I am going to see Senator Obama speak tomorrow, so I wanted to brush up on his proposed tax plan:
Obama’s middle class tax relief plan would provide $80-85 billion in tax cuts to America’s workers, seniors and homeowners by:
- Cutting taxes for 150 million Americans and their families, allowing them to get a tax cut of up to $1000.
- Easing the burden on the middle class by providing a universal homeowner’s tax credit to those who do not itemize their deductions, immediately benefiting 10 million homeowners, the majority of whom make under $50,000 per year.
- Eliminating the income tax for any American senior making less than $50,000 per year, eliminating income taxes for about 7 million American seniors.
- Simplifying tax filings so millions of Americans can do their taxes in less than 5 minutes.
Plenty has been said on the propoal, which unfortunately is not very interesting. Mostly, it is pandering: Eliminating all income tax for seniors—one of this nation's wealthiest demographics—is just silly. But not a lot has been written about the mortgage interest deduction, likely because an astonishingly-high 70% of Americans own their own homes. But the policy—with or without the Senator's reforms—is distortionary and not worth its high cost.
Don't we want to encourage investment?
Yes, but we don't want to single out one asset, which discourages investment in all other vehicles, perturbing investment flows away from the optimal asset allocation. People are willing to buy bigger homes, and pay more for them, than they otherwise would. Portfolios thus overemphasize housing (fueling an asset bubble) at the expense of other, higher-returning investments. This diverts investment away from productive business. It also encourages "cash poor, house rich" scenarios.
Okay, but isn't homeownership in particular a good thing?
Maybe. Studies have shown that homeownership encourages greater participation in one's community. Americans certainly feel that homeownership is part of the American Dream. To be sure, we should not discourage owning over renting. But the mortgage interest deduction costs over $80 billion a year and homeownership is not all roses, either. Homeowners are less mobile than renters, as one example, leading to a less flexible labor force. The question is not whether homeownership is good or bad, but whether it is worth $80 billion.
Yes?
The goal of the interest deduction is to encourage homeownership—not to encourage the purchase of bigger, better, or more homes. This is important, because it means we only care what happens at the margins. That is, the deduction's success rides on those at the cusp, vacillating between buying versus renting, who without the deduction would decide to rent, but with the deduction choose to buy.
Moreover, only tax payers who itemize their deductions, as opposed to those who take the standard deduction, benefit from the mortgage interest deduction. Itemizing your deductions is extra work, and worth it only if your deductions exceed the standard deduction, which is not a given (particularly for those on the margin).
I do not know how large the intersection of on-the-verge-of-buying and itemizing individuals is, but I suspect it is not huge, and $80 billion is a shotgun approach to aiding them. Indeed, the current policy simply is not very true to its goals: you can deduct the interest from up to a $1 million mortgage, and from a second home—
—wait, you can deduct a second home?
Yup, which actually discourages homeownership, by reducing supply and increasing prices. Anyhow, the policy is geared more toward rewarding middle and upper-class homeownership, rather than encouraging homeownership.
Numbers, Mrs. Landingham
Overall, less than one third of Americans itemize their deductions. Only half of homeowners claim the deduction. Perhaps the most interesting statistic is that Canada and Australia have similar homeownership rates to the US, despite no mortgage interest deduction. England previously offered but has since repealed an interest deduction and their homeownership levels remained roughly the same.
Why do we have the deduction at all?
Its a relic from when all interest was deductible, starting with early incarnations of the income tax. Eventually, a deduction on interest became unacceptable and highly distortionary (biasing debt over equity), and it was repealed by the Tax Reform Act of 1986. But the mortgage interest deduction survived.
Isn't the Obama change from a deduction to a credit a step in the right direction?
Not really, as it comes at the problem from the wrong angle. A real solution would end the distributive effects of the current policy. If it is politically untenable to eliminate the deduction, make it apply equally to any investment, not just home purchases. If the goal is to encourage homeownership, then (and it pains me to say this) the deduction needs to be made larger at the bottom of the income scale and eliminated from the top. If the solution is neither investment-agnostic nor more progressive, its just pandering to the middle class, and not a step forward.
What would you do?
My ultimate policy preference is for a consumption tax, without bias toward any one investment vehicle. The FairTax fits this criteria. As a stopgap measure, I would eliminate the mortgage deduction and use the resulting savings to lower the income tax or decrease the deficit.