Friday, March 25, 2005

Idealism and the Mortgage Interest Deduction

After learning to see the world through the lenses of economics, one of the things that most startled me was how different the world looked even though I had exactly the same values that I had had when I accepted the views of Harper's Magazine, Utne Reader, Mother Jones, etc.

A specific case: Why aren't do-gooders outraged by the home mortgage interest deduction? It is an enormous factor in our economy ($779 billion in 1999 vs. around $400 billion total spent on K-12 education) that:

1. Primarily benefits high income people; the higher your mortgage (up to $1 million on up to two homes) the more you benefit. It is a case study in effectively regressive taxation. See http://www.taxfoundation.org/prmortgage.html for how a flat tax that eliminated the mortgage interest deduction would primarily harm those with homes over $300,000.

2. Provides a huge incentive to build or buy bigger homes. Commentators sometimes rant about "real estate porn" when they see ads for enormous homes - and yet, through the mortgage interest deduction the government subsidizes large homes. One would have thought the environmental movement would also be outraged by this - Insofar as one is concerned that we are using too much energy or killing too many trees, one might try to fight this massive payment system that encourages people to build bigger houses.

I can only come up with two reasons why this obvious case of rent-seeking by the wealthy, the real estate industry, and the banking industry has been almost completely ignored by do-gooders:

1. The profound emotional resonance of home ownership is so powerful that either do-gooders believe it (most likely, I'm afraid) or they are strategically afraid to call it into question. What a beautiful emotionally-laden cover for bankers and developers.

2. People become so entrenched in traditional ruts of argumentation that it never occurs to them to quit debating whether or not we should have a flat tax so that they fail to notice this monstrous regressive feature of the existing "progressive" tax code.

One of the reasons that I no longer pay any attention to Harper's Magazine, Utne Reader, Mother Jones, etc. is that they don't usually provide much original thought even regarding the consistent application of their own principles.

To add outrage to outrage, Voith makes the case that the mortgage interest deduction is implicated in the dynamic that creates our disastrous inner-cities, http://www.phil.frb.org/files/br/brma99rv.pdf. This is an amazing argument, brilliant economic analysis that typifies the unintended consequences of a beloved policy (the rhetorical tug of home ownership is right up there with baseball and apple pie). Why don't Utne or Mother Jones report on this stuff!

In the absence of understanding economics, people are prone to believe that somehow Americans simply have the wrong preferences. Do-gooders often wish that people would spend more on education and less on monster houses. But the government is bribing people to buy monster houses while also forcing them to pay for meaningless K-12 education whether they use it or not. In the absence of government influences, houses would be smaller and more would be spent on education.

Moral outrage should not be directed at people's preferences (outrage concerning individual consumer decisions, while satisfying in an atavistic way, is simply not an effective means of changing behavior in a large, pluralistic society) but rather should be directed at those policy distortions that cause those outrages (laws can be changed by means of outraged public opinion).

For more on the mortgage interest deduction, see http://post.economics.harvard.edu/hier/2002papers/HIER1979.pdf, which concludes that there are small positive externalities associated with it (they include local political activism as a positive externality, whereas I suspect that it is usually really rent-seeking) but that it does primarily benefit the rich, banking, and real estate industries while not much increasing levels of home ownership.

The best guess of flat tax advocates in the U.S. is that even if we got one, the mortgage interest deduction would be untouchable.

45 Comments:

Anonymous michael vassar said...

If we eliminated the deduction wouldn't the rational thing to do be for everyone to swap homes with someone else and rent, becoming land-lords and qualifying for tax deductions?
Actually, isn't that rational already? Doesn't economics suggest that no-one who isn't in the top tax bracket should own their home even with the existing tax deduction (unless the incentives problem from renting is horrible, in which case larger incentives to own would be efficient).

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Blogger Glen said...

Suppose I'm a renter thinking of buying a particular house and am willing to pay $300k for it. Now congress passes a law making home interest deductible. Obviously that has made the house more valuable to me. Suppose the net present value of my expected tax savings due to the new law is $100k given interest rates and how long I expect to live there.

I'm now willing to pay $400k for the house.

The market value of the house rises until the higher price paid offsets the subsidy. If the cost of housing rises enough to offset the subsidy, then new buyers receive no net benefit from the law.

People who save "up to $1 million on two homes" spend that much extra buying the homes, so they aren't net beneficiaries either. Who are the beneficiaries? People who own land zoned for housing, and people who already owned houses when the law was passed.

A subsidy of this sort is mostly a one-time windfall for the people who own the subsidized item (houses or land zoned for housing) at the time the law is passed, but thereafter provides much less lingering incentive. The subsidy should get monetized pretty quickly and thereafter have relatively little effect.

If you got rid of the deduction, rich people who owned houses at that time would be hugely harmed, but people who bought similarly large houses the following year would not be harmed at all by the change, because the houses they bought would be cheaper by the amount of the lost subsidy.

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