The House Republican tax reform plan unveiled on Thursday is likely to go through many changes before it has any chance of becoming law. But there’s one aspect of the plan that Republicans should stick with: limiting the mortgage interest deduction, which is one of the most distortionary aspects of the tax code.
In an ideal world, the only purpose of tax policy should be to raise revenue in an efficient and predictable manner to finance limited government functions. In practice, the U.S. tax code is riddled with provisions to aid certain special interests and to steer human behavior.
Conservatives bristle at the idea of government taxing Americans more so that the federal government can spend the money the way that lawmakers and lobbyists see fit. They should also be angered at the idea of a federal government that allows Americans to keep more of their earnings, but only under the condition that those taxpayers spend their money as Washington wants them to.
Such is the case with the mortgage interest deduction. There’s no reason why the tax code should have a bias in favor of individuals and families who own their own homes over those who rent, or that it should have a bias in favor of those who have larger homes in more expensive areas over smaller ones in cheaper areas.
It would be much better to get rid of such bias and use the savings to reduce taxes on a broader number of people, regardless of whether they own or rent, live in a mansion in California or a cottage in Kansas. Put another way, if you don’t like Paul Ryan, Nancy Pelosi, Mitch McConnell, and Chuck Schumer spending your money, then you shouldn’t want them telling you that you’ll get to keep more of your money only if you spend it as they prefer.
Of course, one of the issues that makes tax reform so difficult is that individuals have made decisions around the assumption that certain tax breaks are on the books, and millions of Americans count on the mortgage interest deduction to reduce their tax burden. Taking that into account, House Republicans have come up with a smart way to transition Americans away from their dependence on the deduction.
Under the GOP plan, nothing would change for those with existing mortgages — all current homeowners would be grandfathered in as of Nov. 2 (the date of the release of the bill). For home buyers making purchases after that date, the cap would be lowered to mortgage balances of $500,000, from the current $1,000,000. The plan would also eliminate the deduction for second homes. To be clear, the $500,000 refers to the value of the mortgage, rather than the home value -- so, assuming the recommended 20 percent down payment, that means homes valued at about $625,000.
Between 2013 and 2015, just five percent of houses had mortgages of more than $500,000 -- and those that did were heavily concentrated in high-cost states, according to a study from the National Low Income Housing Coalition. The study found that 81 percent of those large mortgages were in just 10 states and that California alone accounted for nearly 46 percent of them.
Though the deduction is often promoted by special interests, such as the National Association of Realtors, as a big boost to the middle-class, a 2014 study by the R Street Institute found that the deduction overwhelmingly benefitted higher-income taxpayers who have more expensive houses, are more likely to itemize their deductions, and who face higher rates. As for those who argue the government should be encouraging home ownership, the study also found that the deduction does more to encourage wealthier Americans to purchase larger homes than it does to convince lower-income Americans who otherwise would have rented, to become homeowners.
Critics of the plan charge that it would reduce home values. But again, it would only affect a small percentage of homes valued above the cap, and purchasers would still get the benefit of the mortgage deduction on the first $500,000 they borrow. Also, those who want to sell their current houses and purchase new ones would have the benefit of lower price tags when they go shopping.
Furthermore, it’s important not to view the changes to the mortgage interest deduction in the Republican plan in isolation from the broader changes in the bill, because they are connected. That is, the more special interest benefits that are uprooted from the tax code, the more Republicans can do to offer tax relief elsewhere.
Under the plan as it exists, the standard deduction would roughly double, from the current $6,350 for individuals and $12,700 for married couples filing jointly to $12,000 and $24,000, respectively. Also, the tax brackets have been adjusted to lower rates.
Although the mortgage interest deduction would remain on the books, the proposal offers a viable path to make it less and less relevant over time. The reason is that the standard deduction is slated to grow with inflation, while the cap on the mortgage interest deduction is not. Over time, an increasing number of taxpayers will find they can save money by taking the standard deduction, and a dwindling number of homebuyers will find the mortgage deduction useful. As for those homes that were grandfathered in, over time, as more of the mortgage gets paid off, the interest payments will go down, meaning those homeowners will have less interest to deduct and fewer of them will take the deduction.
In the coming weeks and months, there will be plenty of time to debate how other aspects of the bill could be improved. But Republicans are on the right track when it comes to moving the nation beyond the mortgage interest deduction.