Order Code RL33025
CRS Report for Congress
Received through the CRS Web
Fundamental Tax Reform: Options for the
Mortgage Interest Deduction
August 8, 2005
Pamela J. Jackson
Analyst in Public Sector Economics
Government and Finance Division
Congressional Research Service ˜ The Library of Congress
Fundamental Tax Reform: Options for the Mortgage
Interest Deduction
Summary
In the 109th Congress, tax reform has become a major legislative issue. In
January 2005, President Bush appointed a nine-member bipartisan panel to study the
federal tax code and to propose options to reform the code for the purpose of
simplification and/or overhaul. Some legislative proposals for fundamental tax
reform would change the tax base such that income tax credits and deductions, like
the mortgage interest deduction, would be eliminated. Two bills (H.R. 25 and S. 25)
propose a national sales tax that would eliminate the current federal income tax
system, including the mortgage interest deduction. Three other bills (H.R. 1040, S.
812, and S. 1099) propose a flat tax on wages. As proposed, H.R. 1040 and S. 1099
would eliminate the existing income tax system, including the mortgage interest
deduction. S. 812 would eliminate the existing income tax system, but would
preserve the deduction of mortgage interest.
The mortgage interest deduction, which is one of the largest sources of federal
tax revenue loss with an estimated annual cost of $72 billion, is intended to
encourage homeownership. Empirical studies suggest that the mortgage interest
deduction subsidizes mortgage lending which has more impact on housing
consumption than homeownership rates. Other homeownership subsidies, like
down-payment assistance programs, are proven to be more effective at increasing
homeownership among lower-income families and are less expensive than the
mortgage interest deduction.
There are many options relating to the mortgage interest deduction and most are
very controversial. If the deduction were eliminated as a result of fundamental tax
reform, the resulting effects would depend on a variety of variables. These variables
include the nature of tax reform, the resulting changes in the tax base and tax rates,
changes in interest rates, and other economic variables. If the deduction were
eliminated without other tax policy changes, federal income tax revenues would
increase, the tax base could be broadened, and the federal budget deficit could be
reduced. Modifications to the mortgage interest deduction could take any one of
several approaches. Congress could choose to allow the deduction for only one
residence, rather than two, or reduce the allowable principal debt, which is currently
$1 million. These changes would reduce the amount of tax revenue loss associated
with the provision. Congress could choose to improve equity by allowing more low
income households to claim mortgage interest, either as an above-the-line deduction
or as a tax credit. Finally, the mortgage interest deduction could remain unaltered.
It would continue to be a benefit to more than 37 million taxpayers and provide more
than $70 billion in annual tax savings to homeowners.
This report, which will be updated to reflect legislative developments, describes
the deduction for home mortgage interest and provides an economic analysis of the
deduction and concludes with an analysis of the possible changes to the mortgage
interest deduction in the context of tax reform and the potential impacts of those
changes.
Contents
Fundamental Tax Reform and Legislative Developments . . . . . . . . . . . . . . . . . . . 2
An Overview of the Deduction for Mortgage Interest . . . . . . . . . . . . . . . . . . . . . . 3
History of the Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Economic Analysis of the Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Efficiency: Treatment of Mortgage Interest Under an Ideal Income Tax . . . 5
Imputed Rental Income for Homeowners . . . . . . . . . . . . . . . . . . . . . . . 5
Investment Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Debt and Equity Finance Neutrality . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Empirical Estimates of Efficiency Loss Compared to an Ideal
Tax System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Efficiency: Externalities Associated With Homeownership . . . . . . . . . . . . . 8
Positive Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Negative Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Efficiency: Empirical Estimates of the Deduction’s Effect on Home
Ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Empirical Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Low Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Itemizers vs. Non-Itemizers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Data on Deductions Claimed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Simplicity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Possible Policy Changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Elimination of the Mortgage Interest Deduction . . . . . . . . . . . . . . . . . . . . . 16
Elimination as a Result of Tax Reform . . . . . . . . . . . . . . . . . . . . . . . . 17
Elimination Not as a Result Tax Reform . . . . . . . . . . . . . . . . . . . . . . . 19
Modification of the Mortgage Interest Deduction . . . . . . . . . . . . . . . . . . . . 22
Reduce the Amount of Allowable Indebtedness . . . . . . . . . . . . . . . . . 22
Disallow Home Equity Indebtedness . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Allow the Deduction for Principal Residences Only . . . . . . . . . . . . . . 24
Other Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
List of Tables
Table 1. Deductions of Mortgage Interest, Claimed in 2001 . . . . . . . . . . . . . . . 14
Table 2. Distribution of Tax Expenditure by Income Class . . . . . . . . . . . . . . . . 15
Fundamental Tax Reform: Options for the
Mortgage Interest Deduction
In the 109th Congress, tax reform has become a major legislative issue. In
January 2005, President Bush appointed a nine-member bipartisan panel to study the
federal tax code and to propose options to reform the code. Currently, proposals for
fundamental tax reform would change the tax base from income to consumption or
change the way income is taxed. In a pure consumption tax system, income tax
credits and deductions, like the mortgage interest deduction, would be eliminated.
Other proposals for tax reform could simplify the existing income tax system. In
these cases, modifications to the mortgage interest deduction could simplify the tax
code.
It is unclear whether changes to the mortgage interest deduction will occur given
the strength of support that exists for the provision. President Bush has indicated that
homeownership tax incentives are important and should be preserved as tax reform
is being considered. Specifically, in the executive order that established the
President’s Advisory Panel on Federal Tax Reform, one of the very few restrictions
was a request that the panel “recognize the importance of homeownership and charity
in American society.”1 Some analysts have concluded that the Administration’s
statement indicates its support for preserving the mortgage interest deduction along
with all of the other homeownership tax incentives. In one tax journal it was written
“in plain English, the mother of all tax subsidies, the mortgage interest deduction,
shall remain untouched.”2
There are three principal tax provisions for owner-occupied housing and one
implicit tax benefit. The deduction for mortgage interest is the most costly provision,
with an estimate of $72.6 billion in revenue loss for FY2005.3 The exclusion of
capital gains on the sales of homes is the second largest tax provision for
homeowners, with an estimate of nearly $23 billion in tax revenue loss for FY2005.4
The deduction of state and local real estate taxes is the third provision, with an
estimate of nearly $20 billion in tax revenue loss for FY2005.5 The exclusion of net
imputed rental income from taxation, which is not a provision in the tax code but
1 Executive Order 13369, “President’s Advisory Panel on Federal Tax Reform,” website
[http://www.taxreformpanel.gov/executive-order.shtml], visited July 22, 2005.
2 Martin A. Sullivan, “The Economics of the American Dream,” Tax Notes, Jan. 24, 2005,
p. 407.
3 U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for
Fiscal Years 2005 to 2009, JCS-1-05 (Washington: GPO, 2005), p. 33.
4 Ibid.
5 Ibid.
CRS-2
exists implicitly, is estimated to cost $24.1 billion in uncollected tax revenue for
FY2005.6 This would bring the total projected revenue cost for owner-occupied
housing in FY2005 to $139 billion.
The amount of revenue foregone by the federal government to promote
homeownership greatly exceeds government spending on housing. Appropriations
made in the Department of Housing and Urban Development (HUD) budget totaled
$31.5 billion in FY2005. Most of the appropriations for HUD address rental housing
problems, most of which are faced by households with very low incomes or other
special housing needs.
Fundamental Tax Reform and Legislative
Developments
Several tax reform proposals have been introduced, most of which propose to
enact fundamental tax reform by changing the tax base from income to consumption.7
H.R. 25, the Fair Tax Act of 2005, and its companion bill, S. 25, propose a national
sales tax that would eliminate the current federal income tax system including the
mortgage interest deduction. S. 812, the Flat Tax Act of 2005, proposes to replace
the current federal income tax system with a flat rate consumption tax (also known
as a modified value-added tax). The flat tax rate would be 20% of taxable earned
income. The bill defines taxable earned income as the excess of earned income
(wages, salaries, professional fees) over a standard deduction, a deduction for cash
charitable contributions, and a deduction for home mortgage interest. The deductions
the bill proposes to allow are consistent with the previously mentioned mandate
given by President Bush to the tax reform panel. H.R. 1040, the Freedom Flat Tax
Act, proposes to allow taxpayers to choose an election to be subject to a flat tax, in
lieu of the existing income tax. The rate would be 19% of wages for the first two
years after an election is made, and 17% thereafter. The bill proposes to allow a
basic standard deduction and an additional standard deduction for each dependent in
the household but makes no mention of allowing the mortgage interest deduction.
S. 1099, the Tax Simplification Act of 2005, proposes a similar flat tax structure,
with a 19% tax rate on wages for the first two years that would then be reduced to
17% thereafter.
This report describes the deduction for home mortgage interest and explores
rationales for subsidizing homeowners. The report then provides an economic
analysis of the value and performance of the deduction. The report concludes with
a discussion and analysis of the possible changes to the mortgage interest deduction
that could occur under different tax reform scenarios.
