It's not often that I agree with the IMF (in fact, this might be the first time), but yes, the mortgage interest deduction is a regressive tax, and it should be phased out. This is also a good way of checking housing inflation, and if we'd cut it years ago, we wouldn't have had such a huge housing bubble. Should it happen right this minute, when the housing market is still so fragile? No. But it should happen, and we should plan for it now:

The U.S. should consider capping or cutting the popular tax deduction for mortgage interest as it prepares to debate what should replace mortgage giants Fannie Mae and Freddie Mac, the International Monetary Fund said Wednesday.

The IMF, in an analysis of housing finance systems around the world, said an Obama administration paper released earlier this year makes progress toward needed changes in the U.S. mortgage system. But the report criticized the U.S. for not tackling the popular tax deduction for mortgage interest, which the report termed “expensive and regressive.”

The U.S. government’s support of the housing market “has been pervasive but has not yielded many of the expected benefits to prospective or existing homeowners,” the report said. “It is clear that an overhaul is needed.”

“As a first step, we would very much recommend that the U.S. would at least cap the mortgage interest deductability,” said Ann-Margret Westin, an IMF senior economist and one of the authors of the housing report. She approved of the recommendation by the U.S. fiscal commission to halve the mortgage limit for deductions and to let it apply only to private residences, but the IMF said any such move would have to be undertaken over time.

Why is this a good idea?

It’s a $131 billion break for the wealthy. That’s the White House’s official estimate of the 2012 revenue cost of the mortgage interest deduction. A study that looked at proposals to reform the mortgage deduction put out by the Tax Policy Center at the Urban Institute points out that sum is “much more than the total of all outlays by the Department of Housing and Urban Development ($48 billion).” And studies show that most of the benefit goes to taxpayers in the top 20 percent of the income distribution ladder. Significantly, you need to itemize your deductions to claim the break, a step that only about one-third of Americans take. According to the Tax Foundation, for the 2008 tax year, just 26.8 percent of tax returns claimed the mortgage interest deduction. Among the returns that claimed the deduction, the average amount was $12,221.

The Catfood Commission proposal exempts houses under $500,000, in case you were hyperventilating. In most places, for all practical purposes, this will only affect the well-to-do. And in areas that saw extreme bubbles, we can use tax credits to protect those homeowners.

So I've been following the Tea Party objections to the health care reform efforts. They're worried about the deficit, they just want to be left alone without government interference, and they're especially angry at the government singling out some privileged groups for special subsidies. They're proud, self-sufficient patriots and they don't want handouts.

Kids, have I got a proposal for you.

I've discovered a regressive tax break that favors the wealthy and has no good rationalization for its continued use. (According to historians, it was an accident, anyway.) And oddly enough, it costs us about $100 billion annually, or $1 trillion over ten years - exactly the estimated cost of healthcare reform. Really, there's no other word for it but "pork."

It's the mortgage interest deduction.

No, it doesn't seem like a huge deal. (A lot of the people eligible for it don't even bother, because you have to itemize your tax return.) But man, it sure adds up:

But cumulatively, the deduction is a big deal. This year [Ed. note - in 2006, when this was written], it is expected to cost the Treasury $76 billion. And the rewards are greatly skewed in favor of the moderately to the conspicuously rich. On a million-dollar mortgage (the people with those really need help, right?), the tax benefit is worth approximately $21,000 a year. And according to the Joint Committee on Taxation, a little over half of the benefit is taken by just 12 percent of taxpayers, or those with incomes of $100,000 or more.

So clearly, this hits the sweet spot. Why insult people who are already doing well in the free market with this unnecessary and expensive handout?

And what better time to cut it, anyway? While housing prices are already dropping through the floor, this is when phasing out this deduction will have the least negative impact on housing prices. It will lower housing costs down to pre-speculation levels, and that means your paycheck will go farther. And it's something policy wonks on both sides can agree on.

President Obama's already on board with the concept. In his first budget, he proposed lowering the deduction in 2011 for those in the top tax brackets.(Special interest groups successfully opposed it.)

Edward L. Glaeser, an economics professor at Harvard, put it this way:

Problem #1: Subsidizing interest payments encourages people to leverage themselves to the hilt to bet on housing markets. The size of the tax benefit is proportional to your debt. The deduction essentially encourages us to make leveraged bets on the swings of the housing market. That leverage means that housing price swings can easily wipe people out. We are currently experiencing the consequences of subsidizing gambles on housing.

