Here’s What An Inefficient Tax Break Looks Like

April 5th, 2013 at 9:51 pm

There are a lot of people running around DC these days talking about closing tax loopholes.  But when you push them on specifics, most are hard pressed to say which ones.

Though I name names in recent testimony on the topic, I’m sympathetic.  Your loophole is my treasured job-creation program without which the economy will collapse.

So we need some criteria by which to judge what should stay and what should go.  In the link above, I argue for a 3-step test involving revenue forgone, efficiency, and fairness.  Someone suggested adding political feasibility, which makes sense, though given the state of Congressional gridlock, that could shut down the whole enterprise.

Anyway, these thoughts came to mind when I saw the graph below from my CBPP colleague Will Fischer (here’s the post from which I plucked it).  It’s about the mortgage interest deduction (MID), and to my eyes, it’s a picture of an expensive, inefficient, and unfair tax break.

Fischer lines up the billions in tax payments forgone by income class next to a measure of housing cost burden, defined as the number of households that pay more than half of their income for housing.  If economic need were the motivation for the MID, you’d expect the two sides of the graph to correlate.  But they don’t even come close.

The bulk of the deduction’s benefits go to higher-income households who generally could afford a home without assistance:  in 2012, 77 percent of the benefits went to homeowners with incomes above $100,000.  Meanwhile, the deduction provides little benefit to the middle- and lower-income families who are most likely to struggle to afford homeownership (see chart) — and no benefit at all to more than a third of homeowners with mortgages.

The MID is widely believed to subsidize home purchases that would mostly have been made anyway, so it scores high on the inefficiency criterion.  And since it costs the Treasury about $70 billion a year in forgone revenue, it’s expensive.  As the figure shows, it’s distributionally upside down, so it scores no higher on fairness.   In fact, it’s a trifecta loser on my three original criteria.  Of course, once if you add in political feasibility, it’s a much tougher call, though Fischer points out that numerous analysts have proposed reforms that mend the MID without ending it.



Source: Fischer, CBPP

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22 comments in reply to "Here’s What An Inefficient Tax Break Looks Like"

  1. Richard Careaga says:

    The MID survived the 1986 Code’s elimination of interest deductions generally due to a national housing policy that had been (and remains) on autopilot since 1946, when there was a severe housing shortage combined with white flight and explosive household formation and the advent of the Boomer generation. The shortage was due to a long period during which no net housing increase occurred due to the Greater Depression and WWII.

    It has been a long time since we’ve had a housing shortage, a baby boom, or racial covenants in subdivions and many of the other public props to white flight. The house in the suburbs with the white picket fence ideal is no longer universally shared. It is intellectually hazardous to articulate a coherent housing policy reason that the MID should persist.

  2. SeattleAlex says:

    This is the illest chart I’ve seen in some time sir… the juxtaposition is remarkable poignant. Thanks for sharing. Should probably peruse CBPP a bit more frequently than I do.

  3. ThomasH says:

    While I agree about the MID, the post did not really address the economic inefficiency of the deduction, the distortion of the rent/buy decision or to what extent the “inefficiency” is a generic feature of any deduction compared to a partial tax credit.

  4. Bryce says:

    Don’t underestimate the power of the real estate lobby in keeping the MID in place! When I worked for a senator, the number of letters we received when talk of reforming the MID (simply putting a cap on the size of the deduction) was in the air trumped all comers besides the gun lobby.

    Another point worth drawing out is the implicit discrimination of the MID against renters, many of whom, I bet–and especially in cities–pay far more than one-half of their income on housing.

  5. rune lagman says:

    Jared identified the reason, but he is to chicken to say it out loud. The rich benefits from the deduction, so no poltician, that values his campaign contributions, will ever change the distributional effects.

    I’m sorry folks, but it’s that easy.

  6. balt0r says:

    Important information that never gets talked about. I had no idea things were that lopsided, though I have noticed as a prospective homebuyer that I may still end up taking the standard deduction even w/ the MID possibility if I itemize (since I would not be buying an expensive house).

    One issue, though. It should be “Your loophole” not “You’re loophole” in the second paragraph.

  7. Nick Batzdorf says:

    I’d buy this if the deduction were retro-progressive based on gross income – and location! – but I can tell you that otherwise we would probably lose our house if that happened. There are lots of people like us who were pretty close to the 1% for years, but now that we’ve been hit hard by the crash we’re having a very hard time staying afloat.

    To me this seems like the time for the Fed to be bailing out troubled homeowners just like the banks are being bailed out, not having our tax burden raised!

    Put another way, even though we’re still reasonably low down that chart, and on national scales our income doesn’t sound like anything to complain about – compared to most people we are very fortunate (not hungry, kid in private college) – but this would be pretty devastating to us in Los Angeles.

    Obama used $250K as the cutoff figure for a very modest increase in Federal income taxes, and that seemed reasonable: if you’re bringing in $250K even in a major city you’re still not going to be particularly bothered if any income over that is taxed at a slightly higher rate. But we’re not bringing in $250K, and that chart doesn’t the whole story today; if we had to cough up an additional $8K a year – not an insignificant percentage of our income – we’d really be screwed.