6 U.S. Office of Management and Budget, Analytical Perspectives, Budget of the United
States Government, Fiscal Year 2005, Washington, DC: 2005), p. 325.
7 For more detailed information about fundamental tax reform, see CRS Issue Brief
IB95060, Flat Tax Proposals and Fundamental Tax Reform: An Overview; CRS Issue Brief
IB91078, Value-Added Tax as a New Revenue Source; and CRS Issue Brief IB92069, A
Value-Added Tax Contrasted With a National Sales Tax, all by James M. Bickley.
CRS-3
An Overview of the Deduction for Mortgage Interest
Taxpayers may claim an itemized deduction for payments of “qualified” interest
related to a primary or secondary residence. The payments of interest that qualify
include home mortgage interest, which is the interest paid on any loans secured by
either the taxpayer’s main home or a second home. The loans may be a mortgage
(first or second), a line of credit, or a home equity product. Qualified residences can
include cooperative apartments, condominiums, and mobile homes. Mortgage
interest associated with recreational vehicles and boats can be included in the
deduction as long as the vehicles have sleeping, cooking, and toilet amenities. The
debt must also be collateralized by the vehicles to be eligible for the mortgage
interest deduction.
Two types of indebtedness are associated with the interest that can be deducted:
acquisition and home equity. Acquisition indebtedness is debt incurred in acquiring,
constructing, or substantially improving a qualified residence and secured by such
residence. Home equity indebtedness is all non-acquisition debt that is secured by
a qualified residence. The interest on such debt can be deducted even if the proceeds
are used for personal expenditures unrelated to the home. The underlying mortgage
loans can represent acquisition indebtedness of up to $1 million, plus home equity
indebtedness of up to $100,000.8
Any secured debt used to refinance home acquisition debt is treated as home
acquisition debt, up to a certain point. The new debt qualifies as home acquisition
debt only up to the amount of the balance of the old mortgage principal just before
the refinancing. Any additional debt is not home acquisition debt, but may qualify as
home equity debt.9 Thus, when refinancing, acquisition debt may not rise and home
equity loans may not exceed $100,000. For example, if a homeowner with a
$150,000 mortgage refinances the debt for $300,000, the original $150,000 would
be considered as acquisition debt, an additional $100,000 would be considered as
home equity debt, and the interest on these amounts would be deductible. The
interest on the remaining $50,000 of debt would not be deductible.
History of the Deduction
The mortgage interest deduction was not introduced as a provision to subsidize
homeownership. It evolved over time as a result of the tax treatment of interest.
Initially, the federal income tax, instituted in 1913, contained a deduction for all
interest paid with no distinction between interest payments made for business,
personal, living, or family expenses. At that time, most interest payments
represented business expenses. For example, farmers borrowed money to buy land
8 The alternative minimum tax (AMT) rules for deducting mortgage interest are different
from the rules for regular taxes. Mortgage interest paid for home equity indebtedness (taken
out after June 30, 1982) does not qualify as deductible for AMT purposes unless the loan
proceeds are explicitly used to buy, build, or improve the home.
9 U.S. Department of Treasury, Internal Revenue Service, Publication 936: Home Mortgage
Interest Deduction (Washington: GPO, 2004), p. 8.
CRS-4
that would be used for both their residence and their business. Mortgages and other
consumer borrowing were much less prevalent than in later years. Over time, and
with the increasing sophistication of lending markets, mortgage interest became
distinguishable from other kinds of interest.
For several decades, up until the Tax Reform Act of 1986 (TRA; P.L. 99-514),
there were no restrictions on either the dollar amount of residence interest that could
be deducted or the number of homes for which the interest deduction could be
claimed. As part of an effort to limit deductions for personal interest, the TRA
imposed limits on the amount of underlying mortgage loans for which interest could
be deducted. These limits restricted loan amounts up to the purchase price of the
home, plus any improvements, and debt secured by the home but used for qualified
medical and educational expense. The interest deduction was also restricted to
mortgage debt on a first and/or second home.
In addition to changes to the deduction of mortgage interest, the Tax Reform
Act also eliminated the deduction of personal interest, creating tax treatment
distortions between homeowners and renters. Homeowners with sufficient equity
and credit worthiness could use home equity loans to replace personal credit card
debt, thus preserving the income tax deduction for interest on their debt. Renters and
homeowners without sufficient home equity or credit worthiness became unable to
transfer personal debt in order to continue the tax savings, and thus were made worse
off relative to some homeowners by the 1986 tax law.
As part of a group of revenue raising provisions, the deduction of home
mortgage interest was further restricted by the Omnibus Budget Reconciliation Act
of 1987 (P.L. 100-203). That act created an upper limit of $1 million ($500,000 for
married filing separately)10 on the combined acquisition indebtedness for a principal
and second residence. Acquisition indebtedness included any debt incurred to buy,
build, or substantially improve the residence(s). Additionally, the exception for
qualified medical and educational expenses was eliminated and an explicit provision
for home equity indebtedness was enacted.11 In addition to interest on acquisition
indebtedness, interest can be deducted on loan amounts up to $100,000 ($50,000 for
married filing separately) for other debt secured by a principal or second residence,
such as a home equity loan, line of credit, or second mortgage.12
The Omnibus Budget Reconciliation Act of 1990 (P.L. 101-508) enacted
another group of revenue raising provisions that further influenced the mortgage
interest deduction. That act limited the amount of itemized deductions that upper-
income households could claim. Some high-income taxpayers face reduced marginal
benefits from the deduction of mortgage interest due to the limitation on itemized
deductions. In particular, taxpayers with income above the threshold amount of
10 This amount is not indexed for inflation.
11 It is possible for home equity loans to be used for medical, educational, or other purposes.
12 U.S. Congress, Senate Committee on the Budget, Tax Expenditures: Compendium of
Background Material on Individual Provisions, committee print prepared by the
Congressional Research Service, Library of Congress, 103rd Cong., 2nd Sess., S. Prt. 103-101
(Washington: GPO, 1994), p. 185.
CRS-5
$145,950 for 2005 are required to reduce the amount of itemized deductions,
including the mortgage interest deduction, by 3% of the excess of their income above
the threshold amount.
Economic Analysis of the Deduction
The mortgage interest deduction is a federal subsidy that treats homeownership
favorably compared to other economic activity. The major justification for the
deduction for mortgage interest is that it encourages homeownership, which
proponents deem desirable. Homeownership is believed to promote continued
growth and stability of neighborhoods and communities. This effect results, in part,
because homeowners are more likely to participate in community and political
activities, to promote neighborhood cohesion, and to be more socially stable and less
mobile.
Like all tax benefits, economic theory suggests the deduction can be evaluated
by applying the criteria of economic efficiency, equity, and simplicity. These criteria
are discussed in the next sections.
Efficiency: Treatment of Mortgage Interest Under an Ideal
Income Tax
The tax treatment of owner-occupied housing is complex. In a pure income tax
system, the income from financial assets is taxed and the expenses associated with
financial assets are deducted from taxable income. While this tax treatment applies
to financial assets and commercial real estate, it does not apply to owner-occupied
housing, which, from an economic perspective, causes distortions among investment
assets.
Imputed Rental Income for Homeowners. It is important to understand
why tax analysts believe that the mortgage interest deduction creates a subsidy for
housing. The underlying issue regarding the taxation of owner-occupied housing is
the exclusion of imputed rent. Net imputed rental income is the difference between
the income homeowners could receive from renting their homes and the associated
cost of the home, which includes mortgage interest, taxes, insurance, maintenance,
and depreciation. This net imputed rental income is not taxed, unlike the rental
housing market where owners of rental property receive income from their tenants
and are taxed on that income, net of the same expenses as homeowners. Economists
contend that if net imputed rental income were taxed similarly to income from rental
housing, then the deduction of mortgage interest, real estate taxes, maintenance and
depreciation costs, and other expenses would be considered appropriate for
homeowners.
Congress considered the taxation of net imputed rental income for homeowners
during tax reform efforts in 1986. Congress believed that it would not be advisable
to tax imputed net rental income, though it continued to allow the deduction of
mortgage interest. According to the congressional Joint Committee on Taxation
(JCT):
CRS-6
While Congress recognized that the imputed rental value of owner-occupied
housing may be a significant source of untaxed income, the Congress
nevertheless determined that encouraging home ownership is an important policy
goal, achieved in part by providing a deduction for residential mortgage
interest.13
Investment Assets. The non-taxation of imputed rental income contributes
to asset choice distortions. Individuals who own a home have an imputed rental
income from that home in much the same way as holders of financial assets receive
dividends and interest from the assets they hold. Yet homeowners are not taxed on
their (imputed) income stream while stockholders are taxed on their income stream.