Problem #2: The deduction pushes up prices in places where the supply of new homes is constrained, as it is in many coastal markets. Economics 101 teaches us that if we subsidize demand where supply is inelastic then the only effect is to make prices go up. Housing supply is pretty constrained in places like New York City because of land-use restrictions and lack of land. In these places, the deduction doesn’t make housing more affordable. It just transfers money from buyers to sellers, and that makes little sense.

Problem #3: The deduction is wildly regressive. The tax savings for households earning more than $250,000 is 10 times the tax savings for households earning between $40,000 and $75,000 a year, according to recent research by James Poterba and Todd Sinai.

If there ever was a case for small-government egalitarianism, then this is it. Eliminating the home mortgage deduction and replacing it with an across-the-board tax cut would equalize after-tax incomes without a single new government program.

Problem #4: The deduction encourages people to buy larger, single-family detached homes, and that increases carbon emissions and pushes people out of cities. The deduction encourages people to buy more expensive homes, which are generally bigger homes.

Bigger homes use more energy. The deduction is therefore implicitly urging Americans to run higher electricity bills and spend more on home heating. If global warming is a serious problem, then the government should be encouraging us to live in smaller, not bigger, dwellings.

Problem #5: The home mortgage interest deduction is poorly designed to encourage homeownership, which is, after all, the alleged desideratum. Much of the interest deduction’s benefits go to richer Americans who are likely to own homes in any case.

In fact, just about the only special-interest group still championing the deduction: Realtors. Obviously, the bigger the house, the bigger the commission. But is that good for our economy? This was written in 2007 but it's even more applicable now:

Nationally, half of renters and more than one third of mortgage holders — 37 percent, up from 35 percent in 2005, or a rise of more than 1.5 million households — spent at least 30 percent of their gross income on housing costs, the level many government agencies consider the limit of affordability.

“Maybe it all means that housing is not as smart an investment for as many people as we thought,” said Matt Fellowes, a scholar in metropolitan policy at the Brookings Institution. “Stocks perform better than houses over time. Maybe the American dream should be building wealth in general, not building a certain type of wealth, which we see is narrow and dangerous.”

Fourteen percent of mortgage-holders spent at least half their income on housing in 2006, up from 13 percent last year, while among renters there was little change. In both years, 25 percent of renters spent half their income on housing.

The rising housing burden cuts into the money people have available for other expenses and anticipated the rise in foreclosures.

When, whether or how the United States avoids the so-called “fiscal cliff” remains anyone’s guess. But we already know who’s going to pay the price to avert the looming austerity bomb scheduled to detonate next year. Whether a deal ultimately adopts President Obama's plan to end the Bush tax cuts for the two percent of households earning over $250,000 a year, endorses the House Republican proposal to "broaden the base" by limiting $800 billion-worth of still-to-be defined tax deductions or some combination of the two, one thing is certain. Blue state taxpayers will foot much of the bill.

As we'll see in detail below, that result isn't very surprising. After all, blue states generally are wealthier, and are home to larger numbers of those who would be impacted by the Democrats' proposed return to the Clinton-era tax rates for upper-income earners. But largely overlooked is the fact that blue staters will likely be hardest hit by curbing or eliminating many current tax breaks, the path advocated by the GOP.

As the Wall Street Journal recently reported:

Limiting personal income-tax deductions and other federal tax breaks, an idea gaining momentum as part of a fix for America's budget crisis, would hit some parts of the country harder than others, with a series of high-income blue states leading the way...

After California, the highest average itemized deductions--all over $28,000--were claimed by taxpayers in New York, the District of Columbia, Connecticut, New Jersey, Maryland and Massachusetts. All have high state, local and property taxes, which may be deducted from income on federal returns, although other tax provisions already limit some deductions.

As the WSJ's interactive table shows, of the 10 states with the highest percentage of taxpayers itemizing deductions, 9 voted for Barack Obama for President. Only one of the bottom 10 (Florida) supported the Obama. The same is true for the percentage of households claiming the mortgage interest deduction. When it comes to the average dollar value of their home mortgage deductions, state and local income tax deductions and overall itemized deductions, blue states dominate. Only in the dollar value of their charitable deductions do red states top the table. (It is worth noting that charitable giving also reverts to form if contributions to churches and other religious institutions are not included.)

As Ezra Klein explained last week, Republicans claim “base-broadening, rate-lowering tax reform” really means “tax reform that limits itemized deductions among high-income taxpayers.” The result?

Continue reading »