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Jason Bladen, MPP
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Stuck in the MID With You Jason Bladen, University of Maryland Baltimore County Previous research indicates that there are economic benefits to subsidizing housing. I will demonstrate throughout this paper that the mortgage interest deduction (MID) was an unintended consequence of how the US income tax law was originally written in Revenue Act of 1913. I will also demonstrate that the MID is not the most efficient way to subsidize housing, if the goal is to encourage greater levels of homeownership. In fact, contrary to most subsidies, the MID is “upside-down” in the sense that it provides a greater benefit for those purchasing more expensive homes and who are taxed at a higher marginal rate. As early as the period post-World War II, people began to become aware of how inefficient the deduction was especially in the context of 30-year mortgages where very little equity was placed into the loan at its origination. Although there are several ways to view efficiency, this paper will examine the cost of the MID with respect to the stated goal of increasing homeownership. Nevertheless, once the MID was codified into American culture, the politics surrounding the MID have continued to make it difficult to transition from the MID to some more efficient form of subsidy. In fact, failing to consider the political nature of the MID has been the single biggest shortcoming in attempts to develop alternative policies. Although there has been substantial research around the cost and benefits of the MID, as well as research into alternative housing subsidies, I could only find one article that dealt with the MID’s
2   political history. The fact that articles of this nature are not abundant emphasizes the extent to which politics has been ignored in examining alternatives to the MID. Borrowing extensively from the political history of the MID written by Ventry, Jr. (2010), I will discuss the politics of the MID on a decade-by-decade basis. After discussing the political history, I will provide an examination of some of the research on the MID and its effect on housing. However, before I detail either of the items mentioned previously, I will also specify where and how I acquired the data and information used in this analysis. I will also define what a subsidy is and whether it differs from a tax expenditure used to promote a specific purpose. Additionally, I will attempt to show that housing produces positive externalities not captured in the market price of housing and thus is worthy of government intervention. Next, I will look at the MID relative to four alternatives to subsidizing homeownership. The status quo and alternative policies will be examined based on the following five criteria: (1) effect on the level of tax expenditure; (2) effect on vertical equity; (3) likely effect on housing tenure choices; and (4) political feasibility. After subjectively ranking these alternatives, I will discuss whether any of these policies dominate based on those rankings and can overcome the politics of the MID. Although there is currently a lot of focus by politicians and the media on methods for reducing the federal deficit in the wake of the Great Recession, this paper finds little reason to believe that the MID (the country’s third largest tax expenditure) will be modified in the foreseeable future.
3   Beginning of the MID There is no record that indicates that lawmakers intended to subsidize housing when the Revenue Act of 1913 was passed. Initially, the MID appeared to be more of a loophole than conscious effort to encourage housing consumption. After the 16th Amendment made the collection of income tax in the United States constitutional in 1913 and the Revenue Act of 1913 was passed, it allowed “all interest paid within the year by a taxable person on indebtedness” to be deducted. 1 For the most part, the homeownership rate was low and financing was not typically used for home purchases when the law went into effect. The 30-year fixed-rate home mortgage was still two decades away from being instituted and mortgages tended to be interest-only loans with balloon payments at the end of the term.2 It is also true that most high-income households were not using mortgages to finance real property. In fact, in 1910 only a third of homes were secured by a mortgage. During World War I (WWI), the rates and exemptions were changed, which increased the number of individuals and households paying income tax, but this still only affected 15% of households.3 Some have noted that the MID’s beginning was probably more attributable to the practical difficulty of distinguishing between interest paid toward personal debt and interest paid in the operation of a business, such as family-owned farms. In the absence of evidence to the contrary, this seems to be a fairly parsimonious explanation of why the MID was allowed.                                                                                                                           1  Dennis  Ventry,  Jr.  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  236.   2  Dennis  R.  Judd  &  Todd  Swanstrom.  (2012),  “City  Politics.”  Pg.  191   3  Ibid.  Pg.  240.  
4   The Revenue Act of 1913 was a product of America’s progressive era and adopted under the rhetoric of making things fairer for the entire country. In actuality, the Federal income tax allowed the Federal Government the ability to provide services for “states with lower per capita incomes relative to those with higher per capita incomes.”4 Up until WWI, only those whose incomes were significantly higher than the average American paid income taxes.5 In fact, when the Revenue Act of 1913 first initiated income tax collection, only one percent was levied against incomes that are the equivalent of $70,537 for singles and $94,050 for married couples in 2013 dollars.6 Although that level of income does not make an individual or household rich, we do not associate those groups with poverty or needing as much in the way of government support. It was not until a household earned upwards of $470,248 (in 2013 dollars) that a progressive surtax between one and six percent was assessed.7 In the first year that taxes were collected after the passing of the Revenue Act of 1913, the Bureau of Internal Revenue (the precursor to the Internal Revenue Service) only collected taxes from about 358,000 people out of a population of approximately 97.2 million people in the country at the time. 8 9 Of the eight deductions initially specified by the Revenue Act, none of them explicitly mentioned the mortgage interest deduction, but because one of them included interest on consumer debt one of the first income tax loopholes was created.10                                                                                                                           4  Randall  G.  Holcombe  &  Donald  J.  Lacombe,  (1998)  “Interest  Versus  Ideology  in  the  Ratification  of  the  16 th  and   17 th  Amendments.”  Pg.  152.   5  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  240.   6  Ibid.  Pg.  239.  These  values  were  originally  reported  as  $3,000  and  $4,000  for  single  and  married  filers  in  1913   dollars,  respectively.   7  Ibid.  Pg.  239   8  Ibid.  Pg.  240   9  The  US  population  in  1913  was  estimated  using  the  information  provided  by  the  US  Census  Bureau  as  can  be   found  here:  http://www.census.gov/population/estimates/nation/popclockest.txt     10  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  240.  
5   Historically, affluent individuals would attempt to live as far from city centers as the current modes of transportation would allow. Coupled with a decrease in the cost of land, the value of houses in suburbs is on average greater than to similar homes found within cities. The tax code created an incentive for individuals who can afford more expensive properties to take out mortgages and use their assets to make other investments capable of producing a greater return on investment. This implies that the mortgages for affluent individuals will generate large amounts of interest, especially early on, in the servicing of their loan. Thus, almost from its inception, the MID has had the greatest benefit for many individuals who do not actually need the deduction. This is especially true because there were sections of cities that banks would not lend to up until the Community Reinvestment Act of 1977 made the practice of redlining illegal.11 However, the point remains, without mortgages being extended into large sections within cities, there were many people who had no interest to deduct and that is assuming that their incomes were high enough to make itemizing more attractive then using the standard deduction. Currently, the cost of the MID to the Federal Government is almost $70 billion and like most other things is projected to increase over time.12 The MID is primarily defended on the grounds that the credit provides an incentive for homeownership. As US tax law is presently worded, the MID is also allowed on an additional residential property an individual or household might own. People arguing for the expiration of the deduction point out that the deduction has no appreciable                                                                                                                           11  Dennis  R.  Judd  &  Todd  Swanstrom,  (2012)  “City  Politics.”  Pg.  402   12  Joint  Commission  on  Taxation,  (2013),  “Estimates  of  Federal  Tax  Expenditures  for  Fiscal  Years  2012-­‐2017.”  pg.  35  
6   effect on homeownership rates and is inefficient because it helps people who would have purchased a home regardless of whether the deduction was available or not.13 Data and Methods The method for collecting the articles used in this analysis was fairly straightforward. Using the keywords “mortgage interest deduction” in the article search in the UMBC library’s website returned many of the articles I opted to use. Upon finding relevant materials, I took note of the articles that those authors referenced in their analyses to see what they added to the conversation. I also searched keywords such as “housing externalities” and “housing subsidies.” When appropriate, I incorporated material from Judd and Swanstrom’s (2012) textbook “City Politics” as well as information from another textbook from Baumgartner et al. (2009) entitled “Lobbying and Policy Change: Who Wins, Who Loses, and Why.” Moreover, when the utilized text provided figures such as income, standard deductions or other important monetary figures as of the date when the piece was written, those figures were converted into 2013 dollars using the calculator provided by the United States Department of Labor, Bureau of Labor Statistics. 14 This step was taken in order to preserve the magnitude of the monetary values those authors used due to the effect of inflation. I performed another internet search using Google Scholar™ to find information about the history of the mortgage interest deduction. The article I found written by                                                                                                                           13  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  243;  Adam  J.  Cole,  Geoffrey  Gee  &  Nicholas  Turner,  (2011)  “The  Distributional  and  Revenue   Consequences  of  Reforming  the  Mortgage  Interest  Deduction.”    Pg.  982;  Edward  M.  Glaeser  &  Jesse  M.  Shapiro,   (2002),  “The  Benefits  of  the  Home  Mortgage  Deduction.”  Pg.  38;  Rebecca  N.  Morrow.  (2012),  “How  and  Why  the   Mortgage  Interest  Deduction  Failed.”  Pg.  765,  769.   14  Figures  were  converted  into  2013  dollars  using  the  calculator  provided  by  the  Bureau  of  Labor  Statistics  at   http://www.bls.gov/data/inflation_calculator.htm  
7   Dennis Ventry, Jr. was the only one that was helpful with respect to the MID’s history. Rather than incorporating Ventry (2010) into the rest of the literature review, I felt that his analysis is essential to understanding the political history of the deduction. Finally, some of the research literature I use examined specific policy alternatives, so that information will be referenced when critiquing the merits of those proposals. Generally, those articles did not expand on the political feasibility of their proposals, so this is one of the areas I intend to build upon when covering alternatives to the MID later in this paper. The History of the MID The beginning of the MID was an accident. When it provided for the discount of interest paid over the course of the calendar year, the Revenue Act of 1913 never explicitly mentioned mortgage interest, but because that is a form of interest it did not have to.15 In the beginning of American economic policy, the concept of trying to control externalities with taxes and subsidies did not start to advance until 1920 when economist Arthur Pigou introduced that idea in dealing with pollution.16 Economic strategies for dealing with externalities were later refined by economists like Coase and Baumol who introduced additional methods aside from taxation and subsidies to deal with externality problems.17 18                                                                                                                           15  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  236   16  Gideon  Parchomovsky  &  Peter  Siegelman,  (2012),  “Cities,  Property  and  Positive  Externalities.”  Pg.  221   17  Ibid.  Pg.  221   18  William  J.  Baumol,  (1972),  “On  Taxation  and  the  Control  of  Externalities.”  
8   Considering that most people during the 1920’s financed their homes using interest-only or almost interest-only loans for periods ranging between three and 10 years, it is somewhat dubious to describe those people as homeowners.19 Yet for those able to take out mortgages, they now potentially had a deduction they could claim provided they had enough taxable income. Homeownership continued to rise to almost 48% until the Great Depression sent home values spiraling downward and banks no longer had the ability extend mortgages. 20 It is probably safe to say that even though the number of households that benefited from the mortgage interest deduction was very small, as the number of homeowners increased, so did the number of people who could take advantage of that deduction. However, as the country started to feel the effects of the Great Depression, the MID was not a deduction a significant number of Americans could really take advantage of until some time later. Government Intervenes on Behalf of the Housing Market In the 1930’s, the Federal government took several steps to get the decimated housing market back on track and would later create a new group of Americans who cared about the MID. In a shift from the mostly hands-off position of the Hoover Administration, the Roosevelt Administration signed the Home Owners’ Loan Act in 1933, which established the Home Owners’ Loan Corporation (HOLC) and the National Housing Act of 1934, which established the Federal Housing Administration (FHA) and was later amended in 1938 to create the Federal                                                                                                                           19  Dennis  R.  Judd  &  Todd  Swanstrom,  (2012),  “City  Politics.”  Pg.  243.   20  Ibid.  Pg.  243.  
9   National Mortgage Association (FannieMae). 21 Although the primary concern of these agencies was stabilizing the banking and housing sectors of the economy, the actions those agencies took revolutionized the process Americans used to purchase homes. For example, the HOLC changed home loans from nonamortizing, three to ten year loans to fully amortizing, twenty to twenty- five year loans.22 Extending the length of mortgages in this way generated significantly more interest that could potentially be deducted by income tax-paying Americans. The FHA created an even bigger change by establishing 30-year loans terms that were also fully amortizing and required as little as five percent down.23 Not only did the increase in mortgage length increase the amount of interest an individual or household would pay, but also the smaller down payment requirement increased amount of principal being financed, which also increased the total interest to be repaid. Although there were many who were unable to take advantage of these more favorable terms, particularly African-Americans, this also created a much larger group of individuals who could exploit the MID loophole.24 The effects of the Great Depression had not yet subsided. However, to the extent that the nation’s economy was beginning to recover, World War II (WWII) shifted the production of goods to the war effort.25 However, once WWII ended, the changes that came with the Serviceman’s Readjustment Act of 1944 allowed even more individuals and households the                                                                                                                           21  Dennis  R.  Judd  &  Todd  Swanstrom,  (2012),  “City  Politics.”  Pg.  122   22  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  247.   23  Ibid.  Pg.  248.   24  Dennis  R.  Judd  &  Todd  Swanstrom,  (2012),  “City  Politics.”  Pg.  xxx   25  Ibid.  Pg.  xxx  
10   ability to become homeowners.26 Thanks to less-restrictive criteria for extending credit, loans with small down payment requirements (or even zero-down payment Veterans’ Administration loans) and loans with 20 and 30-year terms boosted homeownership to 55% by 1950, up 11.4% from 1940.27 Changes to tax laws passed during this period changed the number of people filing tax returns from 14.7 million to 50 million between 1940 and 1945 with marginal tax rates now ranging between 23% and 94%.28 These rates remained in place for over 20 years while the exemption fell to $5,868 for individuals and $11,736 for married households in 2013 dollars and differed wildly from the structure of the income tax when it was first enacted. 29 The post-WWII efforts to promote homeownership coupled with those income tax base-broadening efforts now created a much larger class of individuals who cared about and were in a position to take advantage of the MID. More Homeowners and More MID Beneficiaries The 1950’s ushered in a period where the rate of homeownership grew dramatically even relative to the late 1940’s. The changes put forth by the FHA and VA enabled this expansion. Mortgage debt increased 295% from $55 billion in 1950 to $162 billion by 1960.30 As a function of the increased debt, the amount of interest being repaid also increased from $2.5 billion to $7.3                                                                                                                           26  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  249.   27  Ibid.  Pg.  249   28  Ibid.  Pg.  250,  251.   29  Ibid.  Pg.  251;  These  amounts  were  actually  written  as  $600  and  $1200  for  single  and  married  filers  in  1949   dollars,  respectively.   30  Ibid.  Pg.  250.  
11   billion (a 292% increase) by 1960.31 During this same time period, the number of people who itemized their deductions also experienced a sharp increase in growth. In 1950, less than 20% of taxpayers itemized, but by 1960 that percentage almost doubled to incorporate 39.5% of filers.32 The MID had become a much more costly tax expenditure, but was not the policy driving the increase in homeownership. In fact, in spite of the number of homeowners affected, Ventry (2010) notes that the government still did not view the MID as actual housing policy. Neither a 1950 Housing and Home Finance Agency study nor a more comprehensive study conducted in 1956 even mentioned the MID.33 However, this does not mean that Congress was ignorant of the cost. According to the Joint Committee on the Economic Report of 1955, the personal interest deduction (of which the MID was a large part) grew faster than any other deduction post WWII.34 Clearly, the 1950’s became a time where many affluent and upwardly mobile Americans learned about the portion of the tax law that allowed for the MID. A marginal rate greater than 90% would be onerous if people were actually paying that much, but as Randolph Paul (prestigious tax lawyer and former Roosevelt advisor) noted, “the bark of our individual income tax was much worse than its bite.”35 In fact, in the late 1950’s soon-to-be Assistant Secretary of the Treasury for Tax Policy, Stanley Surrey, noted that the effective tax rate was more like 48%.36 Nevertheless, regardless of what a household’s marginal rate was, it meant that the government might be paying up to that rate to subsidize the cost of housing. It is                                                                                                                           31  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  250.   32  Ibid.  Pg.  251.   33  Ibid.  Pg.  251.   34  Ibid.  Pg.  252.  Supra  note  156.   35  Ibid.  Pg.  253.   36  Ibid.  Pg.  253.  
