Fairness is a big issue on Capitol Hill. That's especially true when it comes to handing out the goodies. For example, aid to the states in the 2009 stimulus legislation was spread evenly -- no less than $194 per person (in Florida) and no more than $226 per person (in Utah). A good policy reason is required for unequal benefit distribution. For example, Medicaid funds are tilted toward providing more to poorer states. (Low-income states can get as much as three federal dollars for every state dollar spent, while the match for high-income states may only be dollar-for-dollar.) So it is hard to imagine a broad-based government subsidy program in which one state gets $500 per person while a neighboring state gets only $100. Or a government program to support a basic necessity -- say, child nutrition -- in which subsidies are targeted overwhelmingly to locations with well-fed, wealthy residents.
But that's exactly what we find in the tax subsidy program for mortgage interest. The benefits of the mortgage interest deduction are not evenly distributed among the states. As shown in the figure, the per capita tax benefit from the mortgage interest deduction for Californians is more than two and a half times that for Texans. Marylanders get nearly five times the benefit of citizens in neighboring West Virginia.
We always knew the mortgage interest deduction was unfair -- favoring those in high tax brackets with big houses over renters and low-income homeowners. But until we did the calculations -- as far as we know, the first of their kind -- we did not suspect the geographic dispersion of tax benefits would be so large.
Distorted American Dream
In 2008 the value of the mortgage interest deduction was $85.5 billion, according to the Joint Committee on Taxation. The amount of deductions was $470.6 billion, according to the IRS Statistics of Income division. For the 38.5 million taxpayers claiming the deduction, the average amount taken was $12,221, and the average tax benefit from the deduction was $2,220.
In 2008 the U.S. population was 304.1 million, according to the Census Bureau. So the average per capita tax benefit from the mortgage interest deduction was $281. The figure shows how the U.S. average per capita tax benefit compares with those for the six states with the largest per capita benefit and the six states with the lowest tax benefit. (Complete data for the 50 states and the District of Columbia are in the table at the end of this article.)
On a per capita basis, Maryland is the largest beneficiary of the mortgage interest deduction, with each resident receiving $499. After Maryland, the states with the biggest per capita subsidies are California ($464), Connecticut ($446), Virginia ($438), New Jersey ($436), and Massachusetts ($393).
At the other end of the spectrum is West Virginia, which receives only $102 of tax benefit per capita. The other states receiving the lowest per capita tax benefits are Mississippi ($108), North Dakota ($110), South Dakota ($118), Arkansas ($119), and Oklahoma ($131).
Proposals to Limit the Subsidy
The Tax Reform Act of 1986 limited qualified mortgage debt to $1 million. In addition, deductions are allowed for interest on $100,000 of debt secured by home equity. Those limits are still the law today.
Since the 1990s, there have been numerous proposals to eliminate the individual income tax and replace it with a retail sales tax (a FairTax) or a single rate tax on wage income with no itemized deductions (a flat tax). In general, these proposals would sweep away the mortgage interest deduction with much of the rest of the Internal Revenue Code, although a few of the flat tax proposals from members of Congress and presidential candidates retained the deduction.
Beyond these types of fundamental tax reform, most proposals relating to the mortgage interest deduction have been targeted at upper-income households. Given the enormous political contributions, lobbying expenditures, and grass-roots networks of the National Association of Realtors, the National Association of Home Builders, and the Mortgage Bankers Association, a limited repeal is the only realistic possibility. (In the past, Freddie Mac and Fannie Mae would have been included in this group, but they are now prohibited from lobbying the federal government.) Of course, any cutback of the mortgage interest deduction will be fought tooth and nail by the housing lobby.
In 2005 President Bush's advisory commission on tax reform recommended replacing the mortgage interest deduction with a 15 percent credit available to all taxpayers (not just itemizers) and capping the amount of qualified mortgage indebtedness to the average regional price of housing (limits ranging from about $227,000 to $412,000).
In both his budgets, President Obama proposed limiting all itemized deductions so their benefit for upper-income taxpayers is no greater than the benefit received by taxpayers in the 28 percent bracket. A limit on all itemized deductions was also included in the list of recommendations published by Obama's tax reform commission (commonly referred to as the Volcker commission) in the spring of 2010.
In December 2010 the president's deficit reduction commission, chaired by Erskine Bowles and Alan Simpson, proposed replacing the current mortgage interest deduction with a 12 percent tax credit available to all taxpayers. The credit would not be available for interest on mortgages in excess of $500,000, for interest on mortgages on second residences, or for interest on home equity loans.
The Congressional Budget Office has included similar proposals in its latest report on options to raise revenue. The CBO assumes the proposals would not take effect until 2013, presumably when the housing market has adequately recovered from the 2007 collapse. The CBO estimates that converting the mortgage interest deduction to a credit would raise $51.6 billion in 2015 -- approximately half the estimated value of the mortgage interest deduction in that year under current law. A phased-in $500,000 limitation on indebtedness qualified for the mortgage interest deduction would raise only a small fraction of that amount.
A Partisan Issue?
In addition to the wide disparity in benefits, the other striking feature about the mortgage interest deduction is how well the subsidy correlates with Democratic strength. In the figure, the six states with the highest per capita benefit were states captured by Obama in the 2008 election. In the six states with the lowest per capita benefits, Republican challenger John McCain won the vote.
The table shows that Obama won the popular vote in 22 out of the top 26 jurisdictions, compared with 8 out of the 25 states with the lowest per capita benefits.
Unfairness of Federal Mortgage Interest Deduction:
Per Capita Benefits, Top and Bottom States, 2008
Source: Underlying data from the IRS and the U.S. Census Bureau.
These new estimates give a glimpse into the future politics of tax reform and deficit reduction. As tax reform moves forward, we can expect Democratic senators to be the most lukewarm to proposals for limiting the mortgage interest deduction to less expensive homes. And if it is a choice between cutting the mortgage interest deduction and cutting tax subsidies for energy companies, that will be an easy decision for the senators from Oklahoma.
Notes and Sources
The 2008 values for the mortgage tax benefit in the aggregate and by income class are from the JCT, "Estimates of Federal Tax Expenditures for Fiscal Years 2009-2013," JCS-1-10, Table 3, p. 50 (Jan. 11, 2010). The amount of mortgage interest deductions for each state by income category is from the IRS Statistics of Income division and is available at http://www.irs.gov/taxstats/article/0,,id=171535,00.html. State population data for 2008 are from the U.S. Census Bureau, available at http://www.census.gov/popest/archives/2000s/vintage_2008.
In the table, the term "itemizers" refers to taxpayers who took the mortgage interest deduction. The subsidy for each state was calculated by multiplying the total amount of deductions in each income category by a national average tax rate for that income category and then summing the computed totals for each income category.
A first pass at marginal tax rates was computed by dividing the tax benefit for each income category as reported by the JCT and the deduction taken by income category as reported by the SOI Division. The income categories are not strictly comparable because of differences in the definition of income and differences in the aggregation of households. These marginal tax rates were then applied to the deduction amounts to arrive at an estimate of the overall tax benefit. The rates were then adjusted uniformly until the computed tax benefit matched the JCT total tax benefit. The final tax rates used were 7.7 percent (adjusted gross income under $50,000), 13.5 percent ($50,000 to $75,000), 14.8 percent ($75,000 to $100,000), 22.1 percent ($100,000 to $200,000), and 33.9 percent ($200,000 or more).