A Clever Case for the Mortgage Deduction
[Update: Dubay responds here.]
Heritage's Curtis S. Dubay writes:
The deduction has been in the tax code since the income tax began in 1912 because it is essential to maintain the neutrality of the tax code. In fact, the original tax code allowed a deduction for all personal interest expenses, not just mortgage interest. This is sound policy because all interest expenses should be deductible to borrowers if the interest income is taxable to the lenders.
Lenders pay tax on the interest earned from loaning money to borrowers. Today, lenders pay a 35 percent federal corporate tax rate on their interest earnings. ... Because lenders seek a certain after-tax return for taking the risk of making loans, they build the cost imposed on them by taxes directly into the interest rates that they charge.
All else equal, because the taxes cause lenders to raise interest rates, borrowers take fewer mortgages. This would violate tax neutrality because taxes would negatively influence the amount of investment in housing. However, the higher interest rate does not deter borrowers from taking a mortgage, because the MID reduces borrowers’ tax liabilities by the exact extra amount that their interest expense rises because of the tax on lenders.
Two questions from a non-economist, though.
First, if we balance out the bad incentives of taxes by handing out tax breaks in the "exact extra amount" charged to cover the tax, aren't we defeating the purpose of taxation, which is to raise money? (It's not always the exact amount, given our progressive tax system, but in a sidebar Dubay makes clear he sees this as a problem.)
And second: Why is it that the government should give me a tax break to even out the incentives of the corporate tax when I pay interest on a home loan, but not when I buy a different product or service whose price has been pushed up in this manner? Wouldn't the tax code be closer to neutral if it discouraged all economic activity equally?
Perhaps we should repeal the corporate tax entirely, but I don't understand why we'd keep it while canceling it out in this selective manner.
Robert VerBruggen is editor of RealClearPolicy. Twitter: @RAVerBruggen