Monday, November 26, 2012

Shocking Unintended Consequences if Mortgage interest Deduction is Eliminated

Everyone knows that if you take away the mortgage interest deduction, housing prices will crash, homeowners will lose $1000's in home values and pay huge increases in taxes, and the real estate and mortgage industry will slump back into depression.  But as with so many things, what everybody knows may not be right…this analysis might even be dead wrong. 

Our form of government is particularly horrible at thinking through the unintended consequences of its actions.  A perfect example would be the changing of the way apartment owner's wrote off depreciation back in the 80's.  The increasing of the number of years to fully depreciate an apartment building seemed like a perfectly fair and reasonable thing to do.  One can, however, make a strong argument that the result of that tax decision destroyed the savings and loan industry, and cost the government far more in losses from reduced property values and s & l bailouts than it every gained in tax revenues. 

It is far from clear that any change in the mortgage interest deduction will benefit tax revenues, hurt homeowners, or greatly effect mortgage production.  We are about to enter some tall weeds of analysis, for which I apologize in advance. 

The basic assumptions about the effects of the ending of mortgage interest deductions make claims that are mutually exclusive.  Here is a simple one.  Home prices will drop by 15% according to some studies.  Maybe they will drop more or less than this, but let's take that number.  If home prices do drop by that much, it should be clear that it will provide a boost to the real estate market as cost goes down, demand rises.  At least in the short term, marginal buyers will be benefited as they will have a lower down payment and monthly payment, thus adding buyers to the market.  You could further argue that the added demand would at some point push prices back up until there was a leveling effect.

The above proposition would be true only if prices dropped by 15%.  Unfortunately for the entree level buyer, there is no current tax advantage from mortgage interest deductions.  It is clear that the benefit only starts at about $75,000 in income and $200,000 in total mortgage.  And even for that buyer, the tax savings are modest.  Thus the argument for a drop in values only applies on homes of $250,000 or more, and really, quite a bit more. 

Since the mortgage interest deduction does not apply to amounts above $1,000,000, the home value drop and higher tax rate will most impact homeowners with incomes above $100,000 and mortgages above $500,000, but less than $1million.  If homes in that range drop by 15%, new buyers would have roughly no effect on their purchasing power for that value of home.  The loss of tax advantage would be offset by the lower mortgage amount. 

Current owners with mortgages would have a huge double wammy, potentially driving more in this group into upside down status on their mortgages and reducing their ability to pay.  This could result in more foreclosures in the short term, and a huge loss of wealth and purchasing power from the most productive segment of society. 

If the mortgage interests deduction is even good policy, it would seem to be a very bad idea to abruptly end it.  The effect on realtors and mortgage companies would seem to be limited and short term.  But the effect on the middle class would be substantial.  A phased in approach would lower the impact.  This could be done by setting a maximum on schedule A deductions, reducing the cap on the total mortgage interest deduction, or only allowing a declining percentage of the deduction to be applied. 

Most who argue for this deduction to be dropped, insist that there be an accompanying drop in tax rates by 10%.  This would certainly offset the loss of spending power, thus making the same value of home affordable as before.  If spendable income remains roughly the same, an argument can be made that their would not be the drop in home values as you would have the same number of dollars chasing the same supply of homes. 

Please offer your thinking on this.  Are there any errors in the above analysis?  Are we better off to drop the deductions and have a lower tax rate?

For more on this subject also read:

No comments:

Post a Comment