  8. Smith says:

    Impressive but misleading graph. Combining the data with info from here (see page 31 and 38) yields the chart below. Turns out 50% of h.h. (households) are averaging at least $289 per year in benefits. But this chart is terribly misleading too. There are 120 million households, but only 2/3 own their own homes and 1/3 don’t have mortgages (paid it off probably). 2/3 with mortgages * 2/3 with homes = 4/9 so multiply the benefits by the reciprocal 9/4 (of course) to get a realistic picture (while nearly halving the h.h. #). But the standard deduction is over $11,000 so presumably only residents with high state income tax (also deductible) will itemize. So the demographic may encompass 25% of the population but making over $50,000 and saving over $500/year in a high state income tax locality most likely represented by Democratic congressmen. More effective caps on deductions seems possible, but better data and analysis will be needed to inform the effort, frame the debate. Hitting the top Democratic 10% or 20% vs. national 1% is likely to fail.

    inc cost mil. % average
    000s bil. h.h. h.h. benefit
    0-10 0 12 10 0
    10-20 0.1 12 10 $8
    20-30 0.2 13 11 $15
    30-40 0.6 12 10 $50
    40-50 1.2 12 10 $100
    50-75 5.9 20 17 $289
    75-100 7.6 14 11 $551
    100-200 29 20 17 $1,422
    >200 23 5 4 $4,563

    • Smith says:

      I left out that the higher cost of homes in many/most high state income tax geographical areas concentrates the benefits accordingly, and also that targeting interest tends to benefit younger homeowners. Admittedly, actual numbers on this would be helpful.

  9. Jenkins says:

    I could see some limits on the deduction that make sense, such as limiting the amount of interest that could be claimed on second homes (or not permitting any interest on second homes to be deducted).

    Similar to what Nick wrote above, though, there are a lot of families out there who really would be hurt by having to come up with several thousand dollars per year. The impact on home prices also would be very significant, particularly when coupled with the fact that rising mortgage rates, as is virtually certain, also will crush home prices in the future.

  10. PJR says:

    Out of curiosity, would the same logic apply to the deduction for interest paid on mortgaged property that is rented? Isn’t this subsidy far more regressive? What are the implications of eliminating one but not the other?

  11. Wade Hufford says:

    Following up on PJR’s comment, I think interest deductions for investments (stock margin interest among others) or interest on rentals or interest paid by corporations (instead of raising more equity) would seem to be a “fair” target to pursue before attacking a deduction that actually has helped two generations of Californians become solidly middle class and have a “third leg” in their retirement stool (together with social security and retirement savings). I think these would fail the “revenue forgone” and “efficiency” tests at least as much as “principle residence” interest.

    • Jared Bernstein says:

      Agree in the sense that you want to avoid subsidizing spending that would likely have been made even without the subsidy–that ends up a) wasting valuable revenue, and b) getting capitalized into price. So, e.g., turning the MID from a deduction taken at your top marginal rate to a (refundable) 15% credit would be step in the right direction.

    • PJR says:

      Wade I agree with you. Even more generally, definitions of “tax expenditures” should be scrutinized because deductions from business and investment income for “expenses” have long been too generous, subsidizing wasteful spending. Meanwhile, the current mortgage interest deduction cap for a principle residence–interest on loans up to a million dollars–could be slashed to address many of Jared’s valid concerns while maintaining the positives that you suggest. For example, we could reduce the cap by three-quarters, roughly to the median price of a new home today, and index the cap to the CPI-U. (The cap might seem low in some areas–but these generally are areas where people are in the higher tax brackets that increase the value of the deduction.)

  12. Fred Donaldson says:

    Did anyone ever wonder why corporations – which are now officially citizens – deduct the interest paid on their properties, their loans, and only pay taxes on NET profits? Interest on a corporation credit card reduces taxes. Interest on biological citizen-owned cards is not a deduction.

    Income taxes were originally levied on what would be loosely calculated as net personal income, but over the years that has changed to garner even more dollars. Persons with nearly nothing but debt are paying income tax. Corporations with billions in profits are using things like corporate jet expenses to eliminate their taxes.

    My suggestion is that the biological citizens should enjoy every tax saving afforded corporation citizens, because, after all, we’re all just “citizens” with a promise of equal protection under the law.

  13. Jim Carey says:

    any data on what a change to the MID policy would do to housing values (and resultant change in equity)? People calculate in the effect of the MID on the annual cashflow when looking at mortgages. If the MID is scaled back or removed, then it seems that the calculations about how much mortgage could be supported will change significantly. I would expect that to have a depressing effect on how much people can afford to pay, and potentially to impact the value of existing homes, cutting into equity further.

    So I agree that it is unfair. How do we undo the MID without creating a set of new problems?

  14. steve consilvio says:

    The chart really isn’t a surprise, is it? Those who make the least have the most trouble with housing costs.

  15. Kaleberg says:

    It would be more efficient to seriously raise peak marginal tax rates and corporate taxes. If history is a guide, then the economic growth would swamp any other effects.

  16. Pinkybum says:

    Just wanted to echo Smith’s comment – I think that chart is really sloppy. I know in the notes it says that a “severely burdened” household is over half their income but surely there is a better way to represent the economic impact over all households? Could you not include the yearly extra burden in a dollar amount? Or use some rule of thumb like the housing cost should be a third of income and then calculate the excess.

  17. Nick Batzdorf says:

    Okay, I’ve been thinking about Jared’s comment that:

    “…you want to avoid subsidizing spending that would likely have been made even without the subsidy…”

    The problem is that millions of people have already been encouraged by longstanding tax policy to make the spending after calculating that they could afford it! Now suddenly they can’t. Oops. You know, it wouldn’t surprise me if raising their (MY!) tax burden several thousand dollars a year would actually have a Laffable effect on revenue!

    No. Just saying “mortgage interest is no longer deductible” seems like a really cruel idea. If you wanted to start the discussion by making it for new first-home purchases, well, then there are arguments. But for existing home purchases and re-fis, without regard for income and local cost of living…un un uhhh – oh no you do-on’t.