This post originally appeared at Neighborhood Effects, a Mercatus Center blog where we write about the economics of state and local policy.
We’ve already explored Governor O’Malley’s proposal for the Maryland budget here and here, but recently, a perhaps unintended consequence of the budget came to light. By limiting the deduction that residents earning over $100,000 can make on their state income taxes, the proposed budget would limit the size of the mortgage interest tax deduction for many taxpayers.
I stand by my earlier argument that reducing deductions for only one group of people is not a step in the direction of fairness, but a reduction in the mortgage interest tax deduction may be a positive side effect of an otherwise bad policy. From a limited-government perspective, the obvious downside of a reduction in the mortgage-interest tax deduction is that this represents a revenue-positive change in Maryland’s tax code in a state that already has one of the highest tax burdens in the country. Overall though, I think reducing this tax expenditure is a positive change because the policy has many negative consequences.
While the causes of the financial crisis were many, by subsidizing investment in homes, the mortgage interest tax deduction played some part in the overvaluation of housing stock. Aside from the poor incentives that this tax expenditure creates in financial markets, it amounts to favoritism of suburbs over cities. In Triumph of the City, Ed Glaeser argues that the deduction leads many people to abandon renting in a city center for homeownership in the suburbs. However the Federal Reserve Bank of Boston provides evidence that the policy is more likely to lead people to buy larger homes than they otherwise would rather than trading renting for buying a home. Richard K. Green and Andrew Reschovsky write:
If one set out to design a policy to encourage homeownership, it would make sense to target the
largest subsidies to the households least likely to be homeowners, while providing little or no subsidy to
households likely to become homeowners even without a subsidy. Data from countries that do not
subsidize homeownership (such as Canada, Australia, and Japan) indicate, not surprisingly, that
homeownership rates rise with household income. This suggests that a policy to encourage
homeownership should give the largest incentives to households with modest incomes and no subsidies
to high-income households.
The MID, however, does exactly the opposite. For low- to middle-income taxpayers, the mortgage
deduction provides little financial incentive to abandon renting for homeownership. For those
purchasing modestly priced houses and facing the lowest marginal tax rate (currently 10 percent) the
benefits of the mortgage deduction are small. In fact, for households with low state income taxes, the
mortgage deduction may be of no value at all, because the mortgage deduction, even when combined
with other itemized deductions, may be smaller than the standard deduction.
For most high-income taxpayers, the tax savings resulting from the MID are a minor influence on
their decision to become homeowners; these households are likely to own a home regardless of the tax
treatment of housing. Rather than encouraging homeownership among high-income households, the
MID provides an incentive to buy a larger house and to take out a bigger mortgage. Economists have
long argued that the result is an inefficient pattern of investment, with too many resources invested in
housing and too few resources placed in more productive investments in factories and machinery (Mills,
1989; Poterba, 1992).
This analysis ignores that those at the margin of being least likely to be homeowners are likely the riskiest loan candidates and those most likely to foreclose, but they do make a strong case for why the MID leads to larger homes. Regardless of whether the deduction primarily increases homeownership or leads to larger houses, it results in a subsidy for suburban sprawl and its negative side effects of traffic congestion and demand for public services across a wider geographic area.
Unsurprisingly, the Maryland Association of Realtors is strongly opposed to a budget that would lead to lower tax expenditures on housing. The current policy directly subsidizes their industry. The Washington Post reports:
The Greater Capital Area Association of Realtors says that mortgage interest and property taxes account for almost 70 percent of total itemized deductions in Maryland, and they argue that the proposal, if passed, would further harm the area’s housing market, which has struggled to recover.
Jim Scurvin, past president of the Howard County Realtors Association says it’s just wrong to jeopardize an industry responsible for 49 percent of revenue that goes to state and local government
“When someone buys a house, on the average you employ two people, and you put $60,000 into the economy right then and there,” he says. “Real estate is the lead when it comes to getting the economy moving again. We have the wind in our sails, the last thing we need is someone to knock the wind out.”
Scurvin, however, is acknowledging only the visible impact of the tax expenditure. As Frederic Bastiat artfully explained, all policies have unseen consequences. In this case, the unseen impact is that the mortgage interest tax deduction fuels malinvestment in housing at the expense of other, more productive sectors of the economy. While Governor O’Malley’s budget proposal has many negative features, the potential for reducing the state subsidy to housing could be its silver lining. Unfortunately as Maryland realtors demonstrate, eliminating tax expenditures is a painful and politically difficult process.