12   certain that people paying those higher marginal rates did not need additional help in choosing between renting and becoming homeowners. Additionally, it is hard to imagine a scenario where households at the top marginal rate would need more of a financial subsidy than those at lower income levels. Nevertheless, encouraging greater levels of homeownership has been the primary justification for the MID. During the 1950’s, more and more reformers, economists, legal academics began to line up against what they believed to be a very inefficient subsidy.37 They began to believe that if presented with the facts, taxpayers would prefer to ditch the preferential treatment and high rates for a more inclusive tax code with lower rates.38 Thanks to Rep. Wilbur Mills (D-AR), Congress became very familiar with the “tax cuts for tax reform” strategy.39 They argued that even if promoting homeownership was a worthwhile policy goal, the MID really only benefited individuals who had abundant wealth and not those in lower tax brackets that actually needed help in the purchase of a home.40 Even at this point in time, the thought of using direct subsidies (and probably of a specific amount) was preferred over the MID to stimulate homeownership.41 If Washington, or more specifically Congress, is “where good ideas go to die,” as stated by former Senator Jim DeMint (R-SC) in January 2013, it surely did not disprove his axiom in this                                                                                                                           37  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  253,  254.   38  Ibid.  Pg.  255.   39  Ibid.  Pg.  255.   40  Ibid.  Pg.  258   41  Ibid.  Pg.  258,  259.  
13   instance. 42 Not only did politicians circle the wagons around the MID, they also added a couple of provisions in 1951 and then again in 1964, which had the effect of sheltering capital gains from the sale of a primary residence.43 The Revenue Act of 1951 was one of the vehicles used to finance the Korean War.44 However, decreasing fear of inflation and the declining popularity of the law meant that more concessions had to be made to get the tax increase passed.45 The Revenue Act of 1951 allowed homeowners to exclude capital gains from the sale of their primary residence as long as they used those gains to buy a new home in order to encourage them to “trade up.”46 The Revenue Act of 1964 was passed for completely different reasons. Through a series of tax cutting measures, the intent was to “stimulate the economy” and would “raise (rather than lower) revenues…to eliminate deficits in the administrative budgets and then reduce the public debt.”47 The Revenue Act of 1964 allowed homeowners a one-time exclusion of capital gains on their primary residences if they were 55 or older.48 Clearly, as housing prices rise so does the amount of capital gains realized when that property is sold and these policies also favored the more affluent. The 1960’s brought various changes to America, and fiscal policy would not be exempt. In 1961 Stanley Surrey shifted from his role as Harvard professor and began his eight-year tenure as                                                                                                                           42  Jane  C.  Timm,  (2013),  “Sen.  DeMint:  Congress  is  a  mess,  so  we’re  going  straight  to  the  people.”   http://tv.msnbc.com/2013/01/17/sen-­‐demint-­‐congress-­‐is-­‐a-­‐mess-­‐so-­‐were-­‐going-­‐straight-­‐to-­‐the-­‐people/     43  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  259.   44  Rosella  Capella,  (2013),  “Pay-­‐As-­‐You-­‐Go  –  The  Financing  of  the  United  States’  War  Effort  in  Korea.”  Pg.  19   45  Ibid.  Pg.  39-­‐40.   46  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  259.   47  Charles  L.  B.  Lowndes,  (1964),  “The  Revenue  Act  of  1964:  A  Critical  Analysis.”  Pg.  668,  669.   48  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  259.  
14   Assistant Secretary of the Treasury for Tax Policy when President Kennedy appointed him.49 Surrey began an inquisition into the taxation (or lack thereof) of imputed rent which is a missing part of the rationale for the MID. 50 If a person owns a rental property, he or she allowed to deduct mortgage interest and other property-related expenses, but has to claim the income he or she receives from renting that property. However, for a private residence an individual or household does not claim imputed income, but is still allowed to claim the MID. Surrey’s suggestion was that imputed rent should be taxed the way it is in other countries.51 From a theoretical standpoint, his approach was built on a strong and logical foundation. Conversely, from a political standpoint attempting to tax imputed rent took little account of the incentives individuals and households (especially the very affluent ones) had to protect the status quo. In 1963, the Treasury Department suggested capping itemized deductions to 5% of adjusted gross income because of the revenue the government lost as a result of the increased number of people who itemized. What the Treasury Department did not account for is the very vocal coalition that would form between those other organizations who benefited from tax expenditures, such as universities, charities, state and local governments as well as those special interests within the housing sector.52 Working class and middle class voters also supported the MID, but probably did not think about or care that more affluent received a greater benefit from it. Generally, the politics of the MID and housing made it very easy to attach additional incentives that benefited the affluent, but virtually impossible to make it more progressive.                                                                                                                           49  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  253.   50  Litzenberger  &  Sosin  (1978)  use  another  author’s  description  of  “imputed  rent,”  which  describes  it  as  follows:  “a   homeowner  is  playing  two  separate  roles;  he  is  a  tenant  who  pays  ‘imputed  rent’  to  the  landlord  and  he  is  a  real   estate  investor  who  receives  ‘imputed’  rental  income  from  his  ‘tenant.’    Since  the  same  person  plays  both  roles,  no   cash  changes  hand.”  Pg.  950.   51  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  260.   52  Ibid.  Pg.  260.  
15   As a counter strategy, Surrey pivoted from trying to decrease itemized deductions to attempting to increase the standard deduction, which had been losing economic power because it was not indexed for inflation.53 This strategy was pursued in the hope that as less people benefited from itemized deductions like the MID, the MID would become more politically vulnerable in the long term.54 The Treasury Department also attempted to take the “out of sight, out of mind” dimension away from the MID by advocating for Congress to specifically budget for tax expenditures.55 The thought was that this move would force Congress to examine the costs and benefits of these tax expenditures.56 In the case of the MID, the research suggests it was the Surrey’s hope that policymakers and the general public would question what the MID was accomplishing for America given the growing cost.57 This was one of the rare attempts to address the politics of the MID. “In 1968, the first tax expenditure budget appeared in the Annual Report of the Secretary of the Treasury.”58 Avoiding the temptation to become too theoretical in nature, the report stated that the MID accounted for approximately 4.5% of the $44.5 billion dollars of tax expenditures in that year. Even if Congress felt that a housing subsidy was justified on either an economic or social basis, the Treasury Department now felt that it had the context to examine the cost- effectiveness of the MID. The Treasury noted that the government was engaged in providing an                                                                                                                           53  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  265.   54  Ibid.  Pg.  267.   55  Ibid.  Pg.  262.   56  Ibid.  Pg.  263,264.   57  Ibid.  Pg.  262.   58  Ibid.  Pg.  263.  
16   upside-down subsidy through the MID. The Treasury Department found that people in a household making $63,426 (in 2013 dollars) would only get $19 dollars of assistance for every $100 dollars spent on interest, whereas a household that made $1.27 million (in 2013 dollars) would get $70 dollars for every $100 they spent on interest.59 Nevertheless, if the goal was to encourage homeownership, those subsidies should be in reverse. Additionally, even if middle- income households value their subsidies more than affluent households, such a policy does not make our tax policy more progressive. Those advocating for a more progressive tax policy accomplished a partial victory with the Tax Reform Act of 1969 in the beginning of the Nixon administration. Even though it did not succeed in creating a basket of deductions where taxpayers were no longer able to claim deductions on excluded income, such as the MID, it reduced the depreciation rate on residential property and changed the allowable depreciation method on low to moderate-income rental property.60 Before the Act took effect in 1971, there were 35.4 million returns that itemized deductions and by 1972 that number had fallen to 27 million.61 This decrease implies that within the span of three years since the Act passed, there were eight million households who would possibly be indifferent to the MID. Given more political space to attack the MID directly, a 1977 study noted that eliminating homeowners’ tax preferences could raise an additional $53 billion (62% of the FY 2013 sequester) in 2013 dollars. 62 63 Even though then-candidate Jimmy                                                                                                                           59  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  264.  The  original  figures  compared  a  household  making  $10,000  to  a  household  making  $200,000  in   1969  dollars.   60  Ibid  Pg.  267   61  Ibid  Pg.  267   62  Dylan  Matthews,  (2013),  “The  Sequester:  Absolutely  everything  you  could  possibly  need  to  know,  in  one  FAQ.”  
17   Carter campaigned on changing the MID to make it a fairer policy before the 1976 presidential election, he was labeled as attacking lower class and middle class homeowners.64 When asked about his position on the MID by a reporter at Business Week, he replied: “No, I have said this is one of the tax incentives I would consider changing. But I believe we do need some incentives for private home ownership. If I made any changes, I would maintain the stimulation for housing, but shift the tax credits towards lower- and middle- income families.”65 Shortly after President Carter was elected, Sen. Edward Kennedy (D-MA) also proposed making sweeping reforms that included changing the MID and other deductions into credits.66 Nevertheless, President Carter opted not spend political capital on that battle and the effort remained dormant over the course of his presidency. This decision was reaffirmed when a 1978 CBS poll determined that 90% of the country wanted to preserve the MID even if only 25% of returns itemized deductions.67 It appeared that Surrey and the Treasury Department’s hope that Americans would reject the MID if less people benefited from it had failed.                                                                                                                                                                                                                                                                                                                                                                                                         http://www.washingtonpost.com/blogs/wonkblog/wp/2013/02/20/the-­‐sequester-­‐absolutely-­‐everything-­‐you-­‐ could-­‐possibly-­‐need-­‐to-­‐know-­‐in-­‐one-­‐faq/     63  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  268.   64  Ibid.  Pg.  269.   65  Robert  H.  Litzenberger  &  Howard  B.  Sosin,  (1978),  “Taxation  and  the  Incidence  of  Homeownership  Across   Income  Groups.”  Pg.  947.   66  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  269.   67  Ibid.  Pg.  269,270.  
18   The First Direct Modification of the MID? Concerns about inflation, unemployment and the confinement of Americans in Iran led to President Reagan’s victory in 1980 and signaled a shift in the public’s attitude towards government spending. 68 According to a Congressional Budget Office (CBO) report in 1983, dealing with the economic downturn and spiraling budget deficit meant tough choices between increased taxes and spending cuts over the next few years.69 The housing lobby saw this report as a threat to the MID and stated that removing it would have a “devastating impact . . . on the home building and real estate industries, let alone the status of the average American homeowner.”70 Without leadership from President Reagan or Congress during his first term and in the face of its popularity, the MID remained untouched.71 However, potentially emboldened by winning a second term in 1984, President Reagan had the political breathing room to address the MID.72 His State of the Union address signaled that reforming the tax code to promote “fairness, simplicity and incentives for growth” while avoiding tax increases was a component of his second term agenda. Twenty years after Surrey’s efforts, (and ironically in the same year that Secretary Surrey passed away) the tax cuts for tax reform movement finally found a listener even if the reforms differed from what was initially                                                                                                                           68  The  White  House,  (2013),  “Ronald  Reagan.”  http://www.whitehouse.gov/about/presidents/ronaldreagan     69  New  York  Times,  (1983),  “Excerpts  from  Congressional  Budget  Office  Report  on  Reducing  the  Deficit.”   http://www.nytimes.com/1983/02/11/us/excerpts-­‐from-­‐congressional-­‐budget-­‐office-­‐report-­‐on-­‐reducing-­‐the-­‐ deficit.html?pagewanted=1   70  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  271.   71  Ibid.  Pg.  271.   72  Ibid.  Pg.  271.  
19   envisioned. 73 In spite of the president’s intentions, President Reagan was quickly forced to take changes to the MID off the table by real estate representatives and other concerned lobbyists.74 A move which according to Eugene Steuerle, who served as the Deputy Assistant Secretary of the Treasury for Tax Analysis in the late 80’s, “immediately made impossible consideration of a number of promising options.” 75 76 It is not clear from President Reagan’s example if presidential commitment is a necessary condition for MID modification, but it definitely is not a sufficient condition. Ultimately, the Tax Reform Act of 1986 did not act on the Treasury Department’s suggestion to limit the MID to primary residences.77 However, it did accomplish the goal of lowering the marginal tax rates and broadening the tax base.78 At the same time, it also strengthened the MID by including Internal Revenue Code § 163(h)(3), which allowed deducting the interest on a loan to purchase or improve a primary or secondary place of residence as long as that loan was secured by the respective property.79 It was not all roses for the housing industry though because the standard deduction was increased and the deduction of other forms of consumer debt was repealed, effectively making the MID useless to households with incomes less than $90,263 in 2013 dollars.80 Nevertheless, if the late-1970’s CBS poll could be instructive, reducing the                                                                                                                           73  New  York  Times,  (1984),  “Stanley  S.  Surrey,  74;Taxation  Law  Expert.”   http://www.nytimes.com/1984/08/28/obituaries/stanley-­‐s-­‐surrey-­‐74-­‐taxation-­‐law-­‐expert.html   74  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  271.   75  Urban  Institute,  (2013),  “Eugene  Steuerle.”  http://www.urban.org/about/EugeneSteuerle.cfm     76  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  272.   77  Ibid.  Pg.  274.   78  Ibid.  Pg.  274.   79  Ibid.  Pg.  274.   80  Ibid.  Pg.  275.    The  original  amount  was  $42,500  given  in  1986  dollars.    
20   number of people who could take advantage of the MID was unlikely to have a significant effect on public opinion. Presidents 41 through 43 and the MID There were no changes to the MID attempted during the four years of President George H.W. Bush’s term between 1988 and 1992. Additionally, in the 16 years that followed with President Clinton and President George W. Bush, the MID continued its basically “untouchable” status. 81 As far as housing was concerned, Presidents 42 and 43 were primarily focused on removing the barriers to homeownership for Americans.82 During President Bush’s second term, he commissioned a “blue-ribbon” advisory panel that created a report entitled, “Simple, Fair and Pro-Growth: Proposals to Fix America’s Tax System.”83 This report suggested that the MID be converted to a credit because the current incarnation of the MID encouraged “overinvestment in housing at the expense of other productive uses.”84 Once again, in spite of well-intentioned and theoretically sound recommendations by the panel, the politics of acting on those recommendations was unappealing even for a second-term president and as a result the recommendations from the report were                                                                                                                           81  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  277.   82  Ibid.  Pg.  276.   83  David  C.  Ling  &  Gary  A.  McGill,  (2007),  “The  Variation  of  Homeowner  Tax  Preferences  by  Income,  Age  and   Leverage.”  Pg.  506   84  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  277.  
21   abandoned. Each and every time the MID came up over the last century, the best politicians could do was tinker with who benefited from the MID. However, each of these modifications only served to make the MID even more “upside-down” than it was before. Heretofore, the politics of reforming the MID have been an insurmountable force to every politician, bureaucrat or academic who has dared to challenge it. Previous Research Before I examine previous research, I believe a definition of the word “subsidy” is needed. According to Merriam-Webster’s Concise Encyclopedia, the term subsidy is defined as: “Financial assistance, either through direct payments or through indirect means such as price cuts and favourable contracts, to a person or group in order to promote a public objective. Subsidies to transportation, housing, agriculture, mining, and other industries have been instituted on the grounds that their preservation or expansion is in the public interest. Subsidies to the arts, sciences, humanities, and religion also exist in many nations where the private economy is unable to support them. Examples of direct subsidies include payments in cash or in kind, while more-indirect subsidies include governmental provision of goods or services at prices below the normal market price, governmental purchase of goods or services at prices above the market price, and tax concessions. Although subsidies exist to promote the public welfare, they result in either higher taxes or higher prices for consumer goods. Some subsidies, such as protective tariffs, may also encourage the preservation of inefficient producers. A subsidy is desirable only if its effects increase total benefits more than total costs.”85 Because a tax expenditure and a “tax concession” can be viewed as being synonymous, the MID will be referred to as a subsidy for the rest of this paper.                                                                                                                           85  Merriam  Webster,  (2013),  “Subsidy.”  http://www.merriam-­‐webster.com/dictionary/subsidy  
22   The literature considered in this review examined positive and negative aspects of the MID and its effect on housing tenure choices as well as considering alternative policies. Literature favoring alternatives to the MID was more abundant than literature defending it. This literature review also explores the basic question of whether the government should intervene in the housing market at all. About halfway into the presidency of President Jimmy Carter, Litzenberger and Sosin (1978) looked into the then-current structure of the MID and compared it to several alternatives such as taxing imputed rent, eliminating the deduction, capping the MID, and providing a tax credit rather than a deduction. 86 87 Their article was one of the first academic investigations into the usefulness of the MID and probably the closest to being neutral to that question of what to do about it. According to their findings, taxing imputed rent would cause more middle-income households to find it “advantageous to rent.” They also found that removing the MID would make renting more expensive in terms of the proportion of income spent on housing. If a cap were placed on the interest of all consumer loans (which was only relevant before TRA86), high-income households would shift to self-financing and everyone else would be unaffected. Finally, they found that if the MID was converted into a credit it would become more of an incentive for lower income individuals to become homeowners while decreasing the subsidy for upper income                                                                                                                           86  See  footnote  50  for  an  explanation  of  “imputed  rent.”   87  Robert  H.  Litzenberger  and  Howard  B.  Sosin,  (1978),  “Taxation  and  the  Incidence  of  Homeownership  Across   Income  Groups.”  Pg.  948.  
