Almost everyone agrees the tax code must be cleaned up, many credits, exclusions, deductions and other breaks limited or removed. In that way, a broader base allows for keeping rates lower. The effort also invites a more productive economy, the deployment of resources less skewed.
With the approaching “fiscal cliff” and the search for compromise between Republicans and Democrats, the Metropolitan Policy Program at the Brookings Institution has been at the lead in seeking to explain how tax reform could work effectively. Its recent proposal concerning the tax deduction for mortgage interest is instructive, revealing the sound thinking behind a change and the potential for helping to reduce the federal budget deficit and boost the economy.
The Brookings proposal reminds that a key flaw in the economy, exposed in the harsh recession, is the excessive reliance on consumption for growth. Now is the opportunity for an altered model, one fueled more heavily by investment in human capital, innovation and public works, especially in cities and metropolitan regions. Brookings sees tax reform serving as a vehicle for making the shift, generating the new and necessary investment.
The proposal identifies the mortgage interest deduction as a “worst offender” in the too consumption-driven economy. The tax code currently allows taxpayers who itemize their deductions to deduct the interest paid on the first $1 million of a home mortgage, for either a primary or second residence. In addition, a taxpayer can deduct up to $100,000 for a home-equity loan. The deduction has been around since 1913, and long has been touted as a way to promote homeownership.
What Brookings notes is that the mortgage deduction has become one of the largest tax breaks, the federal government forgoing $100 billion a year, and climbing. Projections are the deduction will cost $606 billion in revenue between 2013 and 2017. More, as the proposal stresses, the deduction fails largely in meeting its purpose.
Brookings points to the numbers. Since 1950, the homeownership rate has fluctuated between 63 percent and 68 percent. Several countries with similar rates do not have such mortgage subsidies. Consider Canada at 69 percent and Britain at 71 percent. The analysis further explains the deduction mostly benefits wealthier households. It also tends to benefit the West and East coasts, pushing up housing prices where the supply is limited.
How best to alter the mortgage deduction? Brookings cites the work of the bipartisan deficit-reduction commissions, lowering the mortgage limit, say, to $500,000, erasing the deduction for second homes and shifting the relief to a tax credit. That final step would make the deduction more equitable. Or the mortgage deduction could be part of an overall limit on itemized deductions for taxpayers, as Mitt Romney suggested.
The point is, here is a way to raise an estimated $378 billion to $790 billion over 10 years, directing a large share to deficit reduction and leaving a significant portion for investment, for instance, to make permanent the tax credit for research and development or to establish a national infrastructure bank. That won’t be easy in view of the powerful interests that support the mortgage-interest deduction. Yet it is a way to make the economy stronger.