Most Inane Deduction? The mortgage interest deduction is popular, but it has numerous distorting effects on the economy – and economists also say that it does exactly the opposite of what people think.
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Most Inane Deduction?

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Most Inane Deduction?

Most Inane Deduction?

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(SOUNDBITE OF DROP ELECTRIC SONG, "WAKING UP TO THE FIRE")

CARDIFF GARCIA, HOST:

Hey, everyone. Welcome to THE INDICATOR, where every day we tell you a short story about the economy. I'm Cardiff Garcia.

STACEY VANEK SMITH, HOST:

And I'm Stacey Vanek Smith. Today's short story is about a tax break that is really popular. Even people who do not use it like it. It is also a tax break that economists on both the left and the right absolutely hate.

GARCIA: It's the mortgage interest deduction.

VANEK SMITH: (Singing) Duh-da-da-duh (ph).

GARCIA: People with mortgages can deduct the interest they pay on those mortgages from their incomes when they're doing their taxes. So they pay less in taxes.

VANEK SMITH: And if you own a home, there is a chance you have used it. Today's Planet Money INDICATOR is 32 million. Thirty-two million Americans claimed the mortgage interest tax deduction last year.

GARCIA: Now, in the popular imagination, the mortgage interest deduction is a policy that makes sense - homeownership, the American dream.

VANEK SMITH: Yes, it is.

GARCIA: What could be better? So...

VANEK SMITH: Nothing.

GARCIA: ...Why not let Americans save a little money when they take out a mortgage so that more people can afford to buy a house? Sounds good. Right?

VANEK SMITH: Like apple pie.

GARCIA: Wrong.

VANEK SMITH: No (laughter).

GARCIA: It is terrible, terrible policy.

VANEK SMITH: The worst.

GARCIA: IMHO - in my humble opinion.

VANEK SMITH: (Laughter).

GARCIA: Also an opinion shared by many, many economists. And we're going to tell you some of the reasons why they dislike it so much right after the break.

Until last year, people could deduct the interest on their mortgage loans for mortgages up to a million dollars. That was the cap, a million dollars. But the tax plan passed by Republicans in December lowered that cap to $750,000. So the overall amount - the dollar amount of the deduction taken this year will be smaller.

VANEK SMITH: And the tax bill also raised the standard deduction that people can take on their tax returns. So fewer people will probably claim the mortgage interest deduction because, at least for some people, the standard deduction will now be bigger.

GARCIA: These are pretty big changes, by the way. The mortgage interest deduction obviously still exists, but the tax bill did take a pretty good whack at it. Bill Emmons is a senior economist at the Federal Reserve Bank of St. Louis. He does not much like the mortgage interest deduction. But like a good economist, he also doesn't lapse into hyperbole - unlike me.

VANEK SMITH: (Laughter).

GARCIA: So worst tax break ever according to economists?

BILL EMMONS: I don't know if it's the worst, but it ticks a lot of boxes for being poorly designed.

VANEK SMITH: Oh, he's so gracious.

GARCIA: That's very sober of him.

VANEK SMITH: He's so gracious.

GARCIA: I should note quickly that Bill says he's speaking for himself, not for the St. Louis Fed.

VANEK SMITH: Listen, Yahoo...

(LAUGHTER)

VANEK SMITH: ...Bill says there are several ways in which the mortgage interest deduction is a problem for the economy. First, it means the government collects a lot less money in tax revenue. By one estimate, last year, it cost the government $60 billion.

GARCIA: Not only that but the tax break tends to go to people who already make a decent amount of money. So in fact, last year, 85 percent of the money that people saved by using the mortgage interest deduction went to households that make more than a $100,000 a year.

EMMONS: It's also the case that many people don't get any benefit at all. And it's primarily lower-income people who get no benefit at all.

GARCIA: And that's because lower-income people are less likely to own homes - right? - to get mortgages.

EMMONS: And also, among low-income homeowners, much less likely to itemize their tax returns. That's the only way to collect this deduction.