23   households in particular. 88 Changing the MID to a tax credit rather than a deduction would also make the income tax code more progressive because a fixed amount of money would be worth less to a household as household income increases. Examining imputed rent is one of the alternatives Litzenberger and Sosin discuss because it acknowledges that homeowners are distinct from rental property owners. The benefit homeowners derive from their homes is not taxed like the income a rental property owner collects from his or her tenants. Ling and McGill (2007), Poterba and Sinai (2008), Ventry (2009), Landis and McClure (2010), Saarimaa (2010), Poterba and Sinai (2011), and Cole, Gee and Turner (2011) also acknowledged this benefit in their research.89 Many of the aforementioned authors, as well as a few others, express varying amounts of skepticism about the MID. Anderson, Clemens & Hanson (2007) state, “it may not be particularly effective in altering the choice between renting and owning.”90 Pierce (1989) suggests that removing it would “increase tax revenues and increase both horizontal and vertical                                                                                                                           88  Ibid.  Pg.  948.   89  David  C.  Ling  and  Gary  A.  McGill,  (2007),  “The  Variation  of  Homeowner  Tax  Preferences  by  Income,  Age  and   Leverage.”  Pg.  505;  James  Poterba  and  Todd  Sinai,  (2008),  “Tax  Expenditures  for  Owner-­‐Occupied  Housing:   Deductions  for  Property  Taxes  and  Mortgage  Interest  and  the  Exclusion  of  Imputed  Rental  Income.”  Pg.  86;  David   J.  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage  Interest.”   Pg.  236,  254;  John  D.  Landis  and  Krik  McClure,  (2010),  “Rethinking  Federal  Housing  Policy.”  Pg.  325;  Tuukka   Saarimaa,  (2010),  “Tax  Incentives  and  Demand  for  Mortgage  Debt:  Evidence  from  the  Finnish  1993  Tax  Reform.”   Pg.  36;  James  Poterba  and  Todd  Sinai,  (2011),  “Revenue  Costs  and  Incentive  Effects  of  the  Mortgage  Interest   Deduction  for  Owner-­‐Occupied  Housing.”  Pg.  540;  Adam  J.  Cole,  Geoffrey  Gee,  and  Nicholas  Turner,  (2011),  “The   Distributional  and  Revenue  Consequences  of  Reforming  the  Mortgage  Interest  Deduction.”  Pg.  978.   90  John  E.  Anderson,  Jeffrey  Clemens  and  Andrew  Hanson,  (2007)  “Capping  the  Mortgage  Interest  Deduction.”  Pg.   769.  
24   equity.”91 Landis and McClure (2010) state, “the primary effect of the mortgage interest deduction and capital gains exclusion has been to inflate housing prices, making homeownership more difficult for less well-off households.”92 Morrow (2012) goes further and says that the MID “fails to increase homeownership, increases housing prices and increases borrowing against equity.”93 Also, because the MID “was instituted at the same time as the federal income tax, we have no direct evidence of how much, if at all, it initially increased rates of homeownership.”94 However, academics are hardly unified in their opposition to the MID. Ling and McGill (2007) argue, “homeowner tax preferences…are not skewed to higher-income households, as is widely believed.”95 Woodward and Weicher (1989) make the argument that “it is inaccurate to characterize the mortgage interest deduction as a subsidy to homeownership” because “the treatment of interest as both taxable and deductible equalizes the cost of debt and the cost of equity in a home, and by implication, equalizes the cost of owning for those who can pay cash and those who must borrow.”96 Woodward and Weicher (1989) go further to state that the additional tax preferences rental property owners receive, such as accelerated depreciation, make the cost of renting less expensive for renters.97 They argue that if individuals were assessed a charge for imputed rent, that charge would only be fair if it were levied against everyone                                                                                                                           91  Bethane  Jo  Pierce,  (1989),  “Homeowner  Preferences:  The  Equity  and  Revenue  Effects  of  Proposed  Changes  in   the  Status  Quo.”  Pg.  65.   92  John  D.  Landis  and  Krik  McClure,  (2010),  “Rethinking  Federal  Housing  Policy.”  Pg.  326.   93  Rebecca  N.  Morrow,  (2012),  “Billions  Spent  Inflating  the  Housing  Bubble:  How  and  Why  the  Mortgage  Interest   Deduction  Failed.”  Pg.  755   94  Ibid.  Pg.  761.   95  David  C.  Ling  and  Gary  A.  McGill,  (2007),  “The  Variation  of  Homeowner  Tax  Preferences  by  Income,  Age  and   Leverage.”  Pg.  508.   96  Susan  E.  Woodward  &  John  C.  Weicher,  (1989),  “Goring  the  Wrong  Ox:  A  Defense  of  the  Mortgage  Interest   Deduction.”  Pg.  301,  302.   97  Ibid.  Pg.  305,  306.  
25   regardless of whether they are financing a home or had the assets to purchase a home outright.98 Unlike the previous authors mentioned before, Woodward and Weicher believe that the MID “ultimately improves the efficiency of taxes on the more affluent, and thus potentially benefits the poor also.”99 To make this claim, more information would have to be known about the relative elasticities of rental property demand and supply. It could also be very possible that the benefits from any efficiency improvements go directly to rental property owners. Additionally, this viewpoint is not consistent with the rationale most commonly provided in defense of the MID. It also has nothing to do with the goal of promoting homeownership. Another article written shortly after the Tax Reform Act of 1986 (TRA86) by Pierce (1989) takes a slightly more nuanced position. She notes that even though the removal or limiting of the MID would create greater horizontal equity between renters and homeowners, it would create a new distortion between those homeowners using a mortgage and those who do not.100 Woodward and Weicher (1989) shared the latter half of that concern.101 I believe it should be noted that there is only a tiny percentage of Americans who are in a position to buy a home without financing. This disparity may also serve to motivate affluent households to become affluent enough to be in that position. Regardless of whether that distortion is real, no deduction that declines in value over time (as illustrated in Table 1) is going to bridge that gulf. Ultimately, Pierce (1989) finds that                                                                                                                           98  Susan  E.  Woodward  &  John  C.  Weicher,  (1989),  “Goring  the  Wrong  Ox:  A  Defense  of  the  Mortgage  Interest   Deduction.”  Pg.  308.    The  authors  appear  to  be  referencing  fairness  in  the  sense  of  “horizontal  equity”,  which   compares  how  people  within  a  particular  income  group  are  treated  relative  to  each  other.    This  is  in  contrast  to   “vertical  equity,”  which  compares  how  individuals  across  varying  income  groups  are  treated  relative  to  each  other.     The  concept  of  vertical  equity  will  be  used  in  comparing  alternatives  to  the  MID  later  in  this  paper.   99  Ibid.  Pg.  311   100  Bethane  Jo  Pierce,  (1989),  “Homeowner  Preferences:  The  Equity  and  Revenue  Effects  of  Proposed  Changes  in   the  Status  Quo.”  Pg.  57.   101  See  footnote  97.  
26   among the various policy options she considers, the ones that reduce or eliminate the MID (and also the deduction for property tax, which is not being considered here) have the ability to raise revenue and improve horizontal and vertical equity.102 Aside from an individual or household’s level of affluence, the amount of benefit derived from the MID is also dependent on the recipient’s age. When repaying a standard 30-year mortgage, it takes years before the principle being repaid is greater than the interest. Unless a household is very affluent and has many other types of deductions, or was compelled to purchase a larger house due to changes in the size of their household, the standard deduction will eventually become more appealing than itemizing. Poterba and Sinai (2008) note that “many older homeowners do not even have a mortgage,” and this makes intuitive sense because older homeowners would generally become more risk adverse and more conscious of their own mortality. 103 Taking on significant new debt under such uncertainty would be less than ideal. This implies the MID really only benefits those who are affluent enough to buy homes and upgrade those properties at a relatively young age. If our society believes encouraging more Americans to become homeowners is a worthwhile goal, this characteristic of the MID does nothing to increase that outcome. Nevertheless, a broader question remains about whether the government should even be involved in trying to encourage homeownership. The second part of the review focuses on this question.                                                                                                                           102  Bethane  Jo  Pierce,  (1989),  “Homeowner  Preferences:  The  Equity  and  Revenue  Effects  of  Proposed  Changes  in   the  Status  Quo.”  Pg.  65.   103  James  Poterba  &  Todd  Sinai,  (2008),  “Tax  Expenditures  for  Owner-­‐Occupied  Housing:  Deductions  for  Property     Taxes  and  Mortgage  Interest  and  the  Exclusion  of  Imputed  Rental  Income.”  Pg.  89.  
27   The Rationale for Government Intervention in the Housing Market From the available congressional records before the creation of the Revenue Act of 1913, it is not apparent that much economic theory was used in the initial drafting of income tax policy or its permitted deductions. Ventry (2010) only found a single reference to mortgage interest in the Senate debate leading up to the passage of the Revenue Act.104 Frederick (2013) points out that: “The Revenue Act of 1913 simply ‘was not clear on many points’ and it lacked the abounding detail and precision of modern tax laws. This imprecision may have been a natural consequence of the fact that the government had ‘not yet developed adequate assessment machinery’ necessary to review, assess, and audit millions of complex tax returns, and was therefore only prepared to process a very simple income tax.”105 Early research into externalities, the benefits or harm experienced by parties external to a transaction, focused on negative externalities.106 The first to do so was Arthur Pigou in the early part of the 20th century.107 In order to address pollution, he recommended taxing polluters to make their private marginal costs more in line the cost polluters impose on society.108 Later on, Ronald Coase looked at the problem of negative externalities and determined that if were little to no transaction costs, a better alternative to taxation would be for the parties to negotiate a                                                                                                                           104  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  241.    Supra  note  55.   105  David  Frederick,  (2013),  “Reconciling  Intentions  with  Outcomes:  A  Critical  Examination  of  the  Mortgage  Interest   Deduction.”  Pg.  48.   106  Gideon  Parchomovsky  and  Peter  Siegelman,  (2012)  “Cities,  Properties,  and  Positive  Externalities.”  Pg.  220.   107  Ibid.  Pg.  221.   108  Ibid.  Pg.  221.  
28   solution.109 The best part of handling externalities in this manner was that it did not matter whether someone had the right to harm or the right to be free from harm.110 However, if the transaction costs of coming to an agreement were not nontrivial, Coase’s Theorem would not hold.111 Harold Demsetz, with a focus on property, then determined that “resources held in common would be over-exploited,” but this problem can resolved if the property belongs to a single private owner.112 Parchomovsky and Siegelman (2012) argue that Demsetz solution does not address “interasset externalities, namely those that are imposed on other asset owners by one's use of one's own asset.” Without discussing whether homeownership imposes positive externalities, negative externalities, or both, interasset externalities best describes what occurs with housing. Interasset externalities make housing more complicated than a purely private good, but are these externalities reason for the government to get involved? Glaeser and Shapiro (2003) examine the possible externalities and separate them into two categories: those derived from living around homeowners and those derived from homeownership.113 The reason there is even a distinction between renters and homeowners is because of principal-agent problem with renters. 114    Renters have been observed to be poor caretakers in the multi-family units they occupy because of free- rider problems and as a result the multi-family units they occupy depreciate much faster than the types of properties occupied by homeowners.115 Renters actually have disincentives to improve                                                                                                                           109  Gideon  Parchomovsky  and  Peter  Siegelman,  (2012)  “Cities,  Properties,  and  Positive  Externalities.”  Pg.  221.   110  Ibid.  Pg.  221,  222.   111  Robert  H.  Frank,  (2010),  “Microeconomics  and  Behavior.”  Pg.  540.   112  Gideon  Parchomovsky  and  Peter  Siegelman,  (2012)  “Cities,  Properties,  and  Positive  Externalities.”  Pg.  222.   113  Edward  M.  Glaeser  &  Jesse  M.  Shapiro,  (2002),  “The  Benefits  of  the  Home  Mortgage  Deduction.”  Pg  37.   114  For  a  detailed  explanation  of  the  “principle-­‐agent”  problem,  see  Susan  P.  Shapiro,  (2005),  “Agency  Theory.”     115  Edward  M.  Glaeser  &  Jesse  M.  Shapiro,  (2002),  “The  Benefits  of  the  Home  Mortgage  Deduction.”  Pg  45,  46.  
29   their respective communities because their rent is not fixed and those improvements would allow the owners charge higher rents.116 Glaeser and Shapiro (2002) also noted that there are positive and negative externalities of homeownership worth considering. For example, homeownership is also “strongly correlated with political activism and social connection.”117 Homeowners are more likely to engage with local groups that try to improve local conditions such as non-profits, neighborhood watches or parent-teacher associations. Homeowners are also much more likely to vote locally and on issues with long-term neighborhood impact, such as the improvement of roads and other infrastructure that would make renting in those same neighborhoods more expensive, vis-à-vis voting for policies that have more of a redistributional bent like income transfers.118 Glaeser and Shapiro (2002) also suggest that if government cares about the well-being of children, housing can be viewed as a positive externality because “children of homeowners are 25% less likely to drop out of school than children of comparable renters.”119 However, on the negative side, once individuals become homeowners, they have very rational incentives to prevent increases in housing supply. Additionally, policies that encourage housing consumption can simultaneously make life in cities more expensive by reducing the number of citizens available to pay for the services they provide.120 As Judd and Swanstrom (2012) note, “Cities cannot simply opt out of                                                                                                                           116  Edward  M.  Glaeser  &  Jesse  M.  Shapiro,  (2002),  “The  Benefits  of  the  Home  Mortgage  Deduction.”  Pg.  60.   117  Ibid.  Pg.  38.   118  Ibid.  Pg.  67,  68.   119  Ibid.  Pg  71.   120  Ibid.  Pg.  57,  58.  
30   their responsibilities. Thus, when cities face budgetary shortfalls [partially created by suburban flight], they walk a tightrope; there is only so much they can cut.”121 One assumption that Litzenberger and Sosin (1978) make in considering the MID is that if the shelter provided from rental housing and from purchasing a home are perfect substitutes, then anyone who is able to meet the down payment requirement (for some requirement greater than or equal to zero) would opt to buy rather than rent.122 Without the presence of some kind of subsidy, whether it is the MID or something else, less middle-income people would be able to afford the homes they buy, while those amongst the very rich would be largely unaffected.123 Even among the authors who are for eliminating the MID, they still advocate for some subsidy that more efficiently promotes homeownership for lower and middle-income segments of the population. Positive externalities are often great candidates for government subsidies, but the MID is not a very cost-effective means for subsidizing those positive externalities created from new home purchases. A Consideration of the Status Quo and Alternatives to the MID The articles considered in the literature review typically ignored the role politics played in the historically unsuccessful attempts to modify the MID. When those authors suggested                                                                                                                           121  Dennis  R.  Judd  &  Todd  Swanstrom,  (2012),  “City  Politics.”  Pg.  344   122  Robert  H.  Litzenberger  &  Howard  B.  Sosin,  (1978),  “Taxation  and  the  Incidence  of  Homeownership  Across   Income  Groups.”  pg.  949,  954.   123  Ibid.  pg.  957.  
