seriousness of the cliff negotiators in slaying some of the sacred cows that have been in place for a very long time.

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But let's begin with how they do thngs in Canada. Risks Are Mounting in Canada reports that not allowing mortgage interest deductibility is the Canadian way. And not giving special treament to interest on debt has had no harmful effect on selling houses in Canada. In fact, Canadians do dumb things about taking on excess debt even without government's encouragement. It just doesn't make its repayment a broader taxpayer liability:

"Another contributor to Canada's robust performance has been home building and selling, which made up 16.5% and 4.7% of GDP growth in 2010 and 2011, respectively. Canadian home prices are about 125% higher than their 2000 level, while U.S. prices have fallen to about 40% above that year's level, according to Wells Fargo. What makes Canada's rise more remarkable is that Canadians, unlike Americans, can't deduct mortgage interest on their income-tax returns. . . .

Economists here are predicting a far less jarring end to the boom than a U.S.-style collapse in the real-estate market. But borrowing to buy property has helped make Canadians some of the most leveraged consumers in the world, at a time when their counterparts in other heavily indebted countries—such as the U.S.—are digging out. Household debt is now 163.4% of disposable income in Canada, close to the U.S. level at the height of the subprime crisis. Mortgage rules are generally more conservative in Canada, with banks demanding higher credit scores and shorter amortization periods from borrowers than in the U.S."

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Now let's see what the mortgage deductibility scuttlebutt is all about here in the U.S.

Mortgage Interest Deduction, Once a Sacred Cow, Is Seen as Vulnerable has the developing story:

"A tax break that has long been untouchable could soon be in for some serious manhandling.

Many home buyers deduct their mortgage interest when assessing their tax bill, a perk that has helped bolster the income of millions of families — and the broader housing market.

But as President Obama and Congress try to hash out a deal to reduce the budget deficit, the mortgage interest deduction looks vulnerable. Limits on a broad array of deductions could emerge in any budget deal. It is likely that any caps would be structured to aim at high-income households, and would diminish or end the mortgage tax break for many of those taxpayers.

“This is definitely a chance worth jumping for,” said Amir Sufi, a professor at the Booth School of Business at the University of Chicago. “For a fixed amount of revenue, it’s better to remove deductions than increase marginal tax rates.”

Such a move would be fiercely opposed by the real estate industry. The industry has played a crucial role in defending the tax break, even as other countries with high homeownership have phased it out.

Housing market players who oppose any whittling down of the mortgage deduction still have time to press their case. If President Obama and Congress manage to reach an agreement to avoid the looming tax raises and spending cuts, their deal will be broad in nature. Then, over the following months, Congress will hash out details, like any caps on deductions.

“Until Congress introduces specific legislation, there’s nothing to say about any proposed changes to the mortgage interest deduction,” Gary Thomas, president of the National Association of Realtors, said in an e-mailed statement. “However, it has always been the N.A.R.’s position that the mortgage interest is vital to the stability of the American housing market and economy, and we will remain vigilant in opposing any future plan that modifies or excludes the deductibility of mortgage interest.”

One of the reasons the mortgage tax break is so vulnerable is that both Democrats and Republicans have recently favored capping deductions, including both President Obama and the recent Republican presidential nominee, Mitt Romney.

What is more, deductions could be used to grease a compromise in the budget negotiations. High earners would be hit most by deduction limits, something that might make Republicans recoil. But the party may tolerate such a policy in return for a deal that limits how much actual tax rates go up for high-income households.

Tax numbers suggest it may not be hard to structure deduction limits in a way that leaves most middle-income households untouched.

With the mortgage interest deduction, households realized tax savings of $83 billion in 2010, according to figures from the Reason Foundation. Nearly $65 billion, or 78 percent of those savings, went to households earning $100,000 or more. . . .

One argument against curtailing the mortgage deduction is that it could reduce demand for housing, depressing home prices when the housing market is still somewhat weak. The National Association of Realtors believes a removal of the deduction could reduce property values by 15 percent, according to a presentation last year from its chief economist, Lawrence Yun.

Other analysts say they believe the housing industry overstates the potential impact. With several forms of government subsidy also supporting housing, it’s hard to single out the effect of the mortgage deduction. At the most, the Reason Foundation estimates, the deduction may bolster house prices by 3 percent.

Since any deduction cap is likely to aim at higher earners, expensive houses would be most affected. But big-ticket homes appear much more resilient to shocks than lower-cost dwellings. . . .

Given the apparent sturdiness of the higher end of the housing market, politicians may decide there are few risks in effectively capping mortgage deductions for high earners. Limiting tax breaks in a way that could reduce mortgage relief would be a change for Washington, which has done so much to support housing."

SUMMING UP

If Washington politicians tackle the mortgage interest deductibility issue in earnest next year, that will demonstrate their seriousness of purpose in dealing with our nation's financial problems.

And maybe their seriousness about helping our economy grow in a more sustainable way over the longer term as well.

I hope they do just that.

For one thing, that would place indebtedness on an equal basis with ownership. By so doing, we would no longer incentivize home buyers to take on excessive home related debt which is beyond their ability to repay.

Meanwhile, eliminating the tax break for mortgage interest would hit the highest earners and as a tradeoff perhaps keep the marginal income tax rates lower than they would otherwise be.

If so, that would be good for our nation's future economic growth.

But most important, it would demonstrate convincingly to Americans that the Washington based real estate lobby isn't so special after all. Maybe then other "special interests" would be treated not-so-special as well. If so, that would be great.

At least that's my take.

Thanks. Bob.