The Mortgage Deduction Isn't a Subsidy
Interest deductions have gotten some bad press lately. A few weeks ago over at The Weekly Standard, for example, Ike Brannon savaged the mortgage-interest deduction (MID). He argued that the MID is a subsidy for home buying and overwhelmingly benefits higher income taxpayers. More recently, The Economist embraced the same argument in a cover story — extending it to business-loan interest deductibility as well.
Accept the first part of this argument — that interest deductions are subsidies — and the second part, that they disproportionately benefit the rich, is sure to provoke outrage. Happily, the first part is wrong.
The truth is that, as long as lenders pay taxes on the interest they receive, interest deductions subsidize nothing. They simply prevent a distortion in the market that would harm the economy profoundly. The absence of a penalty is not a subsidy.
The key to understanding how deductions work is to remember that lenders raise the interest rates they charge to cover the cost of their tax bill. In other words, their tax liabilities are baked in the cake of their interest rates. If they did not do this, the return on the loan would not be sufficient to compensate them for the risk of making it and they would be unwilling to lend the money.
If you doubt that lenders incorporate the tax liabilities into the interest rates they offer, just look at the difference between similarly risk-rated corporate bonds and municipal bonds with identical maturities. Interest on corporate bonds is taxable to lenders; interest on municipal bonds is not. The spread between the two rates is almost exactly equal to the tax levied on lenders to corporations.
Interest deductions for borrowers create symmetry, rendering the lending-borrowing decision tax neutral. Where the tax rate of lenders and borrowers is equal, the value of the interest deduction equals the extra amount of interest borrowers pay to cover the lenders’ tax liability. This leaves borrowers paying the net amount of interest they would have paid had income tax never been levied on their lender — and leaves them equally willing to take the loan as they would in a non-tax world.
For a more detailed explanation of how the numbers work out, see this paper. (I can also furnish a mathematical proof if you require one, or if you are having trouble sleeping.)
Where lenders’ interest income is taxable, interest deductions are necessary to keep the tax code from interfering in the lending-borrowing decision. Thus, interest deductions are not subsidies, and policies like the MID should not be considered tax expenditures.
This also means that concern over the MID’s distributional impacts (the second part of Brannon’s argument) is pointless. When a policy serves only to keep the tax code from creating a costly distortion, who receives how much of it is irrelevant. It is simply protecting those who receive it from being unfairly penalized.
Unfortunately, bad press for interest deductions seems destined to continue. The misconception that the MID is a no-good giveaway to the rich, and that businesses’ interest deductions are akin to corporate welfare, have been around so long that they are firmly ingrained in the psyche of many tax-policy pundits.
But good tax policy demands a thorough understanding of the economics that underlie the principles of taxation. That’s why defenders of sound policy — like interest deductions — need to remain ever vigilant, lest Washington begin to believe the myth as well.
Curtis Dubay is a research fellow specializing in tax and economic policy at the Heritage Foundation’s Roe Institute for Economic Policy Studies.