31   alternatives, they also typically ignored their political viability. An exception to this is Morrow’s (2012) observation that “politicians wishing to change the level of incentive for homeownership would have to upset the expectations of taxpayers who already own their homes.”124 Another reason the MID has been so resistant to change is that the parties in favor of the status quo are very well organized. Organizations like charities, state and local governments, universities and others who benefit from federal income tax expenditures have often formed coalitions to protect those deductions.125 Even though relatively small proportion of taxpayers actually benefit from the MID, many support it out of the hope that they would be able to benefit from it someday.126 Despite the current focus on austerity brought on by the Great Recession, any policy that does not account for the coalitions seeking to preserve the status quo will fail. In examining alternatives to the MID, this paper will use the following criteria: (1) the effect on the level of tax expenditure; (2) the effect on vertical equity; (3) the likely effect on housing tenure choices; (4) and political feasibility. Table 1 provides a summary of how the status quo and the alternatives rank according to these criteria.                                                                                                                           124  Rebecca  N.  Morrow,  (2012),  “How  and  Why  the  Mortgage  Interest  Deduction  Failed.”  Pg.  781.   125  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  260.   126  Rebecca  N.  Morrow,  (2012),  “How  and  Why  the  Mortgage  Interest  Deduction  Failed.”  Pg.  759.  
32   Table 1 Alternative   Cost   Vertical   Equity   Housing   Tenure   Political   Feasibility   Status  Quo   $69.7   Poor   None   High   Full  Repeal   $13.9127   Good   None   None   Regional  Cap   $62.7128   Fair   None   Low   Homeowners   credit   -­‐$14.9129   Excellent   High   Low   Dollar amounts are given in billions of 2013 dollars. Starting With the Status Quo According to the Joint Committee on Taxation, the estimated cost of the MID is $69.7 billion and is expected to rise annually until it reaches $83.4 billion by 2017.130 This subsidy is currently third most expensive subsidy behind the subsidy for the “exclusion of employer contributions for health care, health insurance premiums, and long-term care insurance premiums” followed by “reduced rates of tax on dividends and long-term capital gains.”131 Approximately, 34 million tax returns currently claim the MID and 76% of the benefit went to households with incomes greater than $100,000. 132 133 However, the $100,000 threshold is not                                                                                                                           127  Adam  J.  Cole,  Geoffrey  Gee,  and  Nicholas  Turner,  (2011),  “  The  Distributional  and  Revenue  Consequences  of   Reforming  the  Mortgage  Interest  Deduction.”  Pg.  991.    According  to  their  results,  portfolio  reallocation  would   offset  revenue  from  repealing  the  MID  by  20%,  which  makes  the  cost  of  repeal  greater  than  simply  subtracting  the   cost  of  the  status  quo.   128  John  E.  Anderson,  Jeffrey  Clemens  and  Andrew  Hanson,  (2007),  “Capping  the  Mortgage  Interest  Deduction.”  Pg.   777.   129  David  C.  Ling  and  Gary  A.  McGill,  (2007),  “The  Variation  of  Homeowner  Tax  Preference  by  Income,  Age  and   Leverage.”  Pg.  536.   130  Joint  Commission  on  Taxation,  (2013),  “Estimates  of  Federal  Tax  Expenditures  for  Fiscal  Years  2012-­‐2017.”  Pg.   33.   131  Joint  Commission  on  Taxation,  (2013),  “Estimates  of  Federal  Tax  Expenditures  for  Fiscal  Years  2012-­‐2017.”  Pg.   38.   132  Brena  Swanson,  (2013),  “Debate  over  mortgage  interest  deduction  shows  a  great  divide.”   http://www.housingwire.com/news/2013/04/25/debate-­‐over-­‐mortgage-­‐interest-­‐deduction-­‐shows-­‐great-­‐divide  
33   adjusted by location, so this statistic can be somewhat misleading. Currently, the average interest rate is 3.57% with 0.8 points, which is almost as low as it has ever been since 1971.134 As the economy continues to rebound, albeit very slowly, it is unlikely that interest rates will remain this low much longer. For some perspective, it is enlightening to recall that back in 1982 the average interest rate was 16.04% with 2.2 points.135 Although those 1982 rates were indicative of another problem with the economy, it is easy to imagine a time where interest rates are double or even triple the current average rate. Depending on the rate of inflation, this could make the deduction even more expensive in the future than current projections would suggest. Persisting with the MID is definitely an expensive policy choice. In order for the status quo to have a positive impact on vertical equity, the benefit would need to increase as household affluence decreases. There is a fairly broad consensus among academics that the MID becomes more valuable as household affluence increases. Table 2 also supports this claim as well. Even authors who support the MID like Woodward and Weicher (1989) do not do so on the grounds that it improves vertical equity, but rather that it does not penalize those who use debt to finance housing relative to households that can self-finance.136 Nevertheless, with more than three-quarters of the Americans who benefit from the MID earning more than $100,000 (twice the national median household income), the status quo ranks the absolute worst in terms of promoting vertical equity.                                                                                                                                                                                                                                                                                                                                                                                                         133  Will  Fischer  &  Chye-­‐Ching  Huang,  (2013),  “Mortgage  Interest  Deduction  Is  Ripe  for  Reform:  Conversion  to  Tax   Credit  Could  Raise  Revenue  and  Make  Subsidy  More  Effective  and  Fairer.”  pg.  1.   134  Freddie  Mac,  (2013),  “30-­‐Year  Fixed-­‐Rate  Mortgages  Since  1971.”   http://www.freddiemac.com/pmms/pmms30.htm   135  Ibid.  http://www.freddiemac.com/pmms/pmms30.htm   136  Susan  E.  Woodward  &  John  C.  Weicher,  (1989),  “Goring  the  Wrong  Ox:  A  Defense  of  the  Mortgage  Interest   Deduction.”  Pg.  308,  309.  
34   Without any changes to the MID, there is no reason to think that housing tenure choices would be affected, positively or negatively, baring some other economic shock. However, several have argued that there is no proof that the MID ever affected the choice between renting and owning because it always existed alongside the income tax.137 Continuing the status quo is definitely the most politically feasible option. Any attempts to change it would be met with the same swift resistance and derision that the Nixon, Carter, Reagan, and Bush administrations faced when they considered altering the status quo. Organizations like the National Association of Realtors and other real estate interests would oppose it because of the evidence that it increases home values, which benefits everyone that builds, sells or finances homes. Baumgartner et al. (2009), stated that one of the most basic challenges anyone seeking to change the status quo faces is how to get the general public to care about an issue, in this case the MID.138 The previously cited 1978 CBS poll and a more recent 2011 New York Times/CBS poll demonstrate that even if only a small percentage of Americans are able to utilize the MID an overwhelming majority do not want to change it, which implies that all previous attempts to get the public to care were unsuccessful. It is also important to note that 33 years later, the proportion who support the MID is virtually unchanged. Although majorities among Democrats and Republicans both favor the MID, the fact that it is slightly less                                                                                                                           137  Rebecca  N.  Morrow,  (2012),  “Billions  Spent  Inflating  the  Housing  Bubble:  How  and  Why  the  Mortgage  Interest   Deduction  Failed.”  Pg.  761.   138  Frank  R.  Baumgartner,  Jeffrey  M.  Berry,  Marie  Hojnacki,  David  C.  Kimball  and  Beth  L.  Leech,  (2009),  “Lobbying   and  Policy  Change:  Who  Wins,  Who  Loses,  and  Why.”  Pg.  44.  
35   popular among Democrats shows there partisan tilt to opposition.139 Other dueling polls from the National Association of Home Builders (NAHB) and the National Low Income Housing Coalition (NLIHC) found that Americans both want to preserve the MID as it is and want to modify the MID to make it fairer to lower-income households. 140 141 The NAHB also reported that two-thirds of their respondents would be less likely to support a candidate who attempt to eliminate or modify the MID.142 Although the polls from the NAHB and NLIHC are likely to be more biased than the CBS polls, the results do demonstrate that a clear majority supports the MID and only a small minority would do things differently. Given that this position is also supported by well-organized interest who also benefit from tax expenditures, the status quo is the most politically feasible. In pursuing alternatives, it would appear that comparing costs between the status quo and any proposed alternatives would be as simple as examining whether they cost more or less than the $70-83.4 billion range of continuing the way things have been. However, such a comparison is not that straightforward. After all, any change that affects after-tax income can have profound effects on economic behavior depending upon where an individual falls within the American income and wealth continuum. For the purposes of this paper, the following alternatives will be considered: (1) a complete repeal of the MID without a replacement policy; (2) a cap on the                                                                                                                           139  Brian  J.  McCabe,  (2011),  “Despite  Benefit  Disparities,  Middle  Class  Supports  Mortgage  Deduction.”     http://fivethirtyeight.blogs.nytimes.com/2011/07/13/despite-­‐benefit-­‐disparities-­‐middle-­‐class-­‐supports-­‐mortgage-­‐ deduction/   140  Rick  Judson,  (2013),  “Keep  Homeowners'  Tax  Deductions:  Opposing  view.”     http://www.usatoday.com/story/opinion/2013/04/02/mortgage-­‐tax-­‐deduction-­‐editorials-­‐debates/2047927/     141  Amy  Clark,  (2012),  “New  Poll  Highlights  Broad  Support  for  Modifying  Mortgage  Interest  Deduction,  Funding   Affordable  Housing.”  http://nlihc.org/press/releases/1937     142  Brian  J.  McCabe,  (2011),  “Despite  Benefit  Disparities,  Middle  Class  Supports  Mortgage  Deduction.”     http://fivethirtyeight.blogs.nytimes.com/2011/07/13/despite-­‐benefit-­‐disparities-­‐middle-­‐class-­‐supports-­‐mortgage-­‐ deduction/  
36   amount of mortgage interest a household can deduct, adjusted for regional cost of living; and (3) a complete repeal of the MID that would be replaced with 15% tax credit on mortgage interest up to $25,000 regardless of marginal tax rate.143 Repealing the MID One of the arguments commonly made in favor of the MID is that it boosts levels of homeownership, but there is a large body of research to the contrary. Americans who claim the largest MIDs probably would have bought the same house in its absence. However, it may be the case that affluent households would shift from bank financing to self-financing in varying degrees depending on relative wealth, which would decrease might decrease tax revenue from other investments such a household might have held.144 In many respects, the effect of repealing the MID would almost be the exact opposite of maintaining the status quo. Additionally, relative to the other alternatives discussed in this paper, only repealing the MID and replacing it with a tax credit would have a larger impact on cost. The first change over the status quo is the cost to the federal government. Almost immediately, the government would have recovered $55.8 billion dollars and would avoid the projected                                                                                                                           143  This  alternative  is  slightly  less  aggressive  than  the  credit  suggested  by  the  2005  President’s  Advisory  Panel  who   recommended  that  the  cap  be  reduced  to  FHA  limits  over  5  years.    However,  because  it  is  independent  of  a   household’s  marginal  rate,  it  would  mean  less  to  more  affluent  households.    John  E.  Anderson,  Jeffrey  Clemens  &   Andrew  Hanson,  (2007),  “Capping  the  Mortgage  Interest  Deduction.”  Pg.  776;  Rebecca  N.  Morrow,  (2012),  “Billions   Spent  Inflating  the  Housing  Bubble:  How  and  Why  the  Mortgage  Interest  Deduction  Failed.”  Pg.  800.   144  Tuukka  Saarimaa,  (2010),  “Tax  Incentives  and  Demand  for  Mortgage  Debt:  Evidence  from  the  Finnish  1993  Tax   Reform.”  Pg.  21,  22;  Adam  J.  Cole,  Geoffrey  Gee  and  Nicholas  Turner,  (2011),  “The  Distributional  and  Revenue   Consequences  of  Reforming  the  Mortgage  Interest  Deduction.”  Pg.  988.  
37   growth of the MID due to tax bracket creep.145 Although the MID has little effect on increasing homeownership, it is true that some people, especially younger affluent (but not rich) people, would see their disposable incomes decrease in such a way that it has a somewhat negative effect on the overall economy. Conversely, research by Follain and Melamed (1998) suggest that: “Elimination of the MID would induce households to refinance their homes, substituting equity for debt. Taking this portfolio shuffling into account, they estimate that elimination of the MID would add only $10 billion in additional revenue each year.”146 Additionally, repealing the MID would remove what has been previously described as an “upside down subsidy.” This characterization is not hyperbole because larger loans are granted on the basis of ability to pay and assuming a conventional 30-year loan with a loan to value (LTV) ratio of 80%, the column “1st Year Interest” in Table 2 illustrates how much more interest a household pays as the cost of a home increases. The amount of subsidy a household receives from the MID is also impacted by the household’s marginal tax rate. Repealing the MID would have a positive effect on vertical equity by restoring some of the progressivity embedded within the nation’s income tax code. It would increase the extent to which households that earn more income pay more in taxes, which is what makes our income tax progressive. Cole, Gee and Turner (2011) state that repealing the MID would have “the biggest                                                                                                                           145  Adam  J.  Cole,  Geoffrey  Gee  and  Nicholas  Turner,  (2011),  “The  Distributional  and  Revenue  Consequences  of   Reforming  the  Mortgage  Interest  Deduction.”  Pg.  991.   146  John  E.  Anderson,  Jeffrey  Clemens  &  Andrew  Hanson,  (2007),  “Capping  the  Mortgage  Interest  Deduction.”  Pg.   769.  Supra  note  1.  
38   effects on high-income taxpayers and taxpayers who are married, have children, and live in expensive housing markets.”147 Removing the MID would marginally reduce the cost of buying a home because “the MID lowers the cost of capital for housing, which will translate into higher home prices in areas where housing supply is relatively inelastic.”148 The extent of this housing price reduction has been estimated to be “between two and 13 percent.”149 Table 2 Home  Price   LTV   Amount   Financed   1st  Year   Interest   1st  Year   Principal   2nd  Year   Interest    $100,000     0.8    $80,000      $(2,711.76)    $(1,556.32)    $(2,605.98)    $200,000     0.8    $160,000      $(5,423.51)    $(3,112.64)    $(5,211.97)    $250,000     0.8    $200,000      $(6,779.39)    $(3,890.79)    $(6,514.96)    $300,000     0.8    $240,000      $(8,135.27)    $(4,668.95)    $(7,817.95)    $400,000     0.8    $320,000      $(10,847.02)    $(6,225.27)    $(10,423.94)    $500,000     0.8    $400,000      $(13,558.78)    $(7,781.59)    $(13,029.92)    $750,000     0.8    $600,000      $(20,338.16)    $(11,672.38)    $(19,544.88)    $1,000,000     0.8    $800,000      $(27,117.55)    $(15,563.18)    $(26,059.84)   This table illustrates how much interest an individual or household pays in the first two years and how this varies depending on the amount of the loan.150                                                                                                                           147  Adam  J.  Cole,  Geoffrey  Gee  and  Nicholas  Turner,  (2011)  “The  Distributional  and  Revenue  Consequences  of   Reforming  the  Mortgage  Interest  Deduction.”    Pg.  986.   148  Adam  J.  Cole,  Geoffrey  Gee  and  Nicholas  Turner,  (2011)  “The  Distributional  and  Revenue  Consequences  of   Reforming  the  Mortgage  Interest  Deduction.”  Pg.  987.   149  Ibid.  Pg.  987.   150  An  interest  rate  of  3.42%  was  used  based  on  the  overnight  average  rate  ascertained  by  visiting  bankrate.com  on   May  5,  2013.    The  LTV  of  80%  was  chosen  as  the  typical  amount  financed  under  a  conventional  mortgage.  
39   In contrast to the status quo, the political feasibility of repealing the MID would be the lowest. This alternative starts out with approximately 90% of the electorate against it. Organizations like the National Association of Realtors and NAHB would be instantly and vehemently against this policy and would probably be rejoined by organizations like universities, State and local governments, charities and organization that represent medical interests like the American Medical Association, as they have in the past.151 Homeownership is a fundamental part of the American Dream and because of belief systems like the Protestant work ethic, many American probably feel that homeowners are entitled to whatever benefits they can claim. Considering that there are so many Americans who do not benefit (and will probably never benefit) from the MID who still favor its preservation, it is hard to imagine what organized coalition could be formed to counteract such a well-organized group. In the 100 years since the institution of the federal income tax, no such coalition has developed. A Regionally-Based Cap on the MID TRA86 created a one million dollar cap on the MID and although that cap has not been adjusted for inflation since then, a million dollars is still significantly more than most Americans will ever spend on a home purchase. 152 However, it “will affect more mortgages over time as home-price                                                                                                                           151  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  260.   152  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  275.  
