Wednesday, April 2, 2008

Drop tax deductibility of mortgage interest

The New York Times has today an article describing how the last attempt at a tax reform in the United States included provisions that would rectify some of the absurdities coming from the tax deductibility of mortgage interest. This is obviously a political hot potato, but nevertheless I call for the abolition of this deductibility. Make it gradual if you want, but it has ultimately to go. Here is why.

Mortgage interest deductibility is regressive, as it favor rich house owners. That is bad. This deductibility discourages savings, as it encourages getting into debt. That is bad. Arguably, it also encourages holding assets, which is good, but it encourages holding the wrong assets, and this is particularly bad.

This political goal that every American should own his/her home may make sense for politicians, who dislike volatile populations that are not attached to a region. Once home owner, a voter becomes more conservative and favor the status quo. But let us put the interest of the politician aside and think about the home owner.

A household typically earns labor income in the very region where it is living. That income is risky: one may lose a job, one may face a pay cut, etc. How could this risk best be diversified? By holding assets with a return that is negatively correlated to one's labor income. Local real estate is not such an asset. Imagine a local business closing down: labor income is lost and because of this local real estate prices are down as well! A double whammy for the local home owner.

The solution: rent locally, own globally, in real estate and other investment vehicles. How do you encourage that? Lower taxes on investments in general, but certainly not by subsidizing mortgages in local housing.

PS: For the light (or scary) moment: Swimming at the edge of the Victoria Falls.


Anonymous said...

I wish I could rent, I sincerely do, but in the area where I live, the few rental units are dumps. So I had to buy, and it frightens me.

Independent Accountant said...

When I was a young CPA I favored what you say, articulating your position myself! Can you believe it? I made your arguments sans PhD. I thought your "theoretical" arguments made sense. So? They have no real world application. It's favoring tax increases to balance the budget. It will never happen. Similarly I oppose ending the deduction of mortgage interest. Why? It's just another tax increase which will increase spending. What? Tax increases increase spending? Yes! As the prophet Milton Friedman reminds us: it's government spending that is the drain on the economy. Not taxes. Any "balanced budget" will be unbalanced through spending.

TStockmann said...

While I agree with you on ending the mortgage interest deduction (and of course one could offer to make the change revenue-neutral if inclined to placate the anti-gov't Accountant), an even riper target is the treatment of capital gains from the sale of principal residences. Encouraging the buying and selling of houses for profit tends increases the speculative approach and over-investment in this non-productive consumer good. At a minimum, I'd advocate a return to the status quo ante where the gains had to be rolled into another residence to be tax-free except for a once-in-a-lifetime cashout. I'd note the extent to which increases in value represent the famous "sweat-equity" or labor, the sale is already tax-advantaged because the labor value isn't subject to the self-employed payroll tax.

Economic Logician said...

I agree with tstockmann that capital gains should be taxed in the same way, whether they come from stock or real estate appreciation. But I do not think speculation is really a problem. It encourages fluidity in the market, and that is something that real estate markets typically lack (just look at continental Europe).

Anonymous said...

I would add that one often hears the argument that housing is a special good, and should thus not be treated like any investment good. But one can precisely separate the use value and the investment value by renting here and owning there.

TStockmann said...

EL - I would define any premium of the cost of ownership over the cost of rent not attributable to hedonics to be speculation on capital appreciation, and I can't believe any hedonics changed that much over the past decade.

On real estate appreciation, I would be inclined to include owner-occupied property moves as equivalent to the buying and selling rental property as a 1031 exchange. I also don't think a one-time exemption is unduly distorting and promotes the kind of fluidity you favor.

Economic Logician said...

tstockmann: There are other ways in which owner-occupied property may be priced higher: it is better taken care of, because of obvious incentives, and it has tax advantages. In addition, owner occupied housing has a guaranteed revenue (through imputed rent) that a rental unit does not have. Finally, some rental regulation may push the price of rental properties down.