Posted by October 26, 2017
It has been said that Democracy is the worst form of government except all those other forms that have been tried from time to time. Winston S. Churchill
One of the many problems of American democracy is that the electorate, through lack of education or interest, can only think in very limited terms due to the limits of our attention spans. In the era of newspapers, editorial pages, even the working class would sit in a chair with their coffee and read about the nuances of an issue and gain some depth of understanding about the competing positions. With each leap of technology bringing news and views to us more rapidly and that attention span shrinks as we are bombarded with more until we have the 24/7 news cycle (24 seconds until publication, 7 seconds until we move on to the next item) and the electorate can only talk in bumper sticker slogans.
Additionally, there is now the third house of our legislature – the lobbies. Advertising will not buy a candidate an election, but it will give him or her an enormous advantage. Until we reform the method by which we hold our elections, more and more money will be needed and the lobby spending the most dollars will buy the most bumper stickers (physical and virtual) and have the most Congressmen beholden to them.
Policy should not be made on the basis of bumper stickers. Policy should be formulated and debated so that our Congressmen, listen to each other and compromise, because an issue that is purely good or purely evil is extremely rare. Instead, they are becoming more polarized so that each side is immutably wed and welded to the most errant nonsense.
“Tax reform” is one of those warehouses of nonsense. What does it mean? That everyone pays more taxes? Or less? That the sax system is somehow fairer? Or simpler? All of the above. You can have a system that is fair, or you can have one that is simple, but the one is the enemy of the other. And a provision that is fair to one will be unfair to another. Therefore, beware of anyone who touts a budget as “tax reform” because the term implies a wolf in sheep’s clothing.
True tax reform can only be changes that strike at inefficiencies in our economic system. A prime (plus one) example of inefficiency is the deduction for mortgage interest and real estate taxes on owner-occupied homes, or mortgage costs for short.
The main reason we still have the deduction for mortgage costs is the real estate industry. They persuade the first-time home buyer that they will get, as a Christmas present from Uncle Santa Claus, their mortgage costs times their highest tax rate. This rarely happens. Why, you ask. Well, the answer requires math.
The median household in America (based on the most recent Census statistics) is about $55,000 and the median home price is $180,000. Let’s say that home interest rates go back up to the 6% rate of 20 years ago and the buyer puts 5% down. (Mom and Dad didn’t fork over a generous gift for the down payment.) That puts the interest at about $11,000 per year. The average property tax rate in the United States is about 1.2 percent.[i] So real estate taxes of about $2,000 and total mortgage costs of about $13,000. This median-income family gives fairly generously by statistical standards at $2,000, or over 3% of their income.[ii] (Many consider the income tax to be part of their tithe.) Their state income tax or their general sales tax is about $1,000, bringing us to a whopping total of $16,000.
Our average family is a married (traditional or non-traditional[iii]) couple, meaning their standard deduction is $12,700. So the incremental tax deductions from home ownership are $3,300 and the actual tax savings are approximately $500, not the $2,000 the couple was expecting.[iv] (The example ignores state income taxes, so the total benefit might be $600 as opposed to an expected $2,200. It also leaves out the cost of the mortgage insurance premiums, which may or may not be deductible.)
At the other end of the spectrum, the family with income of about $700,000 will receive more benefit because of the alternative minimum tax, or AMT[v]. For example, whop the cost of that Mcmansion up to $2 million (a modest home in a West University equivalent) and say the family, which has income of a million, can put down $500,000. On their AMT, they have $90,000 in interest expense and $24,000 of real estate taxes. They will get $25,200 (the top AMT rate of 28% times $90,000) in benefit for the interest and nothing for the taxes. So the benefit is 24% of the mortgage costs as opposed to 4 % for the median-income family.
From 2005 to 2010, the itemized deductions were not phased out for regular tax and the benefit was about 35%, or about $38,000 of the above mortgage costs. Then the Bush tax cuts “sunsetted” in 2011 and the benefit dropped. So one would expect a drop in activity and home prices at the higher end of the market. Did that happen? The market, which had collapsed in 2007 – 2008, continued its recovery. In fact, the recovery accelerated. So what was the effect of the tax policy on the housing market?
Another example is the British experience. When my wife and I moved to London in 1979, there was a tax rate of 83% and all mortgage interest was deducted. (There was never a deduction for property tax.) We bought a house in Clapham (and yes, I was often the man on the Clapham omnibus) for £60,000, which was about the median home price, and we financed the entire amount. Interest rates were about 10%. So for our interest of £6,000, we received a tax benefit of roughly £5,000. Then the Tories and Maggie (Thatcher, that is, not my daughter) cut the top tax rate down to 60% and froze the amount of deductible interest to a maximum of the rate on a mortgage of £60,000. The benefit was immediately reduced to £3,600 and that became the cap. In 1989, the benefit was changed from a deduction at the top rate to a credit based on the basic rate of 15%, or £900. That represents an 82% cut in the benefit. So house prices should have cratered, right?
Not so much. There was about a three month lull in 1979, then prices started to climb again. When we moved back to London in 1991, the Clapham home would have cost £250,000 and the interest would have been £25,000, but the tax benefit would still be only £900, not even 4%. We bought in a less pricey neighborhood, Balham (Gateway to the South), and the £900 didn’t even factor into the purchase process. Today, the £