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Mortgage_Int_Ded_final

  • 1. Stuck in the MID With You Jason Bladen, University of Maryland Baltimore County Previous research indicates that there are economic benefits to subsidizing housing. I will demonstrate throughout this paper that the mortgage interest deduction (MID) was an unintended consequence of how the US income tax law was originally written in Revenue Act of 1913. I will also demonstrate that the MID is not the most efficient way to subsidize housing, if the goal is to encourage greater levels of homeownership. In fact, contrary to most subsidies, the MID is “upside-down” in the sense that it provides a greater benefit for those purchasing more expensive homes and who are taxed at a higher marginal rate. As early as the period post-World War II, people began to become aware of how inefficient the deduction was especially in the context of 30-year mortgages where very little equity was placed into the loan at its origination. Although there are several ways to view efficiency, this paper will examine the cost of the MID with respect to the stated goal of increasing homeownership. Nevertheless, once the MID was codified into American culture, the politics surrounding the MID have continued to make it difficult to transition from the MID to some more efficient form of subsidy. In fact, failing to consider the political nature of the MID has been the single biggest shortcoming in attempts to develop alternative policies. Although there has been substantial research around the cost and benefits of the MID, as well as research into alternative housing subsidies, I could only find one article that dealt with the MID’s
  • 2. 2   political history. The fact that articles of this nature are not abundant emphasizes the extent to which politics has been ignored in examining alternatives to the MID. Borrowing extensively from the political history of the MID written by Ventry, Jr. (2010), I will discuss the politics of the MID on a decade-by-decade basis. After discussing the political history, I will provide an examination of some of the research on the MID and its effect on housing. However, before I detail either of the items mentioned previously, I will also specify where and how I acquired the data and information used in this analysis. I will also define what a subsidy is and whether it differs from a tax expenditure used to promote a specific purpose. Additionally, I will attempt to show that housing produces positive externalities not captured in the market price of housing and thus is worthy of government intervention. Next, I will look at the MID relative to four alternatives to subsidizing homeownership. The status quo and alternative policies will be examined based on the following five criteria: (1) effect on the level of tax expenditure; (2) effect on vertical equity; (3) likely effect on housing tenure choices; and (4) political feasibility. After subjectively ranking these alternatives, I will discuss whether any of these policies dominate based on those rankings and can overcome the politics of the MID. Although there is currently a lot of focus by politicians and the media on methods for reducing the federal deficit in the wake of the Great Recession, this paper finds little reason to believe that the MID (the country’s third largest tax expenditure) will be modified in the foreseeable future.
  • 3. 3   Beginning of the MID There is no record that indicates that lawmakers intended to subsidize housing when the Revenue Act of 1913 was passed. Initially, the MID appeared to be more of a loophole than conscious effort to encourage housing consumption. After the 16th Amendment made the collection of income tax in the United States constitutional in 1913 and the Revenue Act of 1913 was passed, it allowed “all interest paid within the year by a taxable person on indebtedness” to be deducted. 1 For the most part, the homeownership rate was low and financing was not typically used for home purchases when the law went into effect. The 30-year fixed-rate home mortgage was still two decades away from being instituted and mortgages tended to be interest-only loans with balloon payments at the end of the term.2 It is also true that most high-income households were not using mortgages to finance real property. In fact, in 1910 only a third of homes were secured by a mortgage. During World War I (WWI), the rates and exemptions were changed, which increased the number of individuals and households paying income tax, but this still only affected 15% of households.3 Some have noted that the MID’s beginning was probably more attributable to the practical difficulty of distinguishing between interest paid toward personal debt and interest paid in the operation of a business, such as family-owned farms. In the absence of evidence to the contrary, this seems to be a fairly parsimonious explanation of why the MID was allowed.                                                                                                                           1  Dennis  Ventry,  Jr.  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  236.   2  Dennis  R.  Judd  &  Todd  Swanstrom.  (2012),  “City  Politics.”  Pg.  191   3  Ibid.  Pg.  240.  
  • 4. 4   The Revenue Act of 1913 was a product of America’s progressive era and adopted under the rhetoric of making things fairer for the entire country. In actuality, the Federal income tax allowed the Federal Government the ability to provide services for “states with lower per capita incomes relative to those with higher per capita incomes.”4 Up until WWI, only those whose incomes were significantly higher than the average American paid income taxes.5 In fact, when the Revenue Act of 1913 first initiated income tax collection, only one percent was levied against incomes that are the equivalent of $70,537 for singles and $94,050 for married couples in 2013 dollars.6 Although that level of income does not make an individual or household rich, we do not associate those groups with poverty or needing as much in the way of government support. It was not until a household earned upwards of $470,248 (in 2013 dollars) that a progressive surtax between one and six percent was assessed.7 In the first year that taxes were collected after the passing of the Revenue Act of 1913, the Bureau of Internal Revenue (the precursor to the Internal Revenue Service) only collected taxes from about 358,000 people out of a population of approximately 97.2 million people in the country at the time. 8 9 Of the eight deductions initially specified by the Revenue Act, none of them explicitly mentioned the mortgage interest deduction, but because one of them included interest on consumer debt one of the first income tax loopholes was created.10                                                                                                                           4  Randall  G.  Holcombe  &  Donald  J.  Lacombe,  (1998)  “Interest  Versus  Ideology  in  the  Ratification  of  the  16 th  and   17 th  Amendments.”  Pg.  152.   5  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  240.   6  Ibid.  Pg.  239.  These  values  were  originally  reported  as  $3,000  and  $4,000  for  single  and  married  filers  in  1913   dollars,  respectively.   7  Ibid.  Pg.  239   8  Ibid.  Pg.  240   9  The  US  population  in  1913  was  estimated  using  the  information  provided  by  the  US  Census  Bureau  as  can  be   found  here:  http://www.census.gov/population/estimates/nation/popclockest.txt     10  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  240.  
  • 5. 5   Historically, affluent individuals would attempt to live as far from city centers as the current modes of transportation would allow. Coupled with a decrease in the cost of land, the value of houses in suburbs is on average greater than to similar homes found within cities. The tax code created an incentive for individuals who can afford more expensive properties to take out mortgages and use their assets to make other investments capable of producing a greater return on investment. This implies that the mortgages for affluent individuals will generate large amounts of interest, especially early on, in the servicing of their loan. Thus, almost from its inception, the MID has had the greatest benefit for many individuals who do not actually need the deduction. This is especially true because there were sections of cities that banks would not lend to up until the Community Reinvestment Act of 1977 made the practice of redlining illegal.11 However, the point remains, without mortgages being extended into large sections within cities, there were many people who had no interest to deduct and that is assuming that their incomes were high enough to make itemizing more attractive then using the standard deduction. Currently, the cost of the MID to the Federal Government is almost $70 billion and like most other things is projected to increase over time.12 The MID is primarily defended on the grounds that the credit provides an incentive for homeownership. As US tax law is presently worded, the MID is also allowed on an additional residential property an individual or household might own. People arguing for the expiration of the deduction point out that the deduction has no appreciable                                                                                                                           11  Dennis  R.  Judd  &  Todd  Swanstrom,  (2012)  “City  Politics.”  Pg.  402   12  Joint  Commission  on  Taxation,  (2013),  “Estimates  of  Federal  Tax  Expenditures  for  Fiscal  Years  2012-­‐2017.”  pg.  35  
  • 6. 6   effect on homeownership rates and is inefficient because it helps people who would have purchased a home regardless of whether the deduction was available or not.13 Data and Methods The method for collecting the articles used in this analysis was fairly straightforward. Using the keywords “mortgage interest deduction” in the article search in the UMBC library’s website returned many of the articles I opted to use. Upon finding relevant materials, I took note of the articles that those authors referenced in their analyses to see what they added to the conversation. I also searched keywords such as “housing externalities” and “housing subsidies.” When appropriate, I incorporated material from Judd and Swanstrom’s (2012) textbook “City Politics” as well as information from another textbook from Baumgartner et al. (2009) entitled “Lobbying and Policy Change: Who Wins, Who Loses, and Why.” Moreover, when the utilized text provided figures such as income, standard deductions or other important monetary figures as of the date when the piece was written, those figures were converted into 2013 dollars using the calculator provided by the United States Department of Labor, Bureau of Labor Statistics. 14 This step was taken in order to preserve the magnitude of the monetary values those authors used due to the effect of inflation. I performed another internet search using Google Scholar™ to find information about the history of the mortgage interest deduction. The article I found written by                                                                                                                           13  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  243;  Adam  J.  Cole,  Geoffrey  Gee  &  Nicholas  Turner,  (2011)  “The  Distributional  and  Revenue   Consequences  of  Reforming  the  Mortgage  Interest  Deduction.”    Pg.  982;  Edward  M.  Glaeser  &  Jesse  M.  Shapiro,   (2002),  “The  Benefits  of  the  Home  Mortgage  Deduction.”  Pg.  38;  Rebecca  N.  Morrow.  (2012),  “How  and  Why  the   Mortgage  Interest  Deduction  Failed.”  Pg.  765,  769.   14  Figures  were  converted  into  2013  dollars  using  the  calculator  provided  by  the  Bureau  of  Labor  Statistics  at   http://www.bls.gov/data/inflation_calculator.htm  
  • 7. 7   Dennis Ventry, Jr. was the only one that was helpful with respect to the MID’s history. Rather than incorporating Ventry (2010) into the rest of the literature review, I felt that his analysis is essential to understanding the political history of the deduction. Finally, some of the research literature I use examined specific policy alternatives, so that information will be referenced when critiquing the merits of those proposals. Generally, those articles did not expand on the political feasibility of their proposals, so this is one of the areas I intend to build upon when covering alternatives to the MID later in this paper. The History of the MID The beginning of the MID was an accident. When it provided for the discount of interest paid over the course of the calendar year, the Revenue Act of 1913 never explicitly mentioned mortgage interest, but because that is a form of interest it did not have to.15 In the beginning of American economic policy, the concept of trying to control externalities with taxes and subsidies did not start to advance until 1920 when economist Arthur Pigou introduced that idea in dealing with pollution.16 Economic strategies for dealing with externalities were later refined by economists like Coase and Baumol who introduced additional methods aside from taxation and subsidies to deal with externality problems.17 18                                                                                                                           15  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  236   16  Gideon  Parchomovsky  &  Peter  Siegelman,  (2012),  “Cities,  Property  and  Positive  Externalities.”  Pg.  221   17  Ibid.  Pg.  221   18  William  J.  Baumol,  (1972),  “On  Taxation  and  the  Control  of  Externalities.”  
  • 8. 8   Considering that most people during the 1920’s financed their homes using interest-only or almost interest-only loans for periods ranging between three and 10 years, it is somewhat dubious to describe those people as homeowners.19 Yet for those able to take out mortgages, they now potentially had a deduction they could claim provided they had enough taxable income. Homeownership continued to rise to almost 48% until the Great Depression sent home values spiraling downward and banks no longer had the ability extend mortgages. 20 It is probably safe to say that even though the number of households that benefited from the mortgage interest deduction was very small, as the number of homeowners increased, so did the number of people who could take advantage of that deduction. However, as the country started to feel the effects of the Great Depression, the MID was not a deduction a significant number of Americans could really take advantage of until some time later. Government Intervenes on Behalf of the Housing Market In the 1930’s, the Federal government took several steps to get the decimated housing market back on track and would later create a new group of Americans who cared about the MID. In a shift from the mostly hands-off position of the Hoover Administration, the Roosevelt Administration signed the Home Owners’ Loan Act in 1933, which established the Home Owners’ Loan Corporation (HOLC) and the National Housing Act of 1934, which established the Federal Housing Administration (FHA) and was later amended in 1938 to create the Federal                                                                                                                           19  Dennis  R.  Judd  &  Todd  Swanstrom,  (2012),  “City  Politics.”  Pg.  243.   20  Ibid.  Pg.  243.  
  • 9. 9   National Mortgage Association (FannieMae). 21 Although the primary concern of these agencies was stabilizing the banking and housing sectors of the economy, the actions those agencies took revolutionized the process Americans used to purchase homes. For example, the HOLC changed home loans from nonamortizing, three to ten year loans to fully amortizing, twenty to twenty- five year loans.22 Extending the length of mortgages in this way generated significantly more interest that could potentially be deducted by income tax-paying Americans. The FHA created an even bigger change by establishing 30-year loans terms that were also fully amortizing and required as little as five percent down.23 Not only did the increase in mortgage length increase the amount of interest an individual or household would pay, but also the smaller down payment requirement increased amount of principal being financed, which also increased the total interest to be repaid. Although there were many who were unable to take advantage of these more favorable terms, particularly African-Americans, this also created a much larger group of individuals who could exploit the MID loophole.24 The effects of the Great Depression had not yet subsided. However, to the extent that the nation’s economy was beginning to recover, World War II (WWII) shifted the production of goods to the war effort.25 However, once WWII ended, the changes that came with the Serviceman’s Readjustment Act of 1944 allowed even more individuals and households the                                                                                                                           21  Dennis  R.  Judd  &  Todd  Swanstrom,  (2012),  “City  Politics.”  Pg.  122   22  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  247.   23  Ibid.  Pg.  248.   24  Dennis  R.  Judd  &  Todd  Swanstrom,  (2012),  “City  Politics.”  Pg.  xxx   25  Ibid.  Pg.  xxx  
  • 10. 10   ability to become homeowners.26 Thanks to less-restrictive criteria for extending credit, loans with small down payment requirements (or even zero-down payment Veterans’ Administration loans) and loans with 20 and 30-year terms boosted homeownership to 55% by 1950, up 11.4% from 1940.27 Changes to tax laws passed during this period changed the number of people filing tax returns from 14.7 million to 50 million between 1940 and 1945 with marginal tax rates now ranging between 23% and 94%.28 These rates remained in place for over 20 years while the exemption fell to $5,868 for individuals and $11,736 for married households in 2013 dollars and differed wildly from the structure of the income tax when it was first enacted. 29 The post-WWII efforts to promote homeownership coupled with those income tax base-broadening efforts now created a much larger class of individuals who cared about and were in a position to take advantage of the MID. More Homeowners and More MID Beneficiaries The 1950’s ushered in a period where the rate of homeownership grew dramatically even relative to the late 1940’s. The changes put forth by the FHA and VA enabled this expansion. Mortgage debt increased 295% from $55 billion in 1950 to $162 billion by 1960.30 As a function of the increased debt, the amount of interest being repaid also increased from $2.5 billion to $7.3                                                                                                                           26  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  249.   27  Ibid.  Pg.  249   28  Ibid.  Pg.  250,  251.   29  Ibid.  Pg.  251;  These  amounts  were  actually  written  as  $600  and  $1200  for  single  and  married  filers  in  1949   dollars,  respectively.   30  Ibid.  Pg.  250.  
  • 11. 11   billion (a 292% increase) by 1960.31 During this same time period, the number of people who itemized their deductions also experienced a sharp increase in growth. In 1950, less than 20% of taxpayers itemized, but by 1960 that percentage almost doubled to incorporate 39.5% of filers.32 The MID had become a much more costly tax expenditure, but was not the policy driving the increase in homeownership. In fact, in spite of the number of homeowners affected, Ventry (2010) notes that the government still did not view the MID as actual housing policy. Neither a 1950 Housing and Home Finance Agency study nor a more comprehensive study conducted in 1956 even mentioned the MID.33 However, this does not mean that Congress was ignorant of the cost. According to the Joint Committee on the Economic Report of 1955, the personal interest deduction (of which the MID was a large part) grew faster than any other deduction post WWII.34 Clearly, the 1950’s became a time where many affluent and upwardly mobile Americans learned about the portion of the tax law that allowed for the MID. A marginal rate greater than 90% would be onerous if people were actually paying that much, but as Randolph Paul (prestigious tax lawyer and former Roosevelt advisor) noted, “the bark of our individual income tax was much worse than its bite.”35 In fact, in the late 1950’s soon-to-be Assistant Secretary of the Treasury for Tax Policy, Stanley Surrey, noted that the effective tax rate was more like 48%.36 Nevertheless, regardless of what a household’s marginal rate was, it meant that the government might be paying up to that rate to subsidize the cost of housing. It is                                                                                                                           31  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  250.   32  Ibid.  Pg.  251.   33  Ibid.  Pg.  251.   34  Ibid.  Pg.  252.  Supra  note  156.   35  Ibid.  Pg.  253.   36  Ibid.  Pg.  253.  
