Eliminating the mortgage interest tax deduction would lower home prices and expand opportunities for lower income people, according to a paper in the American Economic Review.
The sweeping changes reached into every corner of the economy , from corporate rates to the amount families can deduct for child care.
There was even a tweak to a policy that many economists would like to see disappear but which lawmakers until now have considered a sacred cow: the home mortgage interest deduction.
In the February issue of the American Economic Review , researchers Kamila Sommer and Paul Sullivan consider the implications for the US housing market if this $90 billion subsidy to homeowners were to be scrapped. They find that getting rid of it would actually improve overall welfare by lowering home prices and expanding opportunities for home ownership among younger and lower-income households.
“The people who are the primary beneficiaries of the deduction are the high-income households,” Sommer said in an interview with the AEA. “When you take it away, house prices fall, they consume less housing, live in smaller houses. but the decline in house prices reduces the entry cost for the marginal households that are previously renting. It’s almost like this reallocation of housing from high-income households to low-income households.”
Critics say the mortgage interest deduction is a regressive tax policy that inflates prices and encourages buyers to choose more expensive houses and take on debt rather than sinking money into other investments. It also robs the Treasury of tax revenue that could be used to close the deficit. But real estate lobbyists say its repeal would depress homeownership and negatively impact social welfare.
It’s almost like this reallocation of housing from high-income households to low-income households.
Kamila Sommer
Eliminating the deduction would actually expand homeownership, according to Sommer and Sullivan. In a stable economy, home prices would fall by 4.2 percent and the homeownership rate would rise from 65 percent to 70 percent. Also, overall welfare improves even though the tax burden has gone up slightly, with all but the top two quintiles of homeowners seeing gains in their non-housing consumption.
Most of that shift in the market would happen in the first five years after the reform. Home prices immediately drop 2.3 percent and achieve nearly three quarters of the overall expected adjustment in the first five years of a three-decade-long transition period. Homeownership rates, meanwhile, happen more gradually, with two-thirds of the adjustment occurring in the first ten years.
Why does the price dip happen so quickly? It’s because the price of a durable good, like housing, is set by people who are buying and selling at that moment. When the deduction is eliminated, anyone shopping for a home might reconsider because the after-tax cost of owning a home just went up. The drop in demand would be felt immediately.
Spreading housing wealthHomeowners with expensive properties benefit the most from the mortgage interest deduction every year on their taxes. Thus, if the tax break were to disappear, they would be disproportionately harmed. The chart below shows the change to the average household welfare (generally defined as the percentage change in their non-housing consumption) if the mortgage interest deduction were eliminated. High-income people who live in the largest homes are in group 1 and the lowest income households are in 5.