This tax treatment causes households to hold more of their assets in owner-occupied
housing than they may have in the absence of the tax-preferred treatment. The
deduction of mortgage interest further expands the preferential treatment of owner-
occupied housing relative to other investment assets.
Homeownership is usually an attractive investment, even before tax benefits are
included. In recent years, from 1999 through 2004, real estate prices increased more
than 56% as compared to the S&P 500 index that declined 6% over the same time
period.14 When the mortgage interest deduction is combined with other housing tax
provisions, like the deduction for state and local real estate taxes, the value of
housing as an investment good rises even further. Some economists feel that this
preferential tax treatment encourages households to overinvest in housing and less
in business investments that might contribute more to increasing the nation’s
productivity and output.15
Debt and Equity Finance Neutrality. A justification for the deduction is
that it allows neutrality with respect to debt versus equity financing.16 The cost of
equity financing is the after-tax yield that would be earned if funds were invested
elsewhere. The cost of debt financing is the after-tax debt interest rate. Because
interest earned is taxable income and mortgage interest is deductible, the choice of
financing the cost of buying a home is tax neutral. As an example, if a taxpayer
chooses to withdraw $250,000 from an investment account to purchase a home, the
cost of that equity financing option is the interest earnings forgone after taxes.
Assuming an interest rate of 6% and a marginal tax rate of 28%, the annual earnings
would have been $15,000 and the after-tax yield would have been $10,800.
Alternatively, if the taxpayer borrows $250,000 to purchase a home, assuming the
same interest rate of 6% and marginal tax rate of 28%, the after-tax cost would be
13 U.S. Congress, Joint Committee on Taxation, General Explanation of the Tax Reform Act
of 1986, committee print, 100th Cong., 1st sess., May 4, 1987 (Washington: GPO, 1987), pp.
263-264.
1 4 S a r a Cl emenc e , “ R e a l E s t a t e vs . S t o c ks , ” F o r b e s w e b s i t e
[http://www.forbes.com/realestate/2005/05/27/cx_sc_0527home.html], visited June 6, 2005.
15 N. Edward Coulson, “Housing Policy and the Social Benefits of Homeownership,”
Business Review - Federal Reserve Bank of Philadelphia, Second Quarter 2002, p. 8.
16 Households with sufficient resources could pay for a home using cash, which is
presumably withdrawn from interest-bearing accounts, thus the reference to “equity”
financing.
CRS-7
$15,000 in interest paid, reduced by $4,200 in mortgage interest deducted, for a total
cost of $10,800. Thus, the two financing options are neutral with respect to
taxation.17
Empirical Estimates of Efficiency Loss Compared to an Ideal Tax
System. For most tax provisions, including the mortgage interest deduction, it is
useful to examine efficiency loss. Efficiency loss, which is also referred to as
deadweight loss, is the loss in economic welfare associated with distortions caused
by taxes or tax preferences.18 These distortions arise when taxpayers are induced to
make substitutions in response to the impacts of a tax or a tax preference. Tax
preferences for housing encourage some households to substitute increased spending
on housing for spending on other goods and services.
Most estimates of inefficiency include a broad tax treatment of owner-occupied
housing, incorporating the mortgage interest deduction, the deduction of real estate
taxes, and the exclusion of imputed rental income. Poterba estimated that the
deadweight loss for homeowners in 1990 was $53 for households with incomes of
$30,000, $326 for households with incomes of $50,000, and $1,631 for households
with incomes of $250,000.19 Deadweight loss was found to increase as the marginal
income tax rate rises and the nominal interest rate declines.20 Poterba found that the
deadweight loss resulting from housing tax preferences declined substantially
between 1980 and 1990 because marginal tax rates and nominal interest rates
declined.21
Gravelle, in a discussion of inefficiency in the tax treatment of capital, found
that while “the estimated welfare cost of the favorable tax treatment of owner-
occupied housing has varied in economic literature,” a welfare loss of 0.1% of
consumption has been associated with the favorable treatment of owner-occupied
housing.22
17 This neutrality exists only if investment earnings are taxed. For many taxpayers, a large
portion of their investment earnings may go untaxed because it is derived from tax-deferred
programs, such as 401(k) retirement programs. Other investment earnings may be taxed at
preferential rates. In these cases, neutrality may not exist.
18 James M. Poterba, “Taxation and Housing: Old Questions, New Answers,” The American
Economic Review, vol 82, no. 2, May 1992, p. 238.
19 Ibid.
20 Poterba used the concept of “economic” income, which equals adjusted gross income plus
tax-deductible retirement and IRA contributions, the excluded component of capital-gains
income and business losses, and the deduction for a dual-earner married couple.
21 Ibid., p. 239.
22 Jane G. Gravelle, The Economic Effects of Taxing Capital Income (Cambridge: The MIT
Press, 1994), p. 205. In this text, Gravelle refers to estimates of efficiency gains from the
Tax Reform Act of 1986 that were published in the author’s article, “Differential Taxation
of Capital Income: Another Look at the 1986 Tax Reform Act,” National Tax Journal, vol.
42, no. 4, Dec. 1989, pp. 446-448.
CRS-8
Efficiency: Externalities Associated With Homeownership
According to economic theory, in most cases, an economy best satisfies the
wants and needs of its participants if markets operate free from distortions by taxes
and other factors. If there is a market failure and a subsidy remedies that failure, then
there is economic justification for the subsidy based on efficiency. But if there is no
market failure, a tax benefit lowers efficiency.
Market failures occur when a market, left on its own, fails to allocate resources
efficiently. In particular, market transactions are inefficient when the marginal
benefits are less than the marginal costs. Market failures may be due to a variety of
factors, including the presence of externalities and common resources; public goods;
imperfect competition; and/or asymmetric or incomplete information.23
There are socially undesirable phenomena that many consider valid targets of
public policy, like inequality, poverty, and inflation, but they are not problems that
meet the definition of economic inefficiency.24 In this context, some of the issues
related to homeownership, like affordable housing and low rates of homeownership
among minority groups, are not considered as market failures. The deduction for
mortgage interest is not economically justified on efficiency grounds in these cases.
The market failure often attributed to homeownership is that of positive
externalities. An externality exists when the activity of an individual directly affects,
positively or negatively, the welfare of another and that effect is not incorporated in
market prices. Proponents claim that homeownership causes positive externalities
since it generates not only private benefits for individuals but also social benefits for
the public at large. The individual does not capture all of these social benefits and,
thus, under invests in real estate. From this perspective, the private demand for
homes is less than social demand and too little investment in homeownership occurs.
Government subsidies to homeownership can stimulate private demand for real estate
in order to attain more optimal levels of homeownership that achieve market
equilibrium outcomes.25
Positive Externalities. The mortgage interest deduction, as a subsidy to
owner-occupied housing, is often justified because it is claimed that homeownership
fosters social stability, social involvement, and socially desirable behaviors among
youths and adults.26 These social benefits from homeownership may take on the
form of better citizenship, increased investment in beautifying property, and civic
involvement that promotes the best interests of the homeowner and the
23 For more detailed information about market failures, see CRS Report RL32162, The Size
and Role of Government: Economic Issues, by Marc Labonte, pp. 14-18.
24 Ibid. p. 14.
25 For a more detailed discussion of externalities, see Harvey Rosen, Public Finance
(Boston: McGraw-Hill, 1999), pp. 85-110.
26 George McCarthy, Shannon Van Zandt, and William Rohe, “The Economics Benefits and
Costs of Homeownership: A Critical Assessment of the Research,” Working Paper No. 01-
02, Research Institute for Housing America, May 2001, pp. 18-29.
CRS-9
neighborhood. There are some specific reasons cited as to why homeownership
creates positive externalities. They include homeowners are civically involved
because the asset value of the home is tied to the strength of the community;
homeowners are less mobile, which adds stability to communities; and homeowners
take better care of their homes.27
While subsidies for homeowners are justified by economists because of the
presence of positive externalities from homeownership, there are some ambiguous
aspects of these attributes of homeownership which cast doubt as to whether
homeownership deserves extensive subsidies.
A few studies have distinguished difficulties in the research on the positive
externalities of homeownership. In these studies the authors have noted their
inability to distinguish whether homeownership caused the desirable behaviors that
led to positive externalities, or, rather, people who possessed the desirable behaviors
tended to become homeowners. Thus, the individual, not homeownership, would be
the source of the positive externality. For instance, Cox28 found that homeowners as
compared to renters were more likely to be civically involved, as did Rohe and
Stegman.29 Yet these studies showed that the type of involvement varied widely
across levels of activity, and was not correlated with any of the expected
homeownership and neighborhood attributes (like house price, level of crime, and
voter participation). If the source of the positive externality lies with the individual
and not with their ownership status, then the arguments in favor of subsidizing
homeownership would be diminished.
Even if the existence of positive externalities from homeownership goes
unquestioned, the appropriate magnitude of subsidies for homeownership is difficult
to quantify. As previously mentioned, the tax provisions and benefits for owner-
occupied housing add up to $139 billion in tax revenue loss for FY2005. One could
argue that the social benefits of homeownership may not be worth that amount of
cost.
