Mortgage Interest Deduction, part 5

At last, we come to the final part of this seemingly never-ending series.  I’ll finally get to what I think is the best way to get ourselves out of the fiscal mess that the MID has created in the fairest way possible.

Recall that the primary real economic effect of the MID is to inflate home prices somewhere in the neighborhood of 10%. (Cynically, I choose to believe the estimates in the academic literature over the NAR’s self-serving estimate of “up to 15%”.)  The net tax benefit to homeowners is basically a wash, or at least, substantially smaller than the raw dollar amount of about $120 billion that is written off per year, due to this price inflation.

With that in mind, I think the fairest way out is pretty simple.  What I’m about to propose isn’t rocket science, but to the best of my knowledge, no one else has proposed it, or at least there’s been no serious discussion of it.  The basic plan:

  • Keep the MID for all existing mortgages for their full term. (Full disclosure:  I would fall into this group, but that’s not why I’m proposing it.)
  • Phase out the MID for new mortgages over a 5-10 year time span.  For example, to do a 5-year phase out, interest paid on mortgages originating in the year 2013 would be 80% deductible for the full term of the loan, interest for mortgages originating in 2014 would be 60% deductible for the full term, and so on, until 2018 when the deduction would be completely phased out for new mortgages.

I’ve seen other phase-out plans based on income, but not based on date of origination of the mortgage, as mine is.  I’ll present my justification in Q&A format:

Wait a minute!  Why do the lucky current homeowners get to keep their deductions in perpetuity (or at least, as long as their loans last), while future home buyers will have to pay taxes on their mortgage interest?

One could get into a philosophical debate about whether the government should consider the MID a “commitment” to those who took out mortgages while it was in effect.  But, for better or worse, many people make their budgets assuming that the MID will continue to be in place.  You might argue that that’s their problem to deal with, but the fact of the matter is that many current mortgage holders would default if the tax break were swept out from under them.  As I’m sure you’re beginning to gather, I’m far from a shill for high house prices as a magical panacea for the economy, but the resulting dip in house prices that would follow a new stream of defaults wouldn’t be good news for anyone.  So, this part of the phase-out plan is more or less an acknowledgement of the fact that we’re essentially stuck with continuing to provide current homeowners their tax break, or else we’d exacerbate the troubles the housing market is already going through.  The main feature of this plan is that everyone knows exactly what tax treatment they’ll be getting for the life of their mortgage when they sign the dotted line.  You know how politicians complain that an environment of uncertainty over government policy can create economic paralysis?  Normally I think that’s a bunch of hogswallop (note to WordPress:  “hogswallop” is a word!  Stop underlining it!), but when you start fiddling with large tax breaks that tens of millions of taxpayers enjoy year in and year out, there might actually be something to it.  This feature of the plan would prevent that from happening.

Why 5-10 years as the phase-out period?

I have to confess that there’s nothing magical about the time period I chose, but I didn’t just pull it out of a hat, either.  For reasons I’ll get into some other time, in the long run, I think that house prices generally follow inflation pretty closely.  For now, consider the following picture (source) as at least a hint that this is true.  See how the inflation-adjusted house prices aren’t really much different from 1970?

 

As I’ve mentioned, going from the MID as we currently have it to no MID at all would probably result in around a 10% drop.  The phase-out plan basically takes that inevitable 10% hit to prices and spreads it out over a period of several years, with a small drop coming each year as buyers are forced to lower their purchase offers to account for the slightly smaller tax break they’ll get.  If we assume an inflation rate of around 2-3%, which is pretty typical historically, then chipping away at the artificial 10% price boost bit by bit over 5-10 years would hopefully mean that there wouldn’t be any sudden drops in home prices.  The 1-2% of value lost per year due to the lowered tax subsidies ought to be offset by natural growth in home prices that would occur during that year.  I don’t claim to have a crystal ball on what will happen with home prices in the future, but I think this gives the best chance of getting rid of the subsidies without dragging the process out over decades, with a reasonably low risk of causing enough of a drop in home values that more people would find themselves underwater on their mortgages.  And of course, the plan can be tweaked by adjusting the term of the phase-out period:  If you’re willing to take the budget hit of the MID for longer, you can extend the phase-out period so that the annual hit to home values is even smaller.

Won’t it take a long time to see any real increase in tax revenues with this slow phase-out?

Yeah, you could say that, but that’s the nature of the beast.  The MID is pretty entrenched in our tax code as it is, and to do away with it without radically changing current owners’ tax situations and current home values takes time.  Once the phase-out period, however long it may be, is completed, the costs of the MID will gradually begin to decrease due to a variety of factors:  some of the mortgages grandfathered in to the MID will come to term each year, some people will voluntarily refinance their mortgages after the MID is phased out, forgoing their tax benefit, and in general, as mortgage balances decline over time, so will the amount of interest paid on them which can be claimed as a deduction.  Determining exactly at what rate the cost of the MID would decrease is virtually impossible to do (since it depends on things like whether future interest rates will be low enough to entice buyers to refinance, whether people choose to pay off their mortgages early, and what terms and interest rates people currently have on their mortgages, something on which there is surprisingly little publicly available data). But as a conservative estimate, certainly within 30 years of the end of the phase-out period, the balances on any few remaining mortgages grandfathered into the MID would be tiny.  40-year mortgages are quite rare, and technically a 30-year mortgage is usually in default if not paid in full by the end of the 30-year period.

The bottom line then, is yes, it will take time to see a real effect on the budget, but this tends to be the case with any feasible solution to major parts of the U.S. budget deficit.  There are no overnight fixes that the general public would tolerate, even though we all may enjoy blaming politicians for failing to find any such fixes.

And what about current homeowners who will, as you admit, suffer a ~10% loss in the value of their homes over time?

Alas, there’s no free lunch.  To get rid of a tax subsidy which carries with it an artificial inflation of home values, you’re going to have to… well, get rid of the artificially inflated home values along with it.  Though I tried to structure the plan to avoid any sudden drops in home values, I should also admit it’s perfectly possible that, if this plan were set into motion, current buyers would factor the expectation of lower price appreciation into their offers, resulting in a bigger drop now.  (Then again, there may be an opposite effect of buyers rushing to buy a place and get a mortgage while there are still subsidies to be had.  I don’t know.  I don’t know of any good historical data to look at to see how this sort of thing plays out in practice.  Economists, historians, got any ideas?)

But the reality is that home owners don’t have any intrinsic right to expect constant appreciation on their investment, any more than the owners of stocks or commodities.  People may buy with the assumption that prices will continue to go up forever, but that isn’t and can’t always be the case.  As I noted above, I’m willing to grant current homeowners the right to continue to receive the MID, to avoid an effect on their short-term budget planning, but I draw the line at continuing the MID forever just because they assumed they could get rich through perpetual price appreciation.  Painful though it may be for those people, the bottom line is that the government can’t afford to keep spending well over $100 billion a year just to keep house prices inflated above their real fair-market value.  This is the best way I can think of to get rid of it in the long term, without giving anyone in particular too much of a reason to complain about it in the short term.

And there you have it!  The main MID series is done, though over time I’ve realized there’s a lot more stuff I could have included.  I’ll probably do a few short entries on various odds and ends, before eventually getting into my next major topic:  Title “Insurance”.  Stay tuned!

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One thought on “Mortgage Interest Deduction, part 5

  1. I really like that you don’t just point out the problems with the MID, you also propose a solution. I’m always annoyed by people who stop short of coming up with a way out, and are content to just kvetch.

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