GOP: All Talk on Eliminating Tax Breaks—No Action

GOP: All Talk on Eliminating Tax Breaks—No Action

iStockphoto/The Fiscal Times

The principal problem for tax reform has always been that people want lower tax rates and in theory are willing to give up tax deductions and loopholes to pay for them, but they strenuously resist eliminating any particular tax preference from which they benefit. And the deduction for mortgage interest has long been among the most sacred of sacred cows in this respect.

Many people mistakenly believe that the mortgage interest deduction was instituted for the express purpose of stimulating home ownership. This is incorrect. The deduction exists because the original income tax of 1913 allowed a deduction for all interest, on the theory that people only borrowed for business or investment purposes.

This was a reasonable assumption at the time. Most people were renters. When they bought a home, they tended to pay cash. Moreover, until World War II very few people paid any federal income taxes: On the eve of war, only 3 percent of the population did. But by the end of the war, 30 percent of the population paid income taxes at rates much higher than today. Consequently, those in the middle class, who previously had given little thought to the value of tax deductions, suddenly wanted them. The mortgage interest deduction was an easy one for them to obtain.

At the same time, innovations in mortgage finance during the Roosevelt administration made it easier to obtain loans for home purchases, and the upward mobility of the middle class in the postwar era made home ownership in rapidly-growing suburbs attractive and achievable. The mortgage interest deduction lowers the cost of home ownership. If someone is in the 25 percent federal tax bracket, then Uncle Sam is essentially paying a quarter of their mortgage interest in the former of lower taxes.

Additionally, home owners can deduct property taxes and essentially pay no capital gains taxes when they sell their home because there is a $500,000 tax exemption on gains for couples and $250,000 for singles.

Of course, people also like the stability of home ownership, the suburban lifestyle, generally better schools than in the cities, and the protection from inflation. Consequently, home ownership has long been a key part – perhaps the key part – of the American Dream. When the after-tax cost of owning a home falls below the cost of renting, most people jump at the chance to own.

The problem, insofar as tax reform is concerned, is that the mortgage interest deduction and that for property taxes reduce federal revenues by $100 billion per year. Including other tax benefits for housing raises the revenue cost to $185 billion. Another problem is that the mortgage interest deduction predominantly benefits the well to do. Three-fourths of all the tax savings from it accrue to those with incomes over $100,000 per year.

The reason is simple. The wealthy are more likely to be homeowners and also benefit more from the deduction for mortgage interest. Someone in the top tax bracket saves 35 cents of each $1 of mortgage interest paid, while someone in the lowest bracket only saves 10 cents.

The middle class benefits a lot less from the mortgage interest deduction than it thinks it does. Those with incomes between $50,000 and $75,000 only save $362 per year in taxes. One reason is that those in the middle class are more likely to stay put and pay down their mortgage, thus reducing the amount of mortgage interest they have to deduct annually.

According to the Census Bureau, about a third of owner-occupied homes have no mortgage at all. Many are the elderly who paid them off and live rent-free and mortgage-free.

Even these people, however, still have a stake in preserving the mortgage interest deduction. That is because the value of the deduction is capitalized into home prices. A common estimate is that home prices would fall by 15 percent if the deduction is abolished. So even those with no mortgage would suffer. There would be macroeconomic and tax simplification benefits from abolishing the mortgage interest deduction. But historically, these reasons have not been persuasive, politically.

Nevertheless, mortgage interest keeps coming up in discussions of tax reform because it is the proverbial elephant in the living room. It is hard to do meaningful reform while leaving it in place. For both revenue and distributional reasons, mortgage interest cannot be ignored in the debate on tax reform.This has created problems, especially for Republicans because they are keen on making tax reform a campaign issue.

GOP nominee Mitt Romney has a plan that would reduce statutory tax rates by 20 percent. But he has said he would eliminate enough deductions and loopholes to equal current federal revenues and also ensure that the wealthy pay the same percentage of total taxes as they pay now.

But the Tax Policy Center recently concluded that Romney’s proposal is mathematically impossible even if the mortgage interest deduction and all other deductions are abolished. Romney reacted angrily to the study, denying he would touch the mortgage interest deduction for middle-income taxpayers. But at the same time, he has steadfastly refused to say what deductions he would in fact get rid of to pay for his plan.

This week, writers of the Republican platform in Tampa dipped their toe in the tax reform water by excising a plank in previous platforms defending the mortgage interest deduction. Under pressure from groups such as the National Association of Home Builders, language was quickly reinserted to protect the deduction.

The fact is that if fundamental tax reform is on the table, then so is the mortgage interest deduction. Making an exception for it automatically becomes the best possible argument for keeping the next most popular deduction and so on – until we are right back where we started. The fact that Republicans backtracked on mortgage interest the moment there was pushback from special interests doesn’t bode well for tax reform even if Mr. Romney wins.