  • 12. 12   certain that people paying those higher marginal rates did not need additional help in choosing between renting and becoming homeowners. Additionally, it is hard to imagine a scenario where households at the top marginal rate would need more of a financial subsidy than those at lower income levels. Nevertheless, encouraging greater levels of homeownership has been the primary justification for the MID. During the 1950’s, more and more reformers, economists, legal academics began to line up against what they believed to be a very inefficient subsidy.37 They began to believe that if presented with the facts, taxpayers would prefer to ditch the preferential treatment and high rates for a more inclusive tax code with lower rates.38 Thanks to Rep. Wilbur Mills (D-AR), Congress became very familiar with the “tax cuts for tax reform” strategy.39 They argued that even if promoting homeownership was a worthwhile policy goal, the MID really only benefited individuals who had abundant wealth and not those in lower tax brackets that actually needed help in the purchase of a home.40 Even at this point in time, the thought of using direct subsidies (and probably of a specific amount) was preferred over the MID to stimulate homeownership.41 If Washington, or more specifically Congress, is “where good ideas go to die,” as stated by former Senator Jim DeMint (R-SC) in January 2013, it surely did not disprove his axiom in this                                                                                                                           37  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  253,  254.   38  Ibid.  Pg.  255.   39  Ibid.  Pg.  255.   40  Ibid.  Pg.  258   41  Ibid.  Pg.  258,  259.  
  • 13. 13   instance. 42 Not only did politicians circle the wagons around the MID, they also added a couple of provisions in 1951 and then again in 1964, which had the effect of sheltering capital gains from the sale of a primary residence.43 The Revenue Act of 1951 was one of the vehicles used to finance the Korean War.44 However, decreasing fear of inflation and the declining popularity of the law meant that more concessions had to be made to get the tax increase passed.45 The Revenue Act of 1951 allowed homeowners to exclude capital gains from the sale of their primary residence as long as they used those gains to buy a new home in order to encourage them to “trade up.”46 The Revenue Act of 1964 was passed for completely different reasons. Through a series of tax cutting measures, the intent was to “stimulate the economy” and would “raise (rather than lower) revenues…to eliminate deficits in the administrative budgets and then reduce the public debt.”47 The Revenue Act of 1964 allowed homeowners a one-time exclusion of capital gains on their primary residences if they were 55 or older.48 Clearly, as housing prices rise so does the amount of capital gains realized when that property is sold and these policies also favored the more affluent. The 1960’s brought various changes to America, and fiscal policy would not be exempt. In 1961 Stanley Surrey shifted from his role as Harvard professor and began his eight-year tenure as                                                                                                                           42  Jane  C.  Timm,  (2013),  “Sen.  DeMint:  Congress  is  a  mess,  so  we’re  going  straight  to  the  people.”   http://tv.msnbc.com/2013/01/17/sen-­‐demint-­‐congress-­‐is-­‐a-­‐mess-­‐so-­‐were-­‐going-­‐straight-­‐to-­‐the-­‐people/     43  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  259.   44  Rosella  Capella,  (2013),  “Pay-­‐As-­‐You-­‐Go  –  The  Financing  of  the  United  States’  War  Effort  in  Korea.”  Pg.  19   45  Ibid.  Pg.  39-­‐40.   46  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  259.   47  Charles  L.  B.  Lowndes,  (1964),  “The  Revenue  Act  of  1964:  A  Critical  Analysis.”  Pg.  668,  669.   48  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  259.  
  • 14. 14   Assistant Secretary of the Treasury for Tax Policy when President Kennedy appointed him.49 Surrey began an inquisition into the taxation (or lack thereof) of imputed rent which is a missing part of the rationale for the MID. 50 If a person owns a rental property, he or she allowed to deduct mortgage interest and other property-related expenses, but has to claim the income he or she receives from renting that property. However, for a private residence an individual or household does not claim imputed income, but is still allowed to claim the MID. Surrey’s suggestion was that imputed rent should be taxed the way it is in other countries.51 From a theoretical standpoint, his approach was built on a strong and logical foundation. Conversely, from a political standpoint attempting to tax imputed rent took little account of the incentives individuals and households (especially the very affluent ones) had to protect the status quo. In 1963, the Treasury Department suggested capping itemized deductions to 5% of adjusted gross income because of the revenue the government lost as a result of the increased number of people who itemized. What the Treasury Department did not account for is the very vocal coalition that would form between those other organizations who benefited from tax expenditures, such as universities, charities, state and local governments as well as those special interests within the housing sector.52 Working class and middle class voters also supported the MID, but probably did not think about or care that more affluent received a greater benefit from it. Generally, the politics of the MID and housing made it very easy to attach additional incentives that benefited the affluent, but virtually impossible to make it more progressive.                                                                                                                           49  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  253.   50  Litzenberger  &  Sosin  (1978)  use  another  author’s  description  of  “imputed  rent,”  which  describes  it  as  follows:  “a   homeowner  is  playing  two  separate  roles;  he  is  a  tenant  who  pays  ‘imputed  rent’  to  the  landlord  and  he  is  a  real   estate  investor  who  receives  ‘imputed’  rental  income  from  his  ‘tenant.’    Since  the  same  person  plays  both  roles,  no   cash  changes  hand.”  Pg.  950.   51  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  260.   52  Ibid.  Pg.  260.  
  • 15. 15   As a counter strategy, Surrey pivoted from trying to decrease itemized deductions to attempting to increase the standard deduction, which had been losing economic power because it was not indexed for inflation.53 This strategy was pursued in the hope that as less people benefited from itemized deductions like the MID, the MID would become more politically vulnerable in the long term.54 The Treasury Department also attempted to take the “out of sight, out of mind” dimension away from the MID by advocating for Congress to specifically budget for tax expenditures.55 The thought was that this move would force Congress to examine the costs and benefits of these tax expenditures.56 In the case of the MID, the research suggests it was the Surrey’s hope that policymakers and the general public would question what the MID was accomplishing for America given the growing cost.57 This was one of the rare attempts to address the politics of the MID. “In 1968, the first tax expenditure budget appeared in the Annual Report of the Secretary of the Treasury.”58 Avoiding the temptation to become too theoretical in nature, the report stated that the MID accounted for approximately 4.5% of the $44.5 billion dollars of tax expenditures in that year. Even if Congress felt that a housing subsidy was justified on either an economic or social basis, the Treasury Department now felt that it had the context to examine the cost- effectiveness of the MID. The Treasury noted that the government was engaged in providing an                                                                                                                           53  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  265.   54  Ibid.  Pg.  267.   55  Ibid.  Pg.  262.   56  Ibid.  Pg.  263,264.   57  Ibid.  Pg.  262.   58  Ibid.  Pg.  263.  
  • 16. 16   upside-down subsidy through the MID. The Treasury Department found that people in a household making $63,426 (in 2013 dollars) would only get $19 dollars of assistance for every $100 dollars spent on interest, whereas a household that made $1.27 million (in 2013 dollars) would get $70 dollars for every $100 they spent on interest.59 Nevertheless, if the goal was to encourage homeownership, those subsidies should be in reverse. Additionally, even if middle- income households value their subsidies more than affluent households, such a policy does not make our tax policy more progressive. Those advocating for a more progressive tax policy accomplished a partial victory with the Tax Reform Act of 1969 in the beginning of the Nixon administration. Even though it did not succeed in creating a basket of deductions where taxpayers were no longer able to claim deductions on excluded income, such as the MID, it reduced the depreciation rate on residential property and changed the allowable depreciation method on low to moderate-income rental property.60 Before the Act took effect in 1971, there were 35.4 million returns that itemized deductions and by 1972 that number had fallen to 27 million.61 This decrease implies that within the span of three years since the Act passed, there were eight million households who would possibly be indifferent to the MID. Given more political space to attack the MID directly, a 1977 study noted that eliminating homeowners’ tax preferences could raise an additional $53 billion (62% of the FY 2013 sequester) in 2013 dollars. 62 63 Even though then-candidate Jimmy                                                                                                                           59  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  264.  The  original  figures  compared  a  household  making  $10,000  to  a  household  making  $200,000  in   1969  dollars.   60  Ibid  Pg.  267   61  Ibid  Pg.  267   62  Dylan  Matthews,  (2013),  “The  Sequester:  Absolutely  everything  you  could  possibly  need  to  know,  in  one  FAQ.”  
  • 17. 17   Carter campaigned on changing the MID to make it a fairer policy before the 1976 presidential election, he was labeled as attacking lower class and middle class homeowners.64 When asked about his position on the MID by a reporter at Business Week, he replied: “No, I have said this is one of the tax incentives I would consider changing. But I believe we do need some incentives for private home ownership. If I made any changes, I would maintain the stimulation for housing, but shift the tax credits towards lower- and middle- income families.”65 Shortly after President Carter was elected, Sen. Edward Kennedy (D-MA) also proposed making sweeping reforms that included changing the MID and other deductions into credits.66 Nevertheless, President Carter opted not spend political capital on that battle and the effort remained dormant over the course of his presidency. This decision was reaffirmed when a 1978 CBS poll determined that 90% of the country wanted to preserve the MID even if only 25% of returns itemized deductions.67 It appeared that Surrey and the Treasury Department’s hope that Americans would reject the MID if less people benefited from it had failed.                                                                                                                                                                                                                                                                                                                                                                                                         http://www.washingtonpost.com/blogs/wonkblog/wp/2013/02/20/the-­‐sequester-­‐absolutely-­‐everything-­‐you-­‐ could-­‐possibly-­‐need-­‐to-­‐know-­‐in-­‐one-­‐faq/     63  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  268.   64  Ibid.  Pg.  269.   65  Robert  H.  Litzenberger  &  Howard  B.  Sosin,  (1978),  “Taxation  and  the  Incidence  of  Homeownership  Across   Income  Groups.”  Pg.  947.   66  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  269.   67  Ibid.  Pg.  269,270.  
  • 18. 18   The First Direct Modification of the MID? Concerns about inflation, unemployment and the confinement of Americans in Iran led to President Reagan’s victory in 1980 and signaled a shift in the public’s attitude towards government spending. 68 According to a Congressional Budget Office (CBO) report in 1983, dealing with the economic downturn and spiraling budget deficit meant tough choices between increased taxes and spending cuts over the next few years.69 The housing lobby saw this report as a threat to the MID and stated that removing it would have a “devastating impact . . . on the home building and real estate industries, let alone the status of the average American homeowner.”70 Without leadership from President Reagan or Congress during his first term and in the face of its popularity, the MID remained untouched.71 However, potentially emboldened by winning a second term in 1984, President Reagan had the political breathing room to address the MID.72 His State of the Union address signaled that reforming the tax code to promote “fairness, simplicity and incentives for growth” while avoiding tax increases was a component of his second term agenda. Twenty years after Surrey’s efforts, (and ironically in the same year that Secretary Surrey passed away) the tax cuts for tax reform movement finally found a listener even if the reforms differed from what was initially                                                                                                                           68  The  White  House,  (2013),  “Ronald  Reagan.”  http://www.whitehouse.gov/about/presidents/ronaldreagan     69  New  York  Times,  (1983),  “Excerpts  from  Congressional  Budget  Office  Report  on  Reducing  the  Deficit.”   http://www.nytimes.com/1983/02/11/us/excerpts-­‐from-­‐congressional-­‐budget-­‐office-­‐report-­‐on-­‐reducing-­‐the-­‐ deficit.html?pagewanted=1   70  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  271.   71  Ibid.  Pg.  271.   72  Ibid.  Pg.  271.  
  • 19. 19   envisioned. 73 In spite of the president’s intentions, President Reagan was quickly forced to take changes to the MID off the table by real estate representatives and other concerned lobbyists.74 A move which according to Eugene Steuerle, who served as the Deputy Assistant Secretary of the Treasury for Tax Analysis in the late 80’s, “immediately made impossible consideration of a number of promising options.” 75 76 It is not clear from President Reagan’s example if presidential commitment is a necessary condition for MID modification, but it definitely is not a sufficient condition. Ultimately, the Tax Reform Act of 1986 did not act on the Treasury Department’s suggestion to limit the MID to primary residences.77 However, it did accomplish the goal of lowering the marginal tax rates and broadening the tax base.78 At the same time, it also strengthened the MID by including Internal Revenue Code § 163(h)(3), which allowed deducting the interest on a loan to purchase or improve a primary or secondary place of residence as long as that loan was secured by the respective property.79 It was not all roses for the housing industry though because the standard deduction was increased and the deduction of other forms of consumer debt was repealed, effectively making the MID useless to households with incomes less than $90,263 in 2013 dollars.80 Nevertheless, if the late-1970’s CBS poll could be instructive, reducing the                                                                                                                           73  New  York  Times,  (1984),  “Stanley  S.  Surrey,  74;Taxation  Law  Expert.”   http://www.nytimes.com/1984/08/28/obituaries/stanley-­‐s-­‐surrey-­‐74-­‐taxation-­‐law-­‐expert.html   74  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  271.   75  Urban  Institute,  (2013),  “Eugene  Steuerle.”  http://www.urban.org/about/EugeneSteuerle.cfm     76  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  272.   77  Ibid.  Pg.  274.   78  Ibid.  Pg.  274.   79  Ibid.  Pg.  274.   80  Ibid.  Pg.  275.    The  original  amount  was  $42,500  given  in  1986  dollars.    
  • 20. 20   number of people who could take advantage of the MID was unlikely to have a significant effect on public opinion. Presidents 41 through 43 and the MID There were no changes to the MID attempted during the four years of President George H.W. Bush’s term between 1988 and 1992. Additionally, in the 16 years that followed with President Clinton and President George W. Bush, the MID continued its basically “untouchable” status. 81 As far as housing was concerned, Presidents 42 and 43 were primarily focused on removing the barriers to homeownership for Americans.82 During President Bush’s second term, he commissioned a “blue-ribbon” advisory panel that created a report entitled, “Simple, Fair and Pro-Growth: Proposals to Fix America’s Tax System.”83 This report suggested that the MID be converted to a credit because the current incarnation of the MID encouraged “overinvestment in housing at the expense of other productive uses.”84 Once again, in spite of well-intentioned and theoretically sound recommendations by the panel, the politics of acting on those recommendations was unappealing even for a second-term president and as a result the recommendations from the report were                                                                                                                           81  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  277.   82  Ibid.  Pg.  276.   83  David  C.  Ling  &  Gary  A.  McGill,  (2007),  “The  Variation  of  Homeowner  Tax  Preferences  by  Income,  Age  and   Leverage.”  Pg.  506   84  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  277.  
  • 21. 21   abandoned. Each and every time the MID came up over the last century, the best politicians could do was tinker with who benefited from the MID. However, each of these modifications only served to make the MID even more “upside-down” than it was before. Heretofore, the politics of reforming the MID have been an insurmountable force to every politician, bureaucrat or academic who has dared to challenge it. Previous Research Before I examine previous research, I believe a definition of the word “subsidy” is needed. According to Merriam-Webster’s Concise Encyclopedia, the term subsidy is defined as: “Financial assistance, either through direct payments or through indirect means such as price cuts and favourable contracts, to a person or group in order to promote a public objective. Subsidies to transportation, housing, agriculture, mining, and other industries have been instituted on the grounds that their preservation or expansion is in the public interest. Subsidies to the arts, sciences, humanities, and religion also exist in many nations where the private economy is unable to support them. Examples of direct subsidies include payments in cash or in kind, while more-indirect subsidies include governmental provision of goods or services at prices below the normal market price, governmental purchase of goods or services at prices above the market price, and tax concessions. Although subsidies exist to promote the public welfare, they result in either higher taxes or higher prices for consumer goods. Some subsidies, such as protective tariffs, may also encourage the preservation of inefficient producers. A subsidy is desirable only if its effects increase total benefits more than total costs.”85 Because a tax expenditure and a “tax concession” can be viewed as being synonymous, the MID will be referred to as a subsidy for the rest of this paper.                                                                                                                           85  Merriam  Webster,  (2013),  “Subsidy.”  http://www.merriam-­‐webster.com/dictionary/subsidy  
  • 22. 22   The literature considered in this review examined positive and negative aspects of the MID and its effect on housing tenure choices as well as considering alternative policies. Literature favoring alternatives to the MID was more abundant than literature defending it. This literature review also explores the basic question of whether the government should intervene in the housing market at all. About halfway into the presidency of President Jimmy Carter, Litzenberger and Sosin (1978) looked into the then-current structure of the MID and compared it to several alternatives such as taxing imputed rent, eliminating the deduction, capping the MID, and providing a tax credit rather than a deduction. 86 87 Their article was one of the first academic investigations into the usefulness of the MID and probably the closest to being neutral to that question of what to do about it. According to their findings, taxing imputed rent would cause more middle-income households to find it “advantageous to rent.” They also found that removing the MID would make renting more expensive in terms of the proportion of income spent on housing. If a cap were placed on the interest of all consumer loans (which was only relevant before TRA86), high-income households would shift to self-financing and everyone else would be unaffected. Finally, they found that if the MID was converted into a credit it would become more of an incentive for lower income individuals to become homeowners while decreasing the subsidy for upper income                                                                                                                           86  See  footnote  50  for  an  explanation  of  “imputed  rent.”   87  Robert  H.  Litzenberger  and  Howard  B.  Sosin,  (1978),  “Taxation  and  the  Incidence  of  Homeownership  Across   Income  Groups.”  Pg.  948.  
