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The Simpson-Bowles plan coming out of the deficit commission is in the headlines. There’s a lot to digest in it, but I’d like to focus particularly on the elimination of the home mortgage tax deduction. They present two possible plans for this deduction. One abolishes it entirely, and the other one eliminates it for second homes, home equity mortgages, and any mortgages over $500,000 in value. Is this a good idea?

The first question to ask is what is the goal of the deduction in the first place and how well does it achieve that goal. The tax credit is part of the larger political project of encouraging homeownership. One might think at this point in the housing recession we’ve collectively moved beyond the point where this is thought to be a good idea, but our general anger at homeownership promoting policies doesn’t change the economic argument for them, which is based on externalities.

The idea is that homeownership encourages investment in both the property and the community, and there is some evidence that both occur, and that there are positive spillovers. Others have argued that homeownership has had a positive effect on children. For example, Green and White argue that children of homeowners are 25% less likely to drop out of high school, and that there is a causal relationship.

Of course, there are potential downsides to homeowners becoming more invested in the community. For instance, some have argued that homeownership encourages people to protect housing values by reducing supply through restrictive zoning and preventing low-income housing developments. Ed Glaeser and Jesse Shapiro find support for this by looking at the relationship between homeownership rates and support for a referendum in California that sought more restrictive zoning laws. As the graph below shows, there is clearly a relationship:

And while this may not be an externality in normal times, homeownership does decrease mobility and can therefore make households less likely to relocate for a job. In a recession where output is below potential, this could exacerbate unemployment.

So given the costs and benefits of homeownership, do we want to subsidize it? This is a tricky question, and absent some convincing analysis which demonstrates that benefits outweigh costs, it would seem unwise to subsidize. I’m not familiar with most of the empirical work on homeownership and outcomes for children, but this seems like the most plausible mechanism for net positive benefits. Then again, zoning restrictions are clearly rampant and problematic, and the causal mechanism there is more obvious.

Nevertheless, in terms of the home mortgage interest deduction, it turns out that question of the desirability of homeownership isn’t really important to answer, since it is unlikely that the deduction actually increases it. Glaeser and Shapiro present a few pieces of evidence to argue this case. First is the following graph, which shows the percent of taxpayers itemizing over time and how it is related to the homeownership rate.

You would expect that if the deduction increases homeownership, then when the percent of people itemizing went up, so too would homeownership rates. This is not what is observed in the data.

Glaeser and Shapiro present further evidence, summarized in the graph below, by showing there is no relationship at the state level between changes in the average value of the mortgage deduction and homeownership rates. Their statistical results suggest that a 1% increase in the subsidy rate causes homeownership to rise by .0009%.

The question then is why is such an expensive subsidy failing to encourage homeownership? The reason is because the subsidy is most valuable to high income households who were going to be homeowners with or without the subsidy. Those who are on the margin between owning and renting, young and the lower-income households, will benefit little or none from the deduction.

The Tax Foundation shows that in 2003 those filing income taxes with less than $30,000 in adjusted gross income represented just 9% of those receiving this deduction, yet they comprise over 50% of tax filers. In contrast, 36% of the deductions went to filers with more than $100,000 in income. Looking at data from 1998, Glaeser and Shapiro find that over 50% of itemized income goes to the top 10% of households. Clearly, this subsidy disproportionately benefits high income families, exactly the kind who are likely to be homeowners regardless.

Despite all of this I think we should be cautious about repealing this deduction. I strongly believe that lower house prices right now cause significant externalities. Even if this deduction occurs five years from now, the value of a house today is in part determined by it’s expected future sales price, and thus expected future price declines will be factored into today’s prices.

The externalities associated with low house prices should be less of problem for high income households, since foreclosures and labor immobility are less likely outcomes for them. This suggests there will be less of a downside, but not zero, to the second approach proposed by Simpson-Bowles, which eliminates the deductions for 2nd mortgages, home equity mortgages, and mortgages over $500,000.  Alternatively, a slow decrease of the value of the deduction may limit the impact on prices.

In the long-run, the deduction should go entirely since a) it doesn’t increase homeownership, and b) it’s unclear whether we want to do that in the first place. In the short-run we should be very cautious, and make sure it is repealed it in a way that limits the impacts on home prices, especially in the relatively lower part of the price distribution where it is likely to cause externalities.

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