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Is the Mortgage-Interest Deduction Really A Middle-Class Tax Break?

Over in the comments section for our editorial about the deficit commission, several readers have taken umbrage with our claim that the mortgage-interest deduction overwhelmingly favors the wealthy. One makes his case by citing this paragraph from a recent Paul Krugman column:

Actually, though, what the co-chairmen are proposing is a mixture of tax cuts and tax increases — tax cuts for the wealthy, tax increases for the middle class. They suggest eliminating tax breaks that, whatever you think of them, matter a lot to middle-class Americans — the deductibility of health benefits and mortgage interest — and using much of the revenue gained thereby, not to reduce the deficit, but to allow sharp reductions in both the top marginal tax rate and in the corporate tax rate.

Were we way off the mortgage-interest deduction? In short, no—unless you use a broad definition of what composes the middle class. Take a look at the top half of this chart from a Tax Policy Center report (pdf), which shows the impact of eliminating the mortgage-interest deduction:

If we get rid of the mortgage-interest deduction, about 22 percent of people in the 40th through 60th income percentiles will pay higher taxes —on average $215 a year, or about half a percent of current after-tax income. For those in the 60th through 80th percentiles, only 45 percent would see their taxes go up—by an average $689, about 1 percent of after-tax income. While there are tax hikes, they’re fairly small in relative terms, and what’s more, less than half of people in these income groups would have to pay them. And below the 40th percentile, almost no one would be affected by repealing the mortgage-interest deduction.

The impact is more substantial farther up the earnings ladder. In the 90th through 95th percentiles, for example, 74 percent of people would see their taxes rise, costing them an additional $2,643 per year on average, about 1.75 percent of their after-tax income. It’s true that repealing the deduction would (in relative terms) have only a small impact on the top 1 percent of earners, but that’s largely because, as AaronW noted in the comments thread, “for the truly wealthy, mortgage debt is a much smaller proportion of their income than for middle income earners.”

From the numbers above, it’s clear that the benefit derived from the deduction is almost perfectly increasing with income. Low- and middle-earners are less likely to itemize their returns, which makes them unlikely to benefit from the mortgage-interest deduction. And because they make less money, they pay taxes in a lower bracket—meaning that every dollar in deductions reduces their tax bill by less than it would for someone in a higher bracket. Calling the mortgage-interest deduction a middle-class tax break essentially requires us to define someone in the 80th or 90th percentile of earnings as middle class. But they’re not; when you make more than 80 percent of the country, you’re rich, even if you don’t want to admit it.

But even if we believe the federal government should be incentivizing homeownership (which I’m not sure I do), the mortgage-interest deduction is one of the worst possible ways to do it. As Jonathan Cohn noted last week, it provides a bigger benefit to people who buy more expensive homes. And if a person making $40,000 a year and a person who makes $100,000 a year buy homes with the same price, the high-earner gets a bigger tax break. How does that make any sense if the goal is to encourage homeownership? It doesn’t, and in fact, there is a wide body of research suggesting that the mortgage-interest deduction does nothing to increase homeownership rates.

There are better options, many of which are detailed in the Tax Policy Center report I linked earlier. We could, for example, replace the deduction with a tax credit for a certain fraction of interest paid. This approach would equalize the benefits high- and low-earners receive, but it would still incentivize purchasing larger homes. Another proposal is to just create a flat, refundable homeowner’s credit, which would make homeownership more affordable while treating poor and rich alike and without pushing people to buy huge houses.

The mortgage-interest deduction is inequitable, ineffective and inexpensive. There’s no (policy-based) reason to keep it when superior alternatives exist.