  • 23. 23   households in particular. 88 Changing the MID to a tax credit rather than a deduction would also make the income tax code more progressive because a fixed amount of money would be worth less to a household as household income increases. Examining imputed rent is one of the alternatives Litzenberger and Sosin discuss because it acknowledges that homeowners are distinct from rental property owners. The benefit homeowners derive from their homes is not taxed like the income a rental property owner collects from his or her tenants. Ling and McGill (2007), Poterba and Sinai (2008), Ventry (2009), Landis and McClure (2010), Saarimaa (2010), Poterba and Sinai (2011), and Cole, Gee and Turner (2011) also acknowledged this benefit in their research.89 Many of the aforementioned authors, as well as a few others, express varying amounts of skepticism about the MID. Anderson, Clemens & Hanson (2007) state, “it may not be particularly effective in altering the choice between renting and owning.”90 Pierce (1989) suggests that removing it would “increase tax revenues and increase both horizontal and vertical                                                                                                                           88  Ibid.  Pg.  948.   89  David  C.  Ling  and  Gary  A.  McGill,  (2007),  “The  Variation  of  Homeowner  Tax  Preferences  by  Income,  Age  and   Leverage.”  Pg.  505;  James  Poterba  and  Todd  Sinai,  (2008),  “Tax  Expenditures  for  Owner-­‐Occupied  Housing:   Deductions  for  Property  Taxes  and  Mortgage  Interest  and  the  Exclusion  of  Imputed  Rental  Income.”  Pg.  86;  David   J.  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage  Interest.”   Pg.  236,  254;  John  D.  Landis  and  Krik  McClure,  (2010),  “Rethinking  Federal  Housing  Policy.”  Pg.  325;  Tuukka   Saarimaa,  (2010),  “Tax  Incentives  and  Demand  for  Mortgage  Debt:  Evidence  from  the  Finnish  1993  Tax  Reform.”   Pg.  36;  James  Poterba  and  Todd  Sinai,  (2011),  “Revenue  Costs  and  Incentive  Effects  of  the  Mortgage  Interest   Deduction  for  Owner-­‐Occupied  Housing.”  Pg.  540;  Adam  J.  Cole,  Geoffrey  Gee,  and  Nicholas  Turner,  (2011),  “The   Distributional  and  Revenue  Consequences  of  Reforming  the  Mortgage  Interest  Deduction.”  Pg.  978.   90  John  E.  Anderson,  Jeffrey  Clemens  and  Andrew  Hanson,  (2007)  “Capping  the  Mortgage  Interest  Deduction.”  Pg.   769.  
  • 24. 24   equity.”91 Landis and McClure (2010) state, “the primary effect of the mortgage interest deduction and capital gains exclusion has been to inflate housing prices, making homeownership more difficult for less well-off households.”92 Morrow (2012) goes further and says that the MID “fails to increase homeownership, increases housing prices and increases borrowing against equity.”93 Also, because the MID “was instituted at the same time as the federal income tax, we have no direct evidence of how much, if at all, it initially increased rates of homeownership.”94 However, academics are hardly unified in their opposition to the MID. Ling and McGill (2007) argue, “homeowner tax preferences…are not skewed to higher-income households, as is widely believed.”95 Woodward and Weicher (1989) make the argument that “it is inaccurate to characterize the mortgage interest deduction as a subsidy to homeownership” because “the treatment of interest as both taxable and deductible equalizes the cost of debt and the cost of equity in a home, and by implication, equalizes the cost of owning for those who can pay cash and those who must borrow.”96 Woodward and Weicher (1989) go further to state that the additional tax preferences rental property owners receive, such as accelerated depreciation, make the cost of renting less expensive for renters.97 They argue that if individuals were assessed a charge for imputed rent, that charge would only be fair if it were levied against everyone                                                                                                                           91  Bethane  Jo  Pierce,  (1989),  “Homeowner  Preferences:  The  Equity  and  Revenue  Effects  of  Proposed  Changes  in   the  Status  Quo.”  Pg.  65.   92  John  D.  Landis  and  Krik  McClure,  (2010),  “Rethinking  Federal  Housing  Policy.”  Pg.  326.   93  Rebecca  N.  Morrow,  (2012),  “Billions  Spent  Inflating  the  Housing  Bubble:  How  and  Why  the  Mortgage  Interest   Deduction  Failed.”  Pg.  755   94  Ibid.  Pg.  761.   95  David  C.  Ling  and  Gary  A.  McGill,  (2007),  “The  Variation  of  Homeowner  Tax  Preferences  by  Income,  Age  and   Leverage.”  Pg.  508.   96  Susan  E.  Woodward  &  John  C.  Weicher,  (1989),  “Goring  the  Wrong  Ox:  A  Defense  of  the  Mortgage  Interest   Deduction.”  Pg.  301,  302.   97  Ibid.  Pg.  305,  306.  
  • 25. 25   regardless of whether they are financing a home or had the assets to purchase a home outright.98 Unlike the previous authors mentioned before, Woodward and Weicher believe that the MID “ultimately improves the efficiency of taxes on the more affluent, and thus potentially benefits the poor also.”99 To make this claim, more information would have to be known about the relative elasticities of rental property demand and supply. It could also be very possible that the benefits from any efficiency improvements go directly to rental property owners. Additionally, this viewpoint is not consistent with the rationale most commonly provided in defense of the MID. It also has nothing to do with the goal of promoting homeownership. Another article written shortly after the Tax Reform Act of 1986 (TRA86) by Pierce (1989) takes a slightly more nuanced position. She notes that even though the removal or limiting of the MID would create greater horizontal equity between renters and homeowners, it would create a new distortion between those homeowners using a mortgage and those who do not.100 Woodward and Weicher (1989) shared the latter half of that concern.101 I believe it should be noted that there is only a tiny percentage of Americans who are in a position to buy a home without financing. This disparity may also serve to motivate affluent households to become affluent enough to be in that position. Regardless of whether that distortion is real, no deduction that declines in value over time (as illustrated in Table 1) is going to bridge that gulf. Ultimately, Pierce (1989) finds that                                                                                                                           98  Susan  E.  Woodward  &  John  C.  Weicher,  (1989),  “Goring  the  Wrong  Ox:  A  Defense  of  the  Mortgage  Interest   Deduction.”  Pg.  308.    The  authors  appear  to  be  referencing  fairness  in  the  sense  of  “horizontal  equity”,  which   compares  how  people  within  a  particular  income  group  are  treated  relative  to  each  other.    This  is  in  contrast  to   “vertical  equity,”  which  compares  how  individuals  across  varying  income  groups  are  treated  relative  to  each  other.     The  concept  of  vertical  equity  will  be  used  in  comparing  alternatives  to  the  MID  later  in  this  paper.   99  Ibid.  Pg.  311   100  Bethane  Jo  Pierce,  (1989),  “Homeowner  Preferences:  The  Equity  and  Revenue  Effects  of  Proposed  Changes  in   the  Status  Quo.”  Pg.  57.   101  See  footnote  97.  
  • 26. 26   among the various policy options she considers, the ones that reduce or eliminate the MID (and also the deduction for property tax, which is not being considered here) have the ability to raise revenue and improve horizontal and vertical equity.102 Aside from an individual or household’s level of affluence, the amount of benefit derived from the MID is also dependent on the recipient’s age. When repaying a standard 30-year mortgage, it takes years before the principle being repaid is greater than the interest. Unless a household is very affluent and has many other types of deductions, or was compelled to purchase a larger house due to changes in the size of their household, the standard deduction will eventually become more appealing than itemizing. Poterba and Sinai (2008) note that “many older homeowners do not even have a mortgage,” and this makes intuitive sense because older homeowners would generally become more risk adverse and more conscious of their own mortality. 103 Taking on significant new debt under such uncertainty would be less than ideal. This implies the MID really only benefits those who are affluent enough to buy homes and upgrade those properties at a relatively young age. If our society believes encouraging more Americans to become homeowners is a worthwhile goal, this characteristic of the MID does nothing to increase that outcome. Nevertheless, a broader question remains about whether the government should even be involved in trying to encourage homeownership. The second part of the review focuses on this question.                                                                                                                           102  Bethane  Jo  Pierce,  (1989),  “Homeowner  Preferences:  The  Equity  and  Revenue  Effects  of  Proposed  Changes  in   the  Status  Quo.”  Pg.  65.   103  James  Poterba  &  Todd  Sinai,  (2008),  “Tax  Expenditures  for  Owner-­‐Occupied  Housing:  Deductions  for  Property     Taxes  and  Mortgage  Interest  and  the  Exclusion  of  Imputed  Rental  Income.”  Pg.  89.  
  • 27. 27   The Rationale for Government Intervention in the Housing Market From the available congressional records before the creation of the Revenue Act of 1913, it is not apparent that much economic theory was used in the initial drafting of income tax policy or its permitted deductions. Ventry (2010) only found a single reference to mortgage interest in the Senate debate leading up to the passage of the Revenue Act.104 Frederick (2013) points out that: “The Revenue Act of 1913 simply ‘was not clear on many points’ and it lacked the abounding detail and precision of modern tax laws. This imprecision may have been a natural consequence of the fact that the government had ‘not yet developed adequate assessment machinery’ necessary to review, assess, and audit millions of complex tax returns, and was therefore only prepared to process a very simple income tax.”105 Early research into externalities, the benefits or harm experienced by parties external to a transaction, focused on negative externalities.106 The first to do so was Arthur Pigou in the early part of the 20th century.107 In order to address pollution, he recommended taxing polluters to make their private marginal costs more in line the cost polluters impose on society.108 Later on, Ronald Coase looked at the problem of negative externalities and determined that if were little to no transaction costs, a better alternative to taxation would be for the parties to negotiate a                                                                                                                           104  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  241.    Supra  note  55.   105  David  Frederick,  (2013),  “Reconciling  Intentions  with  Outcomes:  A  Critical  Examination  of  the  Mortgage  Interest   Deduction.”  Pg.  48.   106  Gideon  Parchomovsky  and  Peter  Siegelman,  (2012)  “Cities,  Properties,  and  Positive  Externalities.”  Pg.  220.   107  Ibid.  Pg.  221.   108  Ibid.  Pg.  221.  
  • 28. 28   solution.109 The best part of handling externalities in this manner was that it did not matter whether someone had the right to harm or the right to be free from harm.110 However, if the transaction costs of coming to an agreement were not nontrivial, Coase’s Theorem would not hold.111 Harold Demsetz, with a focus on property, then determined that “resources held in common would be over-exploited,” but this problem can resolved if the property belongs to a single private owner.112 Parchomovsky and Siegelman (2012) argue that Demsetz solution does not address “interasset externalities, namely those that are imposed on other asset owners by one's use of one's own asset.” Without discussing whether homeownership imposes positive externalities, negative externalities, or both, interasset externalities best describes what occurs with housing. Interasset externalities make housing more complicated than a purely private good, but are these externalities reason for the government to get involved? Glaeser and Shapiro (2003) examine the possible externalities and separate them into two categories: those derived from living around homeowners and those derived from homeownership.113 The reason there is even a distinction between renters and homeowners is because of principal-agent problem with renters. 114    Renters have been observed to be poor caretakers in the multi-family units they occupy because of free- rider problems and as a result the multi-family units they occupy depreciate much faster than the types of properties occupied by homeowners.115 Renters actually have disincentives to improve                                                                                                                           109  Gideon  Parchomovsky  and  Peter  Siegelman,  (2012)  “Cities,  Properties,  and  Positive  Externalities.”  Pg.  221.   110  Ibid.  Pg.  221,  222.   111  Robert  H.  Frank,  (2010),  “Microeconomics  and  Behavior.”  Pg.  540.   112  Gideon  Parchomovsky  and  Peter  Siegelman,  (2012)  “Cities,  Properties,  and  Positive  Externalities.”  Pg.  222.   113  Edward  M.  Glaeser  &  Jesse  M.  Shapiro,  (2002),  “The  Benefits  of  the  Home  Mortgage  Deduction.”  Pg  37.   114  For  a  detailed  explanation  of  the  “principle-­‐agent”  problem,  see  Susan  P.  Shapiro,  (2005),  “Agency  Theory.”     115  Edward  M.  Glaeser  &  Jesse  M.  Shapiro,  (2002),  “The  Benefits  of  the  Home  Mortgage  Deduction.”  Pg  45,  46.  
  • 29. 29   their respective communities because their rent is not fixed and those improvements would allow the owners charge higher rents.116 Glaeser and Shapiro (2002) also noted that there are positive and negative externalities of homeownership worth considering. For example, homeownership is also “strongly correlated with political activism and social connection.”117 Homeowners are more likely to engage with local groups that try to improve local conditions such as non-profits, neighborhood watches or parent-teacher associations. Homeowners are also much more likely to vote locally and on issues with long-term neighborhood impact, such as the improvement of roads and other infrastructure that would make renting in those same neighborhoods more expensive, vis-à-vis voting for policies that have more of a redistributional bent like income transfers.118 Glaeser and Shapiro (2002) also suggest that if government cares about the well-being of children, housing can be viewed as a positive externality because “children of homeowners are 25% less likely to drop out of school than children of comparable renters.”119 However, on the negative side, once individuals become homeowners, they have very rational incentives to prevent increases in housing supply. Additionally, policies that encourage housing consumption can simultaneously make life in cities more expensive by reducing the number of citizens available to pay for the services they provide.120 As Judd and Swanstrom (2012) note, “Cities cannot simply opt out of                                                                                                                           116  Edward  M.  Glaeser  &  Jesse  M.  Shapiro,  (2002),  “The  Benefits  of  the  Home  Mortgage  Deduction.”  Pg.  60.   117  Ibid.  Pg.  38.   118  Ibid.  Pg.  67,  68.   119  Ibid.  Pg  71.   120  Ibid.  Pg.  57,  58.  
  • 30. 30   their responsibilities. Thus, when cities face budgetary shortfalls [partially created by suburban flight], they walk a tightrope; there is only so much they can cut.”121 One assumption that Litzenberger and Sosin (1978) make in considering the MID is that if the shelter provided from rental housing and from purchasing a home are perfect substitutes, then anyone who is able to meet the down payment requirement (for some requirement greater than or equal to zero) would opt to buy rather than rent.122 Without the presence of some kind of subsidy, whether it is the MID or something else, less middle-income people would be able to afford the homes they buy, while those amongst the very rich would be largely unaffected.123 Even among the authors who are for eliminating the MID, they still advocate for some subsidy that more efficiently promotes homeownership for lower and middle-income segments of the population. Positive externalities are often great candidates for government subsidies, but the MID is not a very cost-effective means for subsidizing those positive externalities created from new home purchases. A Consideration of the Status Quo and Alternatives to the MID The articles considered in the literature review typically ignored the role politics played in the historically unsuccessful attempts to modify the MID. When those authors suggested                                                                                                                           121  Dennis  R.  Judd  &  Todd  Swanstrom,  (2012),  “City  Politics.”  Pg.  344   122  Robert  H.  Litzenberger  &  Howard  B.  Sosin,  (1978),  “Taxation  and  the  Incidence  of  Homeownership  Across   Income  Groups.”  pg.  949,  954.   123  Ibid.  pg.  957.  
