There is a lot of talk going on about taxes and budget reductions, as our elected representatives take their stance and lean toward the inevitable compromises. When you look at Europe and the changing landscape of our world, in the context of our history and our current national debt – to say nothing about our personal debt – there is much to be confused about and no shortage of actions that need to be taken. The trouble is, of course, the politicians can’t agree with each other on the actions and my personal opinion is that they seem to be more concerned about their personal beliefs and re-election than they are about those of us who sent them to Washington. Yet, I digress. I need to write an educational piece for the week….
When I was driving back from a meeting in Kansas City, on Wednesday, I heard a report on National Public Radio about the mortgage interest tax deduction. It is, in some form, on the table to be reduced, if not eliminated, as a means to increase federal revenue. As the Tip is designed as an educational tool, let’s see if we can use this debate to educate.
First, what is a tax deduction? A tax deduction is an expenditure that is subsidized by the federal government. A tax deduction reduces the income that is subject to taxation dollar for dollar. Assuming other tax deductions exceed the standard deduction, $1,000 in additional mortgage interest will cost you the after tax amounts in the following table. Notice how the cost varies with your marginal tax bracket. As can be seen, higher income consumers (i.e., higher tax bracket consumers) receive the greatest subsidy from a tax deduction. From the lowest to the highest, the highest marginal tax bracket households pay $296 less, or a 32.89% lower price, for the same $1,000 of interest paid by both marginal tax bracket households.
Marginal Tax Bracket | Single Income | Married Filing Jointly Income | After-tax cost of additional $1,000 in mortgage interest | Percentage reduction as move to each higher tax bracket |
10% Bracket | $0 – $8,425 | $0 – $16,850 | $900 | |
15% Bracket | $8,426 – $34,200 | $16,851 – $68,400 | $850 | -5.55% |
25% Bracket | $34,201 – $82,850 | $68,401 – $138,050 | $750 | -11.76% |
28% Bracket | $82,851 – $192,000 | $138,051 – $232,950 | $720 | -4.00% |
36% Bracket | $192,001 – $375,700 | $232,951 – $375,700 | $640 | -11.11% |
39.6% Bracket | $375,700+ | $375,700+ | $604 | -5.62% |
Homes are good for the economy and homeownership is generally considered to be a positive for communities. High income households have higher rates of homeownership, with 89.3% of the top income quintile being homeowners, compared to 32.6% of the lowest income quintile being homeowners. High income households also purchase larger houses and borrow more money to purchase those homes. We, as a country, support this by providing the largest subsidy to them to purchase their home. James Poterba and Todd Sinai report the following (paper available at: http://real.wharton.upenn.edu/~sinai/papers/Poterba-Sinai-2008-ASSA-final.pdf ):
Household Income | <$40,000 | $40,000-$75,000 | $75,000-$125,000 | $125,000-$250,000 | $250,000+ |
Average Tax Savings from the mortgage interest deduction | $91 | $523 | $1,264 | $2,703 | $5,459 |
Thus, the greatest subsidy is given to the higher income households, both in percentage terms and dollar terms. So, what is the talk coming out of Washington? Current law allows homeowners to deduct the interest they pay on homes mortgages of up to $1 million in principal borrowed. One proposal calls for this to be reduced to $500,000 and for the interest on mortgages to purchase second-homes to be eliminated as a tax deduction. Professor Wheaton of MIT predicts that what will eventually come out of the Senate Committee is a similar proposal, except the tax deductibility of mortgage interest will be changed to a constant percentage tax credit for all households, regardless of taxable income, perhaps 10%, 12%, or 15% of the interest paid. (His radio interview is here: http://www.npr.org/2011/07/20/138555793/mit-professor-discusses-mortgage-deduction-reform.)
If an indicator of financial success is the house we own, we should consider the question of the effect of the tax deduction. Does the United States’ tax deductibility of mortgage interest change homeownership rates and average house size, when compared to a country with a different system of taxes? Fortunately, we have a good example. We can compare the United States, where mortgage interest is tax deductible, to Canada, where mortgage interest is not directly tax deductible. I will summarize in a table:
Characteristic | Canada | United States |
Percentage Homeowners [1] | 67% | 65% |
World rank in house size [2] | #1 | #4 |
%Equity in owned home [3] | 70% | 45% |
Sources:
[1] http://www.nationmaster.com/graph/peo_hom_own-people-home-ownership
[2] http://www.nationmaster.com/graph/peo_siz_of_hou-people-size-of-houses
[3] http://en.wikipedia.org/wiki/Home_mortgage_interest_deduction
It appears that homeownership rates are relatively similar between the two countries. It is a little surprising that the average house size is, in fact, greater in Canada than the United States. One might conjecture, however, that the lack of mortgage interest deductibility seems to have depressed the percentage loan-to-value ratio in Canada to 30% compared to 55% in the United States. Stated another way, Americans have more debt in their home than their neighbors to the north. Perhaps this is due to the upside-down subsidy from the tax deductibility of mortgage interest.
There is, of course, much more to this story than what I’ve written. The main point is that we have choices to make. This is but one. Each one of us has deeply held beliefs about policies and some of these beliefs are based on facts, some are based on political philosophy, and some based on emotions. I am a bit affected by all three, most of the time. I do encourage you to be informed and make up your own mind. Let your congressional representatives know how you feel about this topic or others, as is required by a successful democracy.
Other parts of the NPR radio show that spurred my thinking on this topic:
National Association for Realtors: http://www.npr.org/2011/07/20/138555795/economist-for-realtors-group-discusses-mortgage-deduction
From the Associated Press: http://www.npr.org/templates/story/story.php?storyId=137544950
Center for American Progress: http://www.americanprogress.org/issues/2011/01/te_012611.html
Corporation for Enterprise Development: http://scorecard.cfed.org/housing.php?page=homeownership_by_income
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