TPC Finds Little Price Shock for Reforming the Mortgage Interest Deduction
Tax expenditures in theory promote specific policy goals by subsidizing that behavior through tax benefits. However, in comprehensive tax reform, transition issues in changing tax expenditures can be an issue -- it certainly consumed a lot of lawmakers' thought and energy in the Tax Reform Act of 1986. Making sudden changes to parts of the tax code could be disruptive to sectors in the economy that would be most affected by tax expenditure reductions or other changes.
This is one of the more commonly cited concerns with changing the mortgage interest deduction. While the housing market is beginning to rebound, it is still very fragile. Because the tax benefit of the mortgage interest deduction may affect an individual's ability to purchase and own a home, changing the tax provisions could affect housing prices. A new paper from the Tax Policy Center estimates the effect of changes to the mortgage interest deduction on house prices.
Benjamin Harris of the Tax Policy Center attempts to model the housing effects of a tax change. His model builds off of existing research by incorporating transaction costs. Under Harris's assumptions, the more commonly discussed reforms of the mortage interest deduction, save eliminating it entirely without a replacement, would have a minimal impact on prices.
The president’s 28 percent limit on itemized deductions would barely move housing prices at all, causing them to fall just 0.3 percent. The higher top tax rates put in place in 2013, which drive up the value of deductions for housing for high-income taxpayers, are estimated to increase home prices by an even smaller margin.
By contrast, completely eliminating the mortgage interest and property tax deduction—a drastic change that probably would only happen if accompanied by a new tax preference for housing—would cause housing prices to fall by an average of 11.8 percent in the 23 cities studied. Estimated price declines would range from 10.3 percent in Seattle to 13.8 percent in Milwaukee.
Some proposed tax changes might even boost home prices. I estimate that limiting the mortgage interest deduction to 20 percent while offering a flat credit equal to two percent of a home’s value would raise prices an average of 3.0 percent. Price gains would vary from 1.5 percent in Pittsburgh to 4.6 percent in Portland.
It's worth noting that most plans that would eliminate the mortgage interest deduction would either replace it will a less costly tax provision or phase out the deduction over a long period of time. The Fiscal Commission recommended replacing the mortgage interest deduction with a 12 percent nonrefundable tax credit capped at $500,000 of mortgage debt. The Domenici-Rivlin plan also replaced it with a 15 percent refundable tax credit. Harris also writes that the assumptions of his model, especially his assumption that the supply of housing is perfectly inelastic, may overstate the price changes.
Short-run effects should be given consideration, especially with the fragile state of the overall economy and certain depressed sectors. But this research suggests that the impact of housing prices from reforming the mortgage deduction would be relatively small. Whatever short-run effects exist could be muted by changing the design of tax expenditures and slowly phasing in policy changes. But the benefits are tax reform are large enough that we should not be scared off.