Negative Externalities. There is a negative externality associated with
homeownership: labor immobility. Homeownership, unlike renting, tends to hinder
labor mobility and the ability of individuals to respond to changes in the demand for
labor. Renter-occupied housing, because of its low transaction costs, is ideal for
households that expect to move within a short period of time. Moving from owner-
occupied housing involves higher transaction costs, such as real estate broker fees
and time costs, if the household is selling the property from which it is moving.
27 Edward Glaeser and Jesse Shapiro, The Benefits of the Home Mortgage Interest
Deduction, National Bureau of Economic Research, Working Paper no. 9284, Oct. 2002, pp.
22-24.
28 K. Cox, “Housing Tenure and Neighborhood Activism,” Urban Affairs Quarterly, vol. 18,
no. 1, 1982, pp. 209-207.
29 William Rohe and M. A. Stegman, “The Impact of Home Ownership on the Self-Esteem,
Perceived Control and Life Satisfaction of Low-Income People,” Journal of the American
Planning Association, vol. 60, no. 1, 1994, pp. 173-184.
CRS-10
Labor immobility interferes with the ability of the economy to adjust to
changing market conditions. This is more true during regional downturns in the
economy. For example, a community experiences the loss of an industry and
joblessness rises. Homeowners are reluctant to move because their house may not
sell at a price that exceeds the existing mortgage debt on the house and the
transaction costs of selling the home. Thus, labor becomes more immobile and the
area may remain depressed longer than it might otherwise.
Efficiency: Empirical Estimates of the Deduction’s Effect on
Home Ownership
All of the externalities discussed above depend on whether an individual rents
or owns. The externalities do not depend on how much housing is consumed; yet the
efficiency of the mortgage interest deduction depends upon how many marginal or
additional households are induced to buy homes. The deduction is not considered
effective if it either fails to increase home buying or subsidizes home buying that
would have been undertaken in the absence of the tax incentive.
The presence of a subsidy for owner-occupied housing creates an increased
demand for housing among renters, some of whom respond by becoming
homeowners. Yet, that same subsidy also creates increased demand for housing
among homeowners, some of whom consume more housing. Most notably,
homeowners who increase their demand for housing increase the amount and quality
of housing demanded. In this case, as the mortgage interest deduction subsidizes
existing homeowners, it fails to increase homeownership rates.
It is, however, difficult to prove the mortgage interest deduction’s efficiency, or
lack thereof, because of its continued presence as a subsidy and availability to all
home buyers for so many years. Some economists theorize the value of the mortgage
interest deduction is capitalized into housing prices.30 Buyers of housing, it is
thought, bid up the price of owner-occupied housing to the point where the price of
owner-occupied housing, including tax benefits, is equal to the cost of renting. Thus,
the subsidy is perceived to have given homeowners a capital gain in the past, but new
buyers entering the market face higher prices that offset the subsidy. If the deduction
is capitalized this way, it would not induce non-homeowners to become homeowners,
though, a loss of the mortgage interest deduction might adversely affect housing
prices.
Some analysts have, in an effort to determine the effectiveness of the mortgage
interest deduction, made comparisons to other countries. In particular, Israel and
Australia have homeownership rates well above those of the United States and yet
they do not allow for the deduction of mortgage interest.31 Canada and Japan have
homeownership rates at about the same level as the United States and those countries
30 Michelle J. White and Lawrence J. White, “The Tax Subsidy to Owner-Occupied
Housing: Who Benefits?” Journal of Public Economics, vol. 3, Aug. 1977, pp. 111-126.
31 Bruce Bartlett, “Tax Reform’s Third Rail: Mortgage Interest,” National Center for Policy
Analysis, 2001, website [http://www.ncpa.org/bg/bg139.html], visited June 1, 2005.
CRS-11
do not allow mortgage interest deductibility.32 These rates suggest that
homeownership may not be sensitive to the deductibility of mortgage interest.
However, since none of these nations had a mortgage interest deduction and then
repealed the provision, their ability to provide comparative value to the United States
is limited.
Empirical Study. Few empirical studies have addressed this issue. One study
found that the deduction for mortgage interest subsidizes housing consumption, but
its impact on homeownership rates was minimal.33 Specifically, the authors found
that there was “essentially no relationship” between the home mortgage interest
deduction and the rate of homeownership.34 The authors examined more than 30
years of data on the mortgage subsidy rate, which is the marginal subsidy to mortgage
interest from the deduction for the average taxpayer, and the level of homeownership
and found that a 1% increase in the mortgage subsidy caused homeownership to rise
by .0009%.35 In this context, housing consumption reflected the dollar amount spent
on housing and homeownership rates reflected the number of new homeowners. The
choice of homeownership, according to the authors, was influenced by variables
other than the mortgage interest deduction, like house structure, house type, and
family size.
Low Rate of Return. To the extent that the mortgage interest deduction
promotes homeownership, it can be criticized on the grounds that the provision yields
too little return relative to its cost. In other words, the amount of increase in
homeownership generated by a $1 in tax revenue loss due to the mortgage interest
deduction can be far outweighed by allocating that same $1 to other subsidy
programs.
Results of a recent study of mortgage rates and changes in homeownership
provided evidence that direct spending programs and other policy options are more
successful at increasing rates of homeownership.36 The study reviewed underwriting
simulations and found that down payment reductions had larger effects than
mortgage rate reductions on increasing rates of homeownership. In particular, a
reduction in the required amount of down payment for a home from 5% to 0% of the
purchase price caused an increase in the number of renters who became owners. This
increase equaled a 2 to 2.5 percentage point increase, representing roughly 720,000
renters.37
32 Ibid.
33 Edward Glaeser and Jesse Shapiro, The Benefits of the Home Mortgage Interest
Deduction, National Bureau of Economic Research, Working Paper no. 9284, Oct. 2002.
34 Ibid., p. 40.
35 Ibid., pp. 39-41.
36 Ron Feldman, “The Quest to Raise Homeownership Rates,” Mortgage Banking, vol. 63,
iss. 1, Oct. 2002, pp. 66-73.
37 Ibid., p. 70.
CRS-12
A different simulation, which examined tenure choices, indicated that reducing
the amount that was required for down payment on the purchase of a home increased
the probability of ownership by 4.5 percentage points for all households and 5
percentage points for African-American households.38
Further simulations reported in that study showed that cash payments starting
at around $5,000 had larger effects than other policies on the ability of renters to
purchase homes. A $5,000 down payment assistance grant was reported to increase
the percentage of renters who could buy homes by 11 percentage points in general,
and 13 percentage points for African-American households. A payment of $10,000
per household was reported to cause an effect almost twice as large.39
Home Equity Indebtedness. Home equity indebtedness supports
homeownership by allowing homeowners to finance structural improvements, but
home equity indebtedness is not limited to this kind of spending. For example, home
equity indebtedness can be used to pay for vacations, reduce credit card debt, and
other personal consumption expenses. Home equity financing used for purposes
unrelated to homeownership does not serve the congressional intent of the provision
to encourage homeownership.
Equity
Tax benefits such as those available for homeowners can result in individuals
with similar incomes paying different amounts of tax. In particular, homeowners and
renters who are equal in all other respects, are treated differently as a result of the tax
incentives for homeowners. This differential treatment is a deviation from the
standard of horizontal equity, which requires that people in equal positions should
be treated equally.
Another component of equity in taxation is vertical equity, which requires that
tax burdens be distributed fairly among people with different abilities to pay.
Housing tax deductions, like all deductions, benefit those who have sufficient income
to owe federal taxes, and the higher the income, the greater the benefit.40 Those
individuals without sufficient income do not have the opportunity to benefit from the
provision. The disproportionate benefit to individuals with higher incomes reduces
the progressivity of the tax system, which is often viewed as a reduction in equity.
An example of the effect an income tax deduction has on vertical equity can be
seen by identifying two individual homeowners, both of whom incur $10,000 in
mortgage interest. The tax benefit to the two differs if they are in different tax
38 Ibid., p. 72.
39 Ibid., p. 73.
40 Some high-income taxpayers face reduced marginal benefits from the deduction of
mortgage interest due to the limitation on itemized deductions. Taxpayers with income
above the threshold amount of $145,950 for 2005 are required to reduce the amount of
itemized deductions, including the mortgage interest deduction, by 3% of the excess of their
income above the threshold amount.
CRS-13
brackets. A homeowner with lower income, who may be in the 15% income tax
bracket, receives an exclusion with a value of $1,500, while the other homeowner,
with higher income in the 28% bracket, receives an exclusion worth $2,800. Thus,
the higher income taxpayer, with presumably greater ability to pay taxes, receives a
greater tax benefit than the lower income taxpayer.
Besides renters, there are a few reasons why the mortgage interest deduction
may not be available to certain homeowners.