  • 31. 31   alternatives, they also typically ignored their political viability. An exception to this is Morrow’s (2012) observation that “politicians wishing to change the level of incentive for homeownership would have to upset the expectations of taxpayers who already own their homes.”124 Another reason the MID has been so resistant to change is that the parties in favor of the status quo are very well organized. Organizations like charities, state and local governments, universities and others who benefit from federal income tax expenditures have often formed coalitions to protect those deductions.125 Even though relatively small proportion of taxpayers actually benefit from the MID, many support it out of the hope that they would be able to benefit from it someday.126 Despite the current focus on austerity brought on by the Great Recession, any policy that does not account for the coalitions seeking to preserve the status quo will fail. In examining alternatives to the MID, this paper will use the following criteria: (1) the effect on the level of tax expenditure; (2) the effect on vertical equity; (3) the likely effect on housing tenure choices; (4) and political feasibility. Table 1 provides a summary of how the status quo and the alternatives rank according to these criteria.                                                                                                                           124  Rebecca  N.  Morrow,  (2012),  “How  and  Why  the  Mortgage  Interest  Deduction  Failed.”  Pg.  781.   125  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  260.   126  Rebecca  N.  Morrow,  (2012),  “How  and  Why  the  Mortgage  Interest  Deduction  Failed.”  Pg.  759.  
  • 32. 32   Table 1 Alternative   Cost   Vertical   Equity   Housing   Tenure   Political   Feasibility   Status  Quo   $69.7   Poor   None   High   Full  Repeal   $13.9127   Good   None   None   Regional  Cap   $62.7128   Fair   None   Low   Homeowners   credit   -­‐$14.9129   Excellent   High   Low   Dollar amounts are given in billions of 2013 dollars. Starting With the Status Quo According to the Joint Committee on Taxation, the estimated cost of the MID is $69.7 billion and is expected to rise annually until it reaches $83.4 billion by 2017.130 This subsidy is currently third most expensive subsidy behind the subsidy for the “exclusion of employer contributions for health care, health insurance premiums, and long-term care insurance premiums” followed by “reduced rates of tax on dividends and long-term capital gains.”131 Approximately, 34 million tax returns currently claim the MID and 76% of the benefit went to households with incomes greater than $100,000. 132 133 However, the $100,000 threshold is not                                                                                                                           127  Adam  J.  Cole,  Geoffrey  Gee,  and  Nicholas  Turner,  (2011),  “  The  Distributional  and  Revenue  Consequences  of   Reforming  the  Mortgage  Interest  Deduction.”  Pg.  991.    According  to  their  results,  portfolio  reallocation  would   offset  revenue  from  repealing  the  MID  by  20%,  which  makes  the  cost  of  repeal  greater  than  simply  subtracting  the   cost  of  the  status  quo.   128  John  E.  Anderson,  Jeffrey  Clemens  and  Andrew  Hanson,  (2007),  “Capping  the  Mortgage  Interest  Deduction.”  Pg.   777.   129  David  C.  Ling  and  Gary  A.  McGill,  (2007),  “The  Variation  of  Homeowner  Tax  Preference  by  Income,  Age  and   Leverage.”  Pg.  536.   130  Joint  Commission  on  Taxation,  (2013),  “Estimates  of  Federal  Tax  Expenditures  for  Fiscal  Years  2012-­‐2017.”  Pg.   33.   131  Joint  Commission  on  Taxation,  (2013),  “Estimates  of  Federal  Tax  Expenditures  for  Fiscal  Years  2012-­‐2017.”  Pg.   38.   132  Brena  Swanson,  (2013),  “Debate  over  mortgage  interest  deduction  shows  a  great  divide.”   http://www.housingwire.com/news/2013/04/25/debate-­‐over-­‐mortgage-­‐interest-­‐deduction-­‐shows-­‐great-­‐divide  
  • 33. 33   adjusted by location, so this statistic can be somewhat misleading. Currently, the average interest rate is 3.57% with 0.8 points, which is almost as low as it has ever been since 1971.134 As the economy continues to rebound, albeit very slowly, it is unlikely that interest rates will remain this low much longer. For some perspective, it is enlightening to recall that back in 1982 the average interest rate was 16.04% with 2.2 points.135 Although those 1982 rates were indicative of another problem with the economy, it is easy to imagine a time where interest rates are double or even triple the current average rate. Depending on the rate of inflation, this could make the deduction even more expensive in the future than current projections would suggest. Persisting with the MID is definitely an expensive policy choice. In order for the status quo to have a positive impact on vertical equity, the benefit would need to increase as household affluence decreases. There is a fairly broad consensus among academics that the MID becomes more valuable as household affluence increases. Table 2 also supports this claim as well. Even authors who support the MID like Woodward and Weicher (1989) do not do so on the grounds that it improves vertical equity, but rather that it does not penalize those who use debt to finance housing relative to households that can self-finance.136 Nevertheless, with more than three-quarters of the Americans who benefit from the MID earning more than $100,000 (twice the national median household income), the status quo ranks the absolute worst in terms of promoting vertical equity.                                                                                                                                                                                                                                                                                                                                                                                                         133  Will  Fischer  &  Chye-­‐Ching  Huang,  (2013),  “Mortgage  Interest  Deduction  Is  Ripe  for  Reform:  Conversion  to  Tax   Credit  Could  Raise  Revenue  and  Make  Subsidy  More  Effective  and  Fairer.”  pg.  1.   134  Freddie  Mac,  (2013),  “30-­‐Year  Fixed-­‐Rate  Mortgages  Since  1971.”   http://www.freddiemac.com/pmms/pmms30.htm   135  Ibid.  http://www.freddiemac.com/pmms/pmms30.htm   136  Susan  E.  Woodward  &  John  C.  Weicher,  (1989),  “Goring  the  Wrong  Ox:  A  Defense  of  the  Mortgage  Interest   Deduction.”  Pg.  308,  309.  
  • 34. 34   Without any changes to the MID, there is no reason to think that housing tenure choices would be affected, positively or negatively, baring some other economic shock. However, several have argued that there is no proof that the MID ever affected the choice between renting and owning because it always existed alongside the income tax.137 Continuing the status quo is definitely the most politically feasible option. Any attempts to change it would be met with the same swift resistance and derision that the Nixon, Carter, Reagan, and Bush administrations faced when they considered altering the status quo. Organizations like the National Association of Realtors and other real estate interests would oppose it because of the evidence that it increases home values, which benefits everyone that builds, sells or finances homes. Baumgartner et al. (2009), stated that one of the most basic challenges anyone seeking to change the status quo faces is how to get the general public to care about an issue, in this case the MID.138 The previously cited 1978 CBS poll and a more recent 2011 New York Times/CBS poll demonstrate that even if only a small percentage of Americans are able to utilize the MID an overwhelming majority do not want to change it, which implies that all previous attempts to get the public to care were unsuccessful. It is also important to note that 33 years later, the proportion who support the MID is virtually unchanged. Although majorities among Democrats and Republicans both favor the MID, the fact that it is slightly less                                                                                                                           137  Rebecca  N.  Morrow,  (2012),  “Billions  Spent  Inflating  the  Housing  Bubble:  How  and  Why  the  Mortgage  Interest   Deduction  Failed.”  Pg.  761.   138  Frank  R.  Baumgartner,  Jeffrey  M.  Berry,  Marie  Hojnacki,  David  C.  Kimball  and  Beth  L.  Leech,  (2009),  “Lobbying   and  Policy  Change:  Who  Wins,  Who  Loses,  and  Why.”  Pg.  44.  
  • 35. 35   popular among Democrats shows there partisan tilt to opposition.139 Other dueling polls from the National Association of Home Builders (NAHB) and the National Low Income Housing Coalition (NLIHC) found that Americans both want to preserve the MID as it is and want to modify the MID to make it fairer to lower-income households. 140 141 The NAHB also reported that two-thirds of their respondents would be less likely to support a candidate who attempt to eliminate or modify the MID.142 Although the polls from the NAHB and NLIHC are likely to be more biased than the CBS polls, the results do demonstrate that a clear majority supports the MID and only a small minority would do things differently. Given that this position is also supported by well-organized interest who also benefit from tax expenditures, the status quo is the most politically feasible. In pursuing alternatives, it would appear that comparing costs between the status quo and any proposed alternatives would be as simple as examining whether they cost more or less than the $70-83.4 billion range of continuing the way things have been. However, such a comparison is not that straightforward. After all, any change that affects after-tax income can have profound effects on economic behavior depending upon where an individual falls within the American income and wealth continuum. For the purposes of this paper, the following alternatives will be considered: (1) a complete repeal of the MID without a replacement policy; (2) a cap on the                                                                                                                           139  Brian  J.  McCabe,  (2011),  “Despite  Benefit  Disparities,  Middle  Class  Supports  Mortgage  Deduction.”     http://fivethirtyeight.blogs.nytimes.com/2011/07/13/despite-­‐benefit-­‐disparities-­‐middle-­‐class-­‐supports-­‐mortgage-­‐ deduction/   140  Rick  Judson,  (2013),  “Keep  Homeowners'  Tax  Deductions:  Opposing  view.”     http://www.usatoday.com/story/opinion/2013/04/02/mortgage-­‐tax-­‐deduction-­‐editorials-­‐debates/2047927/     141  Amy  Clark,  (2012),  “New  Poll  Highlights  Broad  Support  for  Modifying  Mortgage  Interest  Deduction,  Funding   Affordable  Housing.”  http://nlihc.org/press/releases/1937     142  Brian  J.  McCabe,  (2011),  “Despite  Benefit  Disparities,  Middle  Class  Supports  Mortgage  Deduction.”     http://fivethirtyeight.blogs.nytimes.com/2011/07/13/despite-­‐benefit-­‐disparities-­‐middle-­‐class-­‐supports-­‐mortgage-­‐ deduction/  
  • 36. 36   amount of mortgage interest a household can deduct, adjusted for regional cost of living; and (3) a complete repeal of the MID that would be replaced with 15% tax credit on mortgage interest up to $25,000 regardless of marginal tax rate.143 Repealing the MID One of the arguments commonly made in favor of the MID is that it boosts levels of homeownership, but there is a large body of research to the contrary. Americans who claim the largest MIDs probably would have bought the same house in its absence. However, it may be the case that affluent households would shift from bank financing to self-financing in varying degrees depending on relative wealth, which would decrease might decrease tax revenue from other investments such a household might have held.144 In many respects, the effect of repealing the MID would almost be the exact opposite of maintaining the status quo. Additionally, relative to the other alternatives discussed in this paper, only repealing the MID and replacing it with a tax credit would have a larger impact on cost. The first change over the status quo is the cost to the federal government. Almost immediately, the government would have recovered $55.8 billion dollars and would avoid the projected                                                                                                                           143  This  alternative  is  slightly  less  aggressive  than  the  credit  suggested  by  the  2005  President’s  Advisory  Panel  who   recommended  that  the  cap  be  reduced  to  FHA  limits  over  5  years.    However,  because  it  is  independent  of  a   household’s  marginal  rate,  it  would  mean  less  to  more  affluent  households.    John  E.  Anderson,  Jeffrey  Clemens  &   Andrew  Hanson,  (2007),  “Capping  the  Mortgage  Interest  Deduction.”  Pg.  776;  Rebecca  N.  Morrow,  (2012),  “Billions   Spent  Inflating  the  Housing  Bubble:  How  and  Why  the  Mortgage  Interest  Deduction  Failed.”  Pg.  800.   144  Tuukka  Saarimaa,  (2010),  “Tax  Incentives  and  Demand  for  Mortgage  Debt:  Evidence  from  the  Finnish  1993  Tax   Reform.”  Pg.  21,  22;  Adam  J.  Cole,  Geoffrey  Gee  and  Nicholas  Turner,  (2011),  “The  Distributional  and  Revenue   Consequences  of  Reforming  the  Mortgage  Interest  Deduction.”  Pg.  988.  
  • 37. 37   growth of the MID due to tax bracket creep.145 Although the MID has little effect on increasing homeownership, it is true that some people, especially younger affluent (but not rich) people, would see their disposable incomes decrease in such a way that it has a somewhat negative effect on the overall economy. Conversely, research by Follain and Melamed (1998) suggest that: “Elimination of the MID would induce households to refinance their homes, substituting equity for debt. Taking this portfolio shuffling into account, they estimate that elimination of the MID would add only $10 billion in additional revenue each year.”146 Additionally, repealing the MID would remove what has been previously described as an “upside down subsidy.” This characterization is not hyperbole because larger loans are granted on the basis of ability to pay and assuming a conventional 30-year loan with a loan to value (LTV) ratio of 80%, the column “1st Year Interest” in Table 2 illustrates how much more interest a household pays as the cost of a home increases. The amount of subsidy a household receives from the MID is also impacted by the household’s marginal tax rate. Repealing the MID would have a positive effect on vertical equity by restoring some of the progressivity embedded within the nation’s income tax code. It would increase the extent to which households that earn more income pay more in taxes, which is what makes our income tax progressive. Cole, Gee and Turner (2011) state that repealing the MID would have “the biggest                                                                                                                           145  Adam  J.  Cole,  Geoffrey  Gee  and  Nicholas  Turner,  (2011),  “The  Distributional  and  Revenue  Consequences  of   Reforming  the  Mortgage  Interest  Deduction.”  Pg.  991.   146  John  E.  Anderson,  Jeffrey  Clemens  &  Andrew  Hanson,  (2007),  “Capping  the  Mortgage  Interest  Deduction.”  Pg.   769.  Supra  note  1.  
  • 38. 38   effects on high-income taxpayers and taxpayers who are married, have children, and live in expensive housing markets.”147 Removing the MID would marginally reduce the cost of buying a home because “the MID lowers the cost of capital for housing, which will translate into higher home prices in areas where housing supply is relatively inelastic.”148 The extent of this housing price reduction has been estimated to be “between two and 13 percent.”149 Table 2 Home  Price   LTV   Amount   Financed   1st  Year   Interest   1st  Year   Principal   2nd  Year   Interest    $100,000     0.8    $80,000      $(2,711.76)    $(1,556.32)    $(2,605.98)    $200,000     0.8    $160,000      $(5,423.51)    $(3,112.64)    $(5,211.97)    $250,000     0.8    $200,000      $(6,779.39)    $(3,890.79)    $(6,514.96)    $300,000     0.8    $240,000      $(8,135.27)    $(4,668.95)    $(7,817.95)    $400,000     0.8    $320,000      $(10,847.02)    $(6,225.27)    $(10,423.94)    $500,000     0.8    $400,000      $(13,558.78)    $(7,781.59)    $(13,029.92)    $750,000     0.8    $600,000      $(20,338.16)    $(11,672.38)    $(19,544.88)    $1,000,000     0.8    $800,000      $(27,117.55)    $(15,563.18)    $(26,059.84)   This table illustrates how much interest an individual or household pays in the first two years and how this varies depending on the amount of the loan.150                                                                                                                           147  Adam  J.  Cole,  Geoffrey  Gee  and  Nicholas  Turner,  (2011)  “The  Distributional  and  Revenue  Consequences  of   Reforming  the  Mortgage  Interest  Deduction.”    Pg.  986.   148  Adam  J.  Cole,  Geoffrey  Gee  and  Nicholas  Turner,  (2011)  “The  Distributional  and  Revenue  Consequences  of   Reforming  the  Mortgage  Interest  Deduction.”  Pg.  987.   149  Ibid.  Pg.  987.   150  An  interest  rate  of  3.42%  was  used  based  on  the  overnight  average  rate  ascertained  by  visiting  bankrate.com  on   May  5,  2013.    The  LTV  of  80%  was  chosen  as  the  typical  amount  financed  under  a  conventional  mortgage.  
  • 39. 39   In contrast to the status quo, the political feasibility of repealing the MID would be the lowest. This alternative starts out with approximately 90% of the electorate against it. Organizations like the National Association of Realtors and NAHB would be instantly and vehemently against this policy and would probably be rejoined by organizations like universities, State and local governments, charities and organization that represent medical interests like the American Medical Association, as they have in the past.151 Homeownership is a fundamental part of the American Dream and because of belief systems like the Protestant work ethic, many American probably feel that homeowners are entitled to whatever benefits they can claim. Considering that there are so many Americans who do not benefit (and will probably never benefit) from the MID who still favor its preservation, it is hard to imagine what organized coalition could be formed to counteract such a well-organized group. In the 100 years since the institution of the federal income tax, no such coalition has developed. A Regionally-Based Cap on the MID TRA86 created a one million dollar cap on the MID and although that cap has not been adjusted for inflation since then, a million dollars is still significantly more than most Americans will ever spend on a home purchase. 152 However, it “will affect more mortgages over time as home-price                                                                                                                           151  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  260.   152  Dennis  Ventry,  Jr.,  (2010),  “The  Accidental  Deduction:  A  History  and  Critique  of  the  Tax  Subsidy  for  Mortgage   Interest.”  Pg.  275.