One frequent point made by free-market types, such as myself, is that the tax code's many preferences and deductions make the tax code distortionary and result in unnecessarily high marginal rates. The prime example cited is always the mortgage interest deduction which is said to favor the well-to-do and cause house prices to rise too high. While the general principle is sound, abolishing the mortgage interest deduction is not necessarily a step in the right direction.1
To see why, consider the following scenarios. The common assumptions are a 40% marginal tax rate, a 10% rate of return, a million dollars in the bank to spend on housing, and no inflation or appreciation. These are merely to make the math simpler; more realistic assumptions change the numbers, but do not alter the conclusion.
Buy. At the beginning of the year, you buy a million dollar house and at the end of the year, you sell it. You end up with the same money in the bank and have lived for a year in a million dollar house.
Rent. You keep the money in the bank, but use the return to rent a house. Under the assumptions, a million dollars earns $100,000, you pay $40,000 in taxes, and pay rent with the remaining $60,000. How much house do you get for that? $600,000. At the end of the year, you have a million in the bank and have lived in a $600,000 house.
Mortgage with Deduction. You get a million dollar house with a mortgage of that size. You earn $100,000 in interest on your bank account and pay the same in mortgage; with the mortgage interest deduction, those two payments cancel out. At the end of the year, you have a million in the bank and have lived in a million dollar house.
Mortgage No Deduction. Now you don't get a deduction for mortgage interest, so you can only afford $60,000 in mortgage payments. So at the end of the year, you have (still) have a million in the bank, but have lived in a $600,000 house.
In each scenario, you start and end with a million in the bank and have lived in a house. Just in two scenarios (Buy and Mortgage with Deduction) you get to live in a lot nicer house than under the other two (Rent and Mortgage No Deduction). An ideal tax code would not prejudice one or the other of the financial structures you chose.
Eliminating the mortgage interest deduction, however, does not fix that problem. It merely moves mortgage holders from the good to the bad outcomes. The discrepancy between Buy and Rent remains the same regardless.
The only ways to really fix the problem are: (a) keeping the mortgage interest deduction and adding a deduction for rent (which seems unlikely given the fiscal impact) and (b) charging imputed income taxes on the in-kind benefit of living in a nice house (which an ideal tax system ought to do, but seems even less politically feasible).
As the distortion problem remains, no matter what we do with the mortgage interest deduction, keeping the mortgage interest deduction would likely be the less distortionary option. It treats owners with mortgages, who incur the risk of price fluctuations and the costs of locational stickiness, the same as outright owners, rather than as renters. That seems like the closer match.
1As a beneficiary of the deduction, you may want to take my argument cum grano salis, but it is sound regardless and—as all the proposed elimination plans are only prospective and I've no plans on moving, preferably ever—my financial interest is pretty remote.