Some homeowners may not have mortgage debt on which they pay interest.
According to the Census Bureau, 30% of all homeowners own their homes free and
clear with no mortgage interest to deduct; in particular, seniors comprise a large
portion of homeowners with no mortgage debt.41 Thus, these individuals do not
benefit from the tax deduction for mortgage interest, though they still benefit from
the non-taxation of imputed rental income. In the case of homeowners without
mortgage debt, their net imputed rental income is relatively higher than those with
mortgage debt. So as mortgage debt falls, along with mortgage deduction claims, the
value of the exclusion of net imputed rental income rises.
Other homeowners may not claim the mortgage interest deduction because
claiming the standard deduction is more advantageous.
Itemizers vs. Non-Itemizers. The mortgage interest deduction can be
claimed only by those taxpayers who itemize. Itemizers tend to be primarily middle-
and upper-income households. Nationally, the percentage of taxpayers who itemized
was 34% in 2003, 35% in 2002, 34% in 2001, and 33% in 2000.42 Lower income
taxpayers generally do not itemize and claim the standard deduction amount instead.
In 2005, the standard deduction amounts are $10,000 for a married couple filing
jointly, $7,300 for heads of household, and $5,000 for single individuals. When the
value of the standard deduction is increased, the difference between it and the value
of the mortgage deduction diminishes for lower income households. This effect
reduces the incentive to purchase owner-occupied housing, but does not make the
taxpayer worse off.
For those households on the homeownership margin, the tax incentive’s
influence on their decision to own as opposed to rent depends on the amount by
which the household’s total itemized deductions exceeds the standard deduction.
Taxpayers would need to have itemized deductions, including deductible taxes such
as real estate taxes, state and local income or sales taxes, or other deductions, that
exceed the standard deduction amount to make itemizing worthwhile.
Data on Deductions Claimed. Income tax and tax expenditure data indicate
that high income households claim the majority of the deductions for mortgage
41 U.S. Department of Commerce, Census Bureau, American FactFinder,
[http://factfinder.census.gov/home/saff/main.html?_lang=en], website visited on Nov. 15,
2004.
42 As reported in the Internal Revenue Service, Statistics of Income Bulletin (Washington:
Winter 2003-2004), pp. 105-107 and at [http://www.irs.gov/pub/irs-soi/03in01pd.xls].
CRS-14
interest and receive the majority of tax savings from claiming those deductions. The
most recent tax year data available from the Internal Revenue Service, 2001, shown
in Table 1, indicated that nearly 67% of taxpayers claiming a deduction for mortgage
interest had incomes of $50,000 or more. These households represented only 29%
of the total number of taxpayers filing returns.43 Additionally, households with
income of $50,000 or more claimed a majority (76%) of the value of the deduction.44
Table 1. Deductions of Mortgage Interest, Claimed in 2001
Share of Tax
Number of
Returns by
Income Group
Tax
Total Amount
Share of
Income
(Adjusted Gross
Returns
of Deduction
Amount of
Group
Income)
Claiming
($ in thousands)
Deduction
Claiming
Deduction
Deduction
Under $5,000
159,867
0.4%
$1,291,310
0.4%
$5,000 under $10,000
320,826
0.9%
$2,490,082
0.8%
$10,000 under $15,000
544,410
1.5%
$3,471,107
1.0%
$15,000 under $20,000
818,701
2.3%
$5,248,461
1.6%
$20,000 under $25,000
1,167,740
3.2%
$7,459,455
2.3%
$25,000 under $30,000
1,400,622
3.9%
$9,169,083
2.8%
$30,000 under $40,000
3,551,427
9.8%
$23,575,153
7.1%
$40,000 under $50,000
3,977,911
10.9%
$27,316,887
8.3%
$50,000 under $75,000
9,545,780
26.3%
$74,679,450
22.6%
$75,000 under $100,000
6,331,711
17.4%
$57,410,870
17.4%
$100,000 under
6,574,062
18.1%
$77,691,655
23.5%
$200,000
$200,000 or more
1,938,132
5.3%
$40,888,865
12.4%
Total
36,331,190
100.0%
$330,692,376
100.0%
Source: Internal Revenue Service, Statistics of Income, website [http://www.irs.gov/pub/irs-
soi/01in21id.xls], visited on October 25, 2004.
While the IRS lists the amount of deductions claimed by households, the
amount of tax savings received by households, or alternatively, the amount of federal
tax revenue loss is calculated by the congressional Joint Committee on Taxation
(JCT). The actual cost of the mortgage interest deduction is determined by the
43 Internal Revenue Service, Statistics of Income, website [http://www.irs.gov/pub/irs-
soi/01in21id.xls], visited on October 25, 2004.
44 Ibid.
CRS-15
amount of federal tax revenue loss that results from taxpayers claiming the deduction.
Tax revenue loss depends on many factors, which include the composition of the
household (i.e., number of adults and dependents), the household’s marginal income
tax rate, and the household’s income. As an example, two households could both
claim $20,000 in mortgage interest deduction that results in different tax revenue
loss. If one household is in the 33% income tax bracket, they would reduce their
taxable income by $6,600. If the other household is in the 25% bracket, their taxable
income is reduced by $5,000. The tax revenue savings to individuals, thus tax
revenue loss to the government, differs across households.
As shown below in Table 2, the JCT estimated that 94.2% of the 2001 tax
savings associated with the mortgage deduction were from households with adjusted
gross income of $50,000 or higher.
Table 2. Distribution of Tax Expenditure by Income Class
(The Mortgage Interest Deduction at 2001 Income Tax Rates and Income Levels)
Amount of Tax
Share of Tax
Adjusted Gross Income Class
Expenditure
Expenditure
(in millions of dollars)
Below $10,000
11
0.0%
$10,000 to $20,000
117
0.2%
$20,000 to $30,000
433
0.7%
$30,000 to $40,000
981
1.5%
$40,000 to $50,000
2,235
3.5%
$50,000 to $75,000
7,927
12.3%
$75,000 to $100,000
12,204
18.9%
$100,000 to $200,000
23,978
37.2%
$200,000 and over
16,664
25.8%
TOTAL
64,530
100.0%
Source: U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for
Fiscal Years 2002 to 2006, JCS-1-02 (Washington: GPO, 2002), p. 34.
Simplicity
The deduction of mortgage interest for homeowners contributes to the
complexity of the tax code and raises the cost of administering the tax system. Those
costs, which can be difficult to isolate and measure, are often excluded in the cost-
benefit analysis of the provision. The complexity of the tax code adds to the time
cost of taxpayers in either learning how to claim various incentives and doing so, or
an increased direct cost of paying tax professionals to perform the service for the
taxpayer. Also, the more complex the tax code is, the more opportunity for tax
evasion and avoidance exists.
CRS-16
Federal Tax Policy. Federal tax policy changes cause unintended
consequences for housing subsidies enacted through the tax code. Several significant
tax cuts have been enacted recently, all of which have affected the pool of potential
beneficiaries of housing tax policy. Most notably, the Economic Growth and Tax
Relief Reconciliation Act of 2001 (EGTRRA, P.L. 107-16) increased the value of
standard deductions and reduced marginal income tax rates for individuals, causing
lower tax burdens. In providing tax relief that was designed to stimulate the
economy, a likely unintended consequence was to reduce the number of taxpayers
claiming the housing tax deduction. As an example, the standard deduction for
married taxpayers filing jointly rose from $7,600 in 2001 to $9,700 in 2004, an
increase of 27.6%. For most households residing in the same home during that time
period, mortgage interest was likely to be lower45 such that some households who
may have been itemizing on their tax returns began to claim the standard deduction.
Additionally, the Jobs and Growth Tax Relief Reconciliation Act of 2003
(JGTRRA; P.L. 108-27), which was passed in May 2003, accelerated many of the tax
provisions of EGTRRA, thus further expanding unintended consequences of
reducing the number of taxpayers benefitting from the mortgage interest deduction.
Possible Policy Changes
Tax reform may cause moderate or fundamental changes in the federal tax
system. These changes could be as far reaching as eliminating the current income tax
system and replacing it with an alternative tax system, like a national sales tax. This
change could eliminate deductions and credits, including the mortgage interest
deduction. Alternatively, Congress could choose to simplify the existing tax code by
modifying or eliminating provisions, like the mortgage interest deduction. Finally,
tax reform could occur and leave the mortgage interest deduction unchanged.
In the absence of tax reform, Congress may or may not make changes to the
mortgage interest deduction. Congress may choose to modify or eliminate the
deduction for homeowners for a variety of reasons, including revenue raising
strategies to reduce the deficit or addressing the equity issues surrounding the
provision. Alternatively, Congress may choose not to alter the mortgage interest
deduction.
Elimination of the Mortgage Interest Deduction
Two possibilities can be examined in analyzing the elimination of the mortgage
interest deduction. The first case is that the provision is eliminated. The second
case, which may be more likely to occur than the first case, is in the event of tax
reform that fundamentally changes the federal tax system and eliminates the
mortgage interest deduction.
