The current US tax code subsidizes more expensive homes at the expense of more business investment — in the process offering the biggest tax benefits to the wealthiest taxpayers. It’s costly policy in more ways than one. The tax break may actually impede middle-class homeownership by driving up prices. And the inefficient use of capital hurts economic growth.
The housing tax benefit comes in two forms. First, it spares homeowners from any tax on imputed rent. If the income tax was neutral it would treat exactly the same both these situations: a) buying a house and renting it out and b) buying a house and living in it. But only the “income” from the former is taxed. That’s a $60 billion a year tax break. Second, homeowners are allowed to deduct mortgage interest. That’s another $100 billion a year. Here’s how AEI’s Alan Viard would alter the tax code in a way he thinks both economically smart and politically doable:
Starting in 2015, the mortgage interest deduction is converted to a 15 percent refundable tax credit available to all homeowners, including those who claim the standard deduction and those with no income tax liability. The credit is limited to interest on $300,000 of mortgage debt (in 2013 dollars), with no tax relief for mortgages on second homes or on home-equity loans. The dollar limit is indexed to the consumer price index (CPI) in the same manner as the bracket endpoints and other dollar values in the tax code. Taxpayers with existing debt are allowed to claim 90 percent of the current-law deduction in 2014 on that debt, declining 10 percent per year thereafter, with the option to switch to the credit at any time. … For the mortgaged portion of home purchases, everyone receives the same 15 percent marginal incentive on modestly priced homes and no one receives any additional incentive for expensive homes. The proposal substantially limits the tax preference for expensive homes while increasing homeownership assistance for taxpayers who are less well off.
Now, it would probably make more economic sense to tax the imputed rents rather than limit the deductibility of mortgage interest since rents are income and interest is an expense. But doing the former is administratively difficult. The Viard plan would raise roughly $300 billion a year in tax revenue, some 80% of which would be paid by those with cash incomes above $200,000, 18% by those with income above $500,000, 6% with income above $1 million. The result, Viard explains, would be to “direct economic resources away from expensive homes, which have been artificially advantaged by the tax system, and toward other sectors of the economy.”
What to do with the $300 billion? Lower deficits, lower investment taxes, even offset harmful defense or basic research cuts from the sequester. This is just the sort of smart, rational policy move that would reassure both domestic voters and international investors that Washington isn’t completely dysfunctional.