President Trump has been floating a good idea for tax reform. As part of a strategy to cut tax rates and eliminate loopholes, his administration may lower the cap on deductions for home mortgage interest payments.
Homeowners currently are allowed to reduce their tax liability by deducting annual interest on up to $1 million of mortgage debt. The plan being considered would cut the allowance by half and let homeowners deduct interest paid on only the first $500,000.
A new analysis by the Tax Foundation finds that this would raise $319 billion in tax revenues over ten years, which could be used to lower everyone’s rates.
As we have argued before, there are many reasons to doubt the merits of the mortgage interest deduction, yet no easy way to eliminate it. Governments have long regarded home ownership as an axiomatically good thing, and arguments can be marshaled in its support. But renting is a perfectly sensible option, and ultimately the case is strong that government should not induce people to borrow hundreds of thousands of dollars to buy homes, or to purchase more expensive homes, when it might not otherwise be in their interest to do so.
Thirty-three million households took the mortgage deduction in 2014, which is nearly 30 percent of the total. The real beneficiaries of this system are banks, which make more and bigger loans, and realtors, who earn larger commissions.
Homeowners tend to think they are winners in this system, but they are its hostages. They forfeit much of its benefit because the system inflates house prices. And in exchange for a tax benefit that shrinks over the life of their mortgage, they make larger monthly payments for decades. Meanwhile, they live in fear that the deduction might someday disappear, which would send the value of their investment plummeting overnight.
Trump’s plan to lower the cap to $500,000 has the merit that it would leave 95 percent of homebuyers unaffected. It would tighten a loophole that disproportionately benefits the wealthy. The effects on households up to the 80th percentile are almost zero, the Tax Foundation reports. The wealthiest one percent would lose a deduction that increases their after-tax pay by about 0.6 percent.
Nevertheless, homeowners’ fear that their home will lose value is worthy of respect. Eliminating the deduction may be good economic policy, but it is also a sort of federal bait and switch. Reducing the cap needs to be done so that pain is ameliorated and gradual rather than extreme and wrenching. It is not uncommon to hear a sort of glee from those contemplating policies that will inflict pain on people who have been materially successful in life. But it’s an odious emotion in which envy is often camouflaged as egalitarian principle, and we do not subscribe to it.
The tax treatment of people’s homes, which is usually the single biggest purchase of their lives, must be sensitively done. Reform will not be easy to pass through Congress. But, deftly done, a common-sense idea to reduce the mortgage deduction can gain bipartisan support. It is one step among many that Trump and Congress can take to eliminate distortions from the tax code.