45 This statement assumes the homeowner has a fixed-rate mortgage and is making the same
amount of payments towards interest and principal each month.
CRS-17
Elimination as a Result of Tax Reform. As mentioned previously, several
tax reform proposals, if enacted, would eliminate the mortgage interest deduction.
There are, however, differences among these proposals concerning the elimination
of the mortgage interest deduction.
Flat Tax. In the 109th Congress, several bills have been proposed to enact a flat
tax. A flat tax is levied on wages and earnings, but is not an income tax. The flat tax
is considered a consumption tax because it does not tax savings and investment. The
difference between a flat tax and a sales tax, both of which are types of consumption
taxes, is where the tax is collected. The flat tax is levied on income as it is earned
and the sales tax is levied on income as it is spent.
Two of the currently proposed flat tax bills (H.R. 1040 and S. 1099) would
eliminate the mortgage interest deduction. S. 812, proposes to preserve the mortgage
interest deduction. H.R. 1040 and S. 1099 would define taxable income for
individual taxpayers as the total of wages, retirement distributions, and
unemployment compensation after subtracting a basic standard deduction and an
additional standard deduction for each dependent. S. 812 proposes a similar
definition of taxable income but would also allow deductions for cash charitable
contributions and home mortgage interest.
In general, flat taxes would eliminate the three primary tax provisions for
owner-occupied housing: the mortgage interest deduction, the deduction of state and
local property taxes, and the exclusion of capital gains on sales of primary
residences.46 As mentioned previously, the cost of these tax provisions combined
with the exclusion of net imputed rental income is estimated to be $139 billion in tax
revenue loss for FY2005.47 While that amount is sizeable, it is unclear as to what
the net change in federal revenue may be as a result of moving to a flat tax. It is
notable that the fundamental tax advantage of owner-occupied housing, the non-
taxation of imputed rental income, would remain unless specifically addressed by
legislation. However, the flat tax would eliminate the favorable treatment of owner-
occupied housing relative to other assets because the returns to all new investment
would be untaxed, not just the returns to homeownership.
Estimates of the effect of the eliminations of these tax provisions were made in
the mid- to late 1990s, when fundamental tax reform was last being considered. A
1996 report estimated that the elimination of both the mortgage interest and property
tax deductions would reduce house prices by an average of 17% but could range from
as low as 11% to as high as 34% depending on the region of the country.48
46 Under a flat tax there is no capital gains tax.
47 U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for
Fiscal Years 2002 to 2006, JCS-1-02 (Washington: GPO, 2002), p. 33.
48 Dennis R. Capozza, Richard K. Green, and Patric Hendershott, “Taxes, Mortgage
Borrowing, and Residential Land Prices,” in Henry Aaron and William Gale, eds., The
Economic Effects of Fundamental Tax Reform, (Washington, D.C.: The Brookings
Institution 1996), p. 192. Due to differences in interest rates and other economic factors,
these numerical estimates would likely be smaller if the elimination of the mortgage interest
(continued...)
CRS-18
In 1996 CRS examined the effect of a flat tax on housing.49 The principal
finding was that if a flat tax were instituted, eliminating the mortgage interest
deduction, demand for owner-occupied housing and homeownership would likely
contract. CRS found that the overall price of housing could fall by 22%, but that
only one-third of that amount of price decline would be due to the loss of housing tax
deductions.50 The remaining portion of the price contraction would occur as a result
of other factors, one of which would be the elimination of the preferential tax
treatment of housing relative to other investment assets. Assets would shift from
housing to business investment, which would improve economic efficiency. The
report stated,
Economists would typically view this shift as a benefit of tax reform, because the
current tax system encourages an inefficient overinvestment of funds in housing
and consequent underinvestment in business assets.51
CRS found much smaller effects than private sector reporting, which had
suggested that the elimination of the mortgage interest deduction would cause larger,
more adverse effects on housing prices and on the economy.52 For example, a
private sector report concluded that enacting a flat-rate income tax would cause home
prices to fall by 15% specifically because of the elimination of the deduction for
mortgage interest. The price decline would in turn eliminate $1.7 trillion of
homeowners’ equity.53
Capozza, Green, and Hendershott examined the effects of a flat tax on housing
and found house price declines ranging from 10 to 30%.54 The authors noted that
house price changes that could occur under a flat tax would vary based on what
changes occurred with interest rates and with property taxes. The higher these two
variables were found to be, the greater the percentage decline in house prices.55 After
performing regional analysis, the authors further concluded that the degree of house
price decline would vary by region and would be dependent on the rate of property
taxation and the existing price level of houses in the region. High-priced
metropolitan areas in California, as an example, would be hardest hit, while low-
48 (...continued)
deduction occurred in the current year.
49 CRS Report 96-379E, The Flat Tax and Other Proposals: Effects on Housing, by Jane
Gravelle, Apr. 29, 1996 (Available from the author).
50 Ibid., p. 6.
51 Ibid., p. 4.
52 Ibid., p. 1.
53 Roger E. Brinner, Mark Lasky and David Wyss, Residential Real Estate Impacts of Flat
Tax Legislation (Lexington, MA: DRI/McGraw-Hill, 1995).
54 Capozza, Green, and Hendershott, “Taxes, Mortgage Borrowing, and Residential Land
Prices,” p. 190.
55 Ibid. It is important to note that these estimates were made when interest rates were
higher than in 2005 so the effects would be much smaller given today’s interest rates.
CRS-19
priced metropolitan areas in the south would experience the smallest degree of house
price decline.
The issue of fundamental tax reform and housing was further examined in a
working paper from the National Bureau of Economic Research (NBER).56 The
authors simulated tests of housing market response to fundamental tax reform and
found that tax reform proposals would cause contraction in the quantity of housing
stock, though the degree of contraction varied depending on the type of tax reform.57
The authors reported that the removal of the deductions for mortgage interest and
property taxes would cause a 1.9% decline in the housing stock, while a flat tax
enactment would cause an 8% decline.58 The authors note that their results are
constructed under a partial equilibrium assumption that the long-run supply of
housing is perfectly elastic and that if housing demand were to grow more elastic, the
impact of eliminating tax benefits for owner-occupied housing causes a greater
decline in the stock of housing.59
National Retail Sales Tax. Movement to a sales tax system from the current
income tax system would eliminate existing tax subsidies to owner-occupied
housing, including the mortgage interest deduction and would also eliminate the
significance of the net exclusion of imputed rental income. A national retail sales tax
would repeal the personal and corporate income tax code and replace it with a tax on
all final sales of goods and services to consumers.
A national retail sales tax would impose a tax on newly built homes, which
would cause existing homes to enjoy a tax advantage. Under most concepts of a
national retail sales tax, the sale of an existing home would be categorized as the sale
of used property and would not be taxed. As proposed, H.R. 25 and S. 25 are
consistent with this tax treatment. In this context, the value of existing homes,
relative to newly built homes, would rise. If rental payments for housing were taxed,
owners of existing homes would also enjoy a tax advantage over renters.
Elimination Not as a Result Tax Reform. Generally, eliminating the
mortgage interest deduction separate from tax reform would harm itemizing
homeowners with the highest amounts of mortgage debt and, in particular, those
homeowners who could not easily replace that debt with equity. Homeowners with
mortgages would be expected to reduce their debt and new homebuyers would incur
less debt than they would have previously. For some, homeownership would no
longer be an optimal choice.60 If this were the case, a reduction in the demand for
56 Donald Bruce and Douglas Holtz-Eakin, “Apocalypse Now? Fundamental Tax Reform
and Residential Housing Values,” National Bureau of Economic Research Working Paper
6282, Nov. 1997.
57 Ibid., p. 9.
58 Ibid., p. 10.
59 Ibid.
60 The presence of high transaction costs make selling seem impractical for homeowners.
Renters, on the other hand, could choose to forgo home purchases.
CRS-20
homes would occur and housing prices would decline, at least in the short run, and
lead to a decrease in the quantity of owner-occupied housing in the long run.
A 1996 study examined the possibility of eliminating the mortgage interest
deduction, noting that the benefits of the mortgage interest deduction accrued
overwhelmingly to young households and to high income households.61 The authors
found that the younger households had limited wealth and were forced to borrow to
finance homeownership, while higher income households’ participation with the
mortgage interest deduction was to engage in tax arbitrage. For the higher income
households, the loss of the deduction would lead these households to use financial
assets to reduce or eliminate their mortgage debt. This alternative, however, is not
available to households without financial assets.
