A realistic gambit on tax reform

Everyone knows the current federal tax code is a complicated mess. It is full of targeted tax preferences, deductions, credits, and loopholes, while at the same time it is plagued with high marginal rates. The status quo is a good arrangement for lawyers, accountants and lobbyists, but it has hamstrung the broader economy. From tax reform during the Reagan administration to a recent iteration authored by former Senate Finance Committee Chairman Max Baucus (D-Mont.) and former House Ways and Means Committee Chairman Dave Camp (R-Mich.), all serious proposals begin from the simple premise of eliminating exemptions, deductions and credits while lowering marginal rates. That is the crux of every Republican presidential candidate’s tax plan, virtually all of which would be superior to the status quo.

{mosads}Though every candidate who has released a tax plan proposes to eliminate the vast majority of deductions, only three of the legitimate contenders for the Republican presidential nomination, Ben Carson and Sens. Marco Rubio (Fla.) and Ted Cruz (Texas), have courageously proposed reforming a sacred cow of the tax code: the mortgage interest deduction. Despite what false prophets on the fringes of American politics say, public policy remains the art of the possible. That is why Carson’s proposal to completely eliminate the mortgage interest deduction is a nonstarter. What may be possible, however, is limiting the deduction as part of a broader tax reform package, which is what both Rubio and Cruz have proposed.

Current law provides that married couples filing jointly can deduct the interest they pay annually on the first $1 million of mortgage debt for principal residences and second homes ($500,000 for individuals and married filing separately). Rubio’s tax plan, authored with Sen. Mike Lee (R-Utah), would limit the deduction to the first $300,000 of the debt used to acquire a residence. Meanwhile, Cruz’s tax plan would cap the mortgage interest deduction for the first $500,000 on the acquisition debt. Each plan would more than offset the loss of a portion of the deduction with tax cuts elsewhere in the code.

Along with creating a more efficient tax code, Rubio and Cruz’s plans to limit the mortgage interest deduction have the added benefit of helping to stabilize our broken housing finance system that was badly exposed during the 2008 financial crisis.

Unscrupulous behavior and shoddy private sector underwriting standards coupled with bad public policy – from the Federal Reserve, to the Department of Housing and Urban Development, to the tax code – brought the financial sector to the brink of collapse and left many Americans without work.

From major Wall Street institutions to homeowners, excessive leverage was a primary cause of the financial crisis.  Though far from the only – or even the primary – culprit, the mortgage interest deduction certainly played a role in the housing market collapse. For starters, it helped fuel the skyrocketing homes prices in the lead up to the crisis. In addition, the deduction favors debt over equity. As a result, many homebuyers put little money down and had extremely high loan-to-value ratios. With little skin in the game, once prices fell homeowners simply defaulted on their obligations and walked away.

Proponents of the current tax preference for mortgage interest argue that eliminating the deduction would decimate the housing market. Yet a 2014 article by economists Andrew Hanson, Ike Brannon and Zackary Hawley published in National Affairs found, “empirical studies have made it reasonably clear that [the mortgage interest deduction and the deduction for property taxes] do not appreciably increase the home-ownership rate.”

One thing the current mortgage interest deduction does encourage is the purchase and construction of larger homes. The same National Affairs article stated that “the mortgage-interest deduction … encourages the purchase of larger homes by people who would otherwise own smaller ones. Estimates show that the generosity of this deduction alone increases the average size of homes by between 11 percent and 18 percent.”

Immediately capping the mortgage interest deduction at $500,000 or $300,000 would disadvantage those who purchased their homes with the expectation of receiving preferential tax treatment. To be more workable and politically palatable, Rubio and Cruz ought to consider phasing in the cap over a period of years. A gradual phase in would allow mortgagors to pay down additional principal while still benefiting from the deduction. 

The current tax treatment of mortgage interest does little to increase homeownership, but does provide incentives to those who can already afford to buy to purchase larger homes. Using revenues generated by capping the deduction to lower marginal rates elsewhere in the tax code would be a major boon to the economy and it could help stabilize our housing finance system. By targeting the mortgage interest deduction as part of a broader effort to lower tax rates, Rubio and Cruz are staking out a politically risky – but ultimately correct – policy position.  Other candidates should take note. 

Packard is Policy and Government Affairs manager at the National Taxpayers Union.