VANEK SMITH: Another big problem, says Bill, is that the mortgage interest deduction incentivizes people to buy bigger, more expensive homes.

EMMONS: The existence of this deduction encourages people to have bigger houses and bigger mortgages. And those bigger houses tend to need more land.

GARCIA: Bill says that the mortgage interest deduction, therefore, keeps house prices overall higher than they otherwise would be. Since people know they can deduct their interest, they just end up buying bigger houses rather than using the deduction to just save more money on the house they would've bought otherwise. So these bigger houses obviously take up more space. And so the deduction also contributes at least a little bit, Bill thinks, to more urban sprawl.

EMMONS: As this game goes on, more of the available funds in the economy are being funneled into building these bigger houses, taking money away from possibly more productive uses and, say, business investment.

VANEK SMITH: And finally, since the mortgage interest deduction encourages people to take out bigger mortgages - bigger loans, it makes things worse when the economy takes a bad turn.

EMMONS: Now, the problem with that, as we learned in the housing boom and bust, is that mortgage debt is risky. Things happen. Bad things happen. Sometimes people aren't able to pay that mortgage. And if there's a very, very large mortgage - say, 80 percent, 90 percent, 95 percent of the value of the house - the margin of error, or the margin of safety, is very, very narrow.

VANEK SMITH: We saw this during the financial crisis, when so many people lost their homes in foreclosures because they could not afford their mortgage payments. And those effects crippled the entire U.S. economy.

GARCIA: So to sum up, the mortgage interest deduction is a big tax deduction that mostly benefits people that already make a lot of money. It's responsible for making houses bigger and more expensive, and it leaves people more vulnerable to economic recessions. But guess what. It gets worse. There's a kicker here.

VANEK SMITH: But wait - there's more.

GARCIA: There is more.

VANEK SMITH: Bill points to new research from earlier this year by economists at the Federal Reserve showing that the mortgage interest deduction doesn't even do the one thing that people think it's good for. It does not lead to more people having homes. It does the exact opposite, actually. Since the mortgage interest deduction leads to higher home prices, it actually reduces the home ownership rate because some people cannot afford those higher prices.

EMMONS: Some estimates suggest that the homeownership rate may be pushed down by as much as 5 percentage points because of the mortgage interest deduction.

GARCIA: Five percentage points - that's a lot of people.

EMMONS: Yes, it is. In fact, that amount is almost the same amount as the homeownership rate actually dropped from the peak before the bubble burst and near the trough.

GARCIA: I just want to riff on this last point...

VANEK SMITH: Yeah.

GARCIA: ...That Bill made first second. OK? We consider the financial crisis to have been, like, this world historical event - this event that caused...

VANEK SMITH: Yeah.

GARCIA: ...So many people pain and suffering. And one of those enormous effects was that all these people lost their homes, to the point where the homeownership rate overall dropped by about 5 or 6 percentage points. And what Bill's saying here is that this policy has the same effect. But because it doesn't happen all at once, we maybe don't see it.

VANEK SMITH: The mortgage interest deduction has had the same effect on homeownership that the financial crash did - that the housing crisis did?

GARCIA: According to these estimates...

VANEK SMITH: Wow.

GARCIA: ...Signed by Bill, yes. That's exactly right. So like, it's had the same kind of insidious effect. We just don't recognize it. Right? It's kind of amazing. I mean, it's just - it's speculative. These are estimates, but it is amazing. So like I said - yeah, worst tax break ever.

VANEK SMITH: (Laughter).

GARCIA: Still, Bill sees at least one point of optimism here. Economists have been banging their heads about how awful the mortgage interest deduction is for years. And it seemed like it would never change, but it did change. It's not gone yet, but the cuts to the mortgage interest deduction in last year's tax plan were at least a sign that maybe all those economists weren't banging their heads for nothing.

This podcast is produced by Darius Rafieyan. And also, if you want to look at the research that we cited in this episode, we are including it at npr.org/money.

(SOUNDBITE OF DROP ELECTRIC SONG, "WAKING UP TO THE FIRE")

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