Some economists theorize that the loss of the mortgage interest deduction
separate from tax reform would adversely affect housing prices because the value of
the subsidy is capitalized into housing prices. Buyers of housing, it is thought, bid
up the price of owner-occupied housing to the point where the price of owner-
occupied housing, including tax benefits, is equal to the cost of renting.62 Thus, the
subsidy is perceived to have given homeowners a capital gain in the past, the loss of
which could be factored in to housing prices.63
The full economic implications of eliminating the mortgage interest deduction
depend upon whether or not the subsidy is capitalized into real estate prices. If it is
fully capitalized eliminating the subsidy would not affect the cost of owning but
many owners would experience significant changes in wealth.64 Gyourko and Sinai
found that in 2003, the value of the subsidy amounted to about a fifth of property
value, on average, in the United States. In particular, they found there were more
than 40 metropolitan areas, including many densely populated ones in and around
Boston, New York City, Washington, D.C., Los Angeles, and San Francisco for
which the present value of the subsidy flow is greater than 25% of house values. The
increased revenue associated with eliminating the subsidy could be redistributed back
to taxpayers in the form of lower taxes. According to the authors, the net wealth
effect of lower taxes would likely be significant enough to offset, at least in part, the
loss of the mortgage interest deduction.65 The report did not address how these
decreased property values would effect state and local government revenue.
61 Dennis R. Capozza, Richard K. Green, and Patric Hendershott, “Taxes, Mortgage
Borrowing, and Residential Land Prices,” in Henry Aaron and William Gale, eds., The
Economic Effects of Fundamental Tax Reform (Washington, D.C.: The Brookings Institution
1996), pp. 174-175.
62 Michelle J. White and Lawrence J. White, “The Tax Subsidy to Owner-Occupied
Housing: Who Benefits?” Journal of Public Economics, vol. 3, Aug. 1977, pp. 111-126.
63 Ibid., p. 112.
64 Joseph Gyourko and Todd Sinai, “The Spatial Distribution of Housing-Related Ordinary
Income Tax Benefits,” Real Estate Economics, Winter 2003, vol. 31, iss. 4, pp. 529-531.
65 Ibid., p. 530.
CRS-21
If the tax subsidy is not capitalized into real estate prices, the cost of ownership
rises when the deduction is eliminated. In 2003, Gyourko and Sinai determined that
the rise in cost of ownership could equal between 4% and 6% of annual household
income in over half of the nation’s metropolitan areas. However, in 20 metropolitan
areas, including many in California, Hawaii, and Massachusetts, costs of
homeownership amounted to 10% of income or more. Their analysis indicated that
if the tax savings from eliminating the subsidy were rebated through the
implementation of a tax credit, this rebate would more than offset the increase in the
cost of ownership in most areas. However, the authors noted that returning the tax
savings through the existing tax system would not provide a similar offset.66
Effects Outside the Housing Market. Repealing the mortgage interest
deduction would cause responses outside the housing market. Demand for mortgage
debt financing would decline causing mortgage lending to decline. Capozza, Green,
and Hendershott estimated that loan-to-value ratios, the amount of debt relative to
equity value in the home, would fall by more than 30% and that house price declines
of 10% could accompany mortgage lending declines of about 40%.67 Mortgage
interest rates could fall in response to lower demand for mortgage debt. Lower
mortgage rates could attract new homebuyers which could increase demand for
homes and cause house price increases, thereby reversing declines in mortgage
lending and house prices. The net results, however, would likely yield lower house
prices, lower before-tax mortgage rates, higher after-tax mortgage rates, and lower
mortgage lending.
Elimination by Phasing out the Provision. Bourassa and Grigsby
examined the possibility of the elimination of the mortgage interest deduction and
offered a plan for phasing out the provision that would minimally affect housing
demand.68 Citing that proposals to limit the mortgage deduction are opposed on the
“grounds that existing homeowners would suffer huge capital losses,” the authors
proposed a 15- to 20-year period of phasing in the elimination of the tax provision.
This type of elimination, the authors argued, would not adversely affect demand for
housing or the capital values of the existing stock.69
Finally, the repeal of the deduction could be justified as a second-best policy to
address the absence of taxation on net imputed rental income. Net imputed rental
income from homeownership has never been included as taxable income in the
federal income tax. This is due in part to limited acceptance by non-economists of
the idea that owning a home (or other consumer durables) provides owners with
implicit income that should be taxed, and in part because of the administrative
difficulty of taxing such income. Further, many economists doubt that imputed rent
66 Ibid., p. 557.
67 Capozza, Green, and Hendershott, “Taxes, Mortgage Borrowing, and Residential Land
Prices,” p. 196.
68 Steven C. Bourassa and William G. Grigsby, “Income Tax Concessions for Owner-
Occupied Housing,” Housing Policy Debate, vol. 11, iss. 3, (Washington, DC: Fannie Mae
Foundation, 2000), p. 541.
69 Ibid., p. 541.
CRS-22
could be accurately taxed in the United States as a practical matter. Little is known,
for example, about the probable rental value of owner-occupied homes; only rough
estimates could be made from available data on assessed house values. Available
data on rental rates is not useful because of the differences in size and quality of
rental units as compared to owner-occupied properties.
Modification of the Mortgage Interest Deduction
Congress could choose to modify the provision to either simplify the tax code,
increase tax revenue, or both. In the event of tax reform, these modifications could
be considered and included in various reform proposals. For instance, Congress
could choose to implement a flat tax and allow some modified version of the
mortgage interest deduction. The possibilities in this regard could be endless. Thus,
the modifications listed below describe possible policy options that could be taken
without regard to a particular form of systematic tax change.
Reduce the Amount of Allowable Indebtedness. One possible way of
modifying the mortgage interest deduction would be to reduce the maximum
allowable mortgage debt limit from $1 million to a lesser amount. This choice would
reduce the tax benefit for those homeowners with debt in excess of the allowable
amount, presumably high income households with very large houses. The reduction
in tax savings could cause the prices of homes worth more than the allowable debt
amount to decline, which would reduce demand for those homes.
There are a few possible consequences of reducing the debt limit. Some
homeowners would use equity to pay down some or all of their mortgage debt. Other
households may reduce their level of housing consumption by moving to less
expensive homes. Marginal homeowners, who are typically not high income
households or purchasers of expensive homes, are unlikely to be affected by a
reduction in allowable debt.
In February 2005, the Congressional Budget Office (CBO) examined this policy
option. It estimated that reducing the amount of mortgage principal that could be
allowed from $1 million to $500,000 would affect 700,000 taxpayers with large
mortgages and raise $2.7 billion in FY2006.70 The number of taxpayers affected by
the year 2010 would rise to 1.3 million with an increase in revenue of $4.3 billion
that year. Over the period of 2006 through 2010, the total revenue increase from
limiting the principal debt that could be claimed for the mortgage interest deduction
would be $47.9 billion. CBO estimated that less than 1% of all homeowners and
about 3% of new homebuyers would be affected by the limit.71
This policy option would not be any more complex than the existing tax code,
though there would be increased administrative costs associated with the change.
There would be increased costs to make taxpayers aware of the change and also
70 U.S. Congress, Congressional Budget Office, Budget Options, Congressional Study,
(Washington: GPO, 2005), p. 278.
71 Ibid.
CRS-23
increased costs to change tax forms. If the reduction in allowable mortgage debt
caused increases in attempts to avoid or evade taxation, IRS costs could rise.
Disallow Home Equity Indebtedness. Disallowing home equity
indebtedness is another possible modification to the mortgage interest deduction.
As mentioned previously, home equity debt often finances personal
consumption rather than financing homeownership, which causes disparate treatment
among similarly situated taxpayers. As an example, two taxpayers can incur $20,000
in consumption debt. The taxpayer who finances this debt with a credit card, as
opposed to a home equity loan, is unable to receive a tax benefit by deducting the
interest charges. The taxpayer who uses a home equity loan to pay off the credit card
debt can deduct the interest and thus is favorably treated by the tax code.
The interest deduction’s disparate treatment of homeowners also reflects
differences in housing appreciation and values. Homeowners with housing price
appreciation can take advantage of home equity debt while other homeowners, with
flat or declining home values, may not be able to benefit from home equity debt.72
Allowing home equity indebtedness deductibility also favors those homeowners who
have sufficient credit worthiness to incur home equity debt. This effect further
contributes to disparate treatment of taxpayers to the extent that some homeowners
are unable to obtain home equity loans. On the other hand, eliminating home equity
deductibility negatively affects households who have no significant pool of funds
from which to finance needed repairs or improvements. These households, who are
more likely to be lower-income and/or elderly households, would lose the benefit of
the tax savings if home equity indebtedness were disallowed. Yet this loss only
applies to those households who were benefitting from the tax savings, which may
have been a small portion of the affected population.
This policy choice has been presented as an option to improve tax compliance
and reform tax expenditures by the Joint Committee on Taxation (JCT). The option
was estimated to raise $0.3 billion in tax revenue for FY2006 and $22.6 billion in tax
revenue over the 10-year period beginning in FY2006.73
Allow the Deduction for Principal Residences Only. The mortgage
interest deduction could be limited to acquisition indebtedness associated with
principal residences only. Presumably it is higher income households that are able
to afford more than one residence, so disallowing the mortgage interest from debt on
a second residence (or mobile home, yacht, or other qualifying property) would
contribute to making the provision more equitable by reducing the amount of benefit
that higher income households can receive.
This modification may contribute to a decrease in demand for housing, vacation
homes in particular, which could lead to a short-term decrease in the price of vacation
homes. The supply response to that decrease in demand may cause a reduction in the
72 Ibid., p. 55.
73 U.S. Congress, Joint Committee on Taxation, Options to Improve Tax Compliance and
Reform Expenditures, JCS-02-05 (Washington: GPO, 2005), pp. 52-56.
CRS-24
quantity of vacation homes which would result in higher prices and a lower quantity
of vacation homes.
This change would increase tax revenue by reducing the amount of mortgage
interest taxpayers deduct and could be simpler to administer. It is, however, possible
that this change could increase attempts at tax avoidance or evasion if individuals
attempted to claim residences that are not their principal residence. In this case, IRS
administration costs would rise.
Other Options. There are many possibilities that Congress could choose to
modify the mortgage interest deduction. Some policy options would not necessarily
simplify the tax code or increase tax revenue but might, instead, improve the equity
of the provision. This section discusses those possibilities.
Impose an Income Eligibility. The deduction as it currently exists does not
limit participation by taxpayers to households with particular income levels. The
imposition of an income threshold, as in the case of certain other tax provisions,
would increase tax revenue by reducing the number of taxpayers eligible to claim the
deduction. As an example, the tax credit for new homebuyers in Washington, D.C.,
is a nonrefundable credit against federal taxes of up to $5,000 for the first-time
purchase of a principal residence in the District of Columbia. The credit is phased
out for individuals with adjusted gross income (AGI) of $70,000 to $90,000 and for
joint filers with AGI of $110,000 to $130,000. In particular, for every $1,000 of AGI
above $110,000 for joint tax filers, the credit is reduced by $250. Once AGI exceeds
$130,000, no credit may be taken.
Imposing an income cap could increase equity because the cap would disallow
high-income households from claiming the deduction. In doing so, the provision
would subsidize homeownership for households with less income which may add
progressivity to the tax code. It would still be the case that low-income households
with no tax liability, or those who claim the standard deduction, would not benefit
from the provision.
This policy choice would add complexity to the tax code by further complicating
the tax provision. This option would require taxpayers to do more work in
determining their eligibility for the provision. The Internal Revenue Service would
also have increased administrative effort to enforce income restrictions for those
claiming the provision.
Above-the-Line Deduction. An above-the-line deduction, which would be
available to taxpayers regardless of whether they claim the standard deduction or
itemize deductions, could increase equity. This possibility would allow the
deduction of mortgage interest to be available to more modest income taxpayers than
is currently allowed by tax law. This change would contribute to progressivity in the
tax code, but would also increase tax revenue loss by allowing more individuals to
claim the deduction.
At its initial introduction, an above-the-line deduction would add complexity to
the tax code and tax filing forms. Because of its newness, the provision would
increase the administrative work taxpayers experience in filing their income tax
CRS-25
returns and the work the IRS performs in processing those returns. Yet, over time,
an above-the-line provision would not be any more complex than the existing
deduction. The enactment of an above-the-line deduction could, however, be
perceived as undermining the concept of the standard deduction, which exists in part
to simplify the tax code.
Tax Credit. Another possible change that would increase the equity of the
deduction would be to transform the mortgage interest deduction into a partial tax
credit. This change would benefit lower income individuals by allowing them to
benefit from claiming mortgage interest. Those taxpayers who claim the standard
deduction could also claim a tax credit for mortgage interest.
This policy option would provide taxpayers at different income levels with the
same rate of subsidy for mortgage interest payments, unlike the current deduction
which varies with the marginal tax rate. The tax credit would also allow lower
income households that currently do not claim mortgage interest, perhaps because the
interest they pay is less than the value of the standard deduction, to benefit by
claiming a tax credit for mortgage interest.
This option could either increase or decrease federal revenues, depending on the
amount of credit chosen. Estimates for this policy option were made by the
Congressional Budget Office (CBO) 25 years ago. At that time, CBO determined
that moving to a 25% tax credit would increase revenues by about $2.4 billion in the
year the study was conducted, and by $4.3 billion in the next year. At that rate of
25%, only a small group of wealthy taxpayers would be worse off. A credit of 30%
or more would have decreased revenues. CBO also found that a tax credit of this
amount would raise house prices for less expensive homes and lower them for
higher-priced units. This effect could lead to some upper-income homeowners
experiencing a decrease in the value of their homes as well as an increase in their tax
payments. Allowing current owners the choice of a deduction or credit could have
limited those capital losses, but the revenue tax revenue losses from doing so would
have been substantial.74
Higher income taxpayers may be less well off by the transformation of the
current mortgage interest deduction to a tax credit if the tax credit were only a partial
credit. For higher income taxpayers, the value of the current mortgage interest
deduction is likely to be greater than the value of a proposed tax credit which could
cause an after-tax reduction in price for high income households. Yet, higher income
households are less sensitive than lower income households to changes in price, so
the loss in value of the mortgage interest deduction if it were to become a tax credit
may not be significant enough to cause high income households to abandon
homeownership. If high income households responded at all, they may reduce their
housing consumption, perhaps by purchasing less expensive housing.
As a result, this proposal could increase homeownership because it is most
likely to alter decisions about homeownership at the margin. More families in the
74 U.S. Congress, Congressional Budget Office, Tax Treatment of Homeownership: Issues
and Options, Congressional Study (Washington: GPO, 1981), p. 19.
CRS-26
lower- and middle-income groups may choose to own, rather than rent. Others in
those same groups may choose to buy more housing than they currently own.
It is notable, however, that in terms of the measurement of income for taxation
purposes, tax analysts believe a tax credit is not appropriate under a pure income tax
system. Tax credits are dollar-for-dollar reductions in a taxpayer’s federal and/or
state income tax liability, while tax deductions are offsets to a taxpayer’s pretax
income. Since income taxes are meant to raise revenue from taxpayers’ according
to their ability to pay, tax deductions alter income to best reflect taxpayers ability to
pay. Deductions, unlike credits, reduce the base amount of income to be taxed and
in doing so, affect the variable benefits correlated to a taxpayer’s particular income
tax rate or bracket.75
Conclusion
Current tax reform proposals promote consumption-based tax systems, most of
which would eliminate the mortgage interest deduction. In the case of either a flat
tax or a sales tax, all credits and deductions as they exist in the current income tax
system would be eliminated. The deduction of mortgage interest would no longer be
allowed, unless specifically addressed by legislation. As an example, S. 812
proposes a flat tax that includes the preservation of the mortgage interest deduction
along with the charitable contributions deduction.
Although the mortgage interest deduction is generally defended on the basis of
supporting access to homeownership, most studies conclude that its primary effect
is on housing consumption, not homeownership. Most of the benefits of the
deduction accrue to households with well-above-average incomes, while households
on the cusp of homeownership tend to have lower income. Depending on how they
are structured, most studies suggest that lower income households would be aided
more by down-payment assistance than by the deduction for mortgage interest.
Eliminating the mortgage interest deduction separate from tax reform would
have several effects. It would tend to reduce debt relative to equity by ending the
neutrality between equity- and debt-financing. It would lead some households who
may have been considering homeownership to choose to continue to rent. Some
owner-households may choose to consume less housing, either by choosing smaller
homes or fewer amenities. The elimination could lower home prices relative to rents
in the market and could cause households to convert housing assets to business
investment.
If the deduction were eliminated as a result of fundamental tax reform, the
resulting effects would depend on a variety of variables. These variables include the
nature of tax reform, the resulting changes in the tax base and tax rates, changes in
interest rates, and other economic variables. If the deduction were eliminated
without other tax policy changes, federal income tax revenues could increase, the tax
75 Babette B. Barton, et al., eds., Study of Federal Tax Law: The Taxation of Income, 19th
Ed., (Chicago, IL: CCH Incorporated, 1994), p. 341.
CRS-27
base could be broadened, and the federal budget deficit could be reduced. This
elimination could lead to greater economic efficiency, increased equity, and
simplification of the current income tax system.
Modifications to the mortgage interest deduction could also have several effects.
Congress could choose to allow the deduction for only one residence, rather than two,
or reduce the allowable principal debt from $1 million to some lower amount,
perhaps $500,000. These changes would reduce the amount of tax revenue loss
associated with the provision without adding complexity to the tax code. Congress
could also choose to improve the equitable nature of the provision by allowing more
low income households to claim mortgage interest, either as an above-the-line
deduction or as a tax credit.
Finally, the mortgage interest deduction could remain unaltered. It would
continue to be a benefit to more than 37 million taxpayers and provide more than $70
billion in annual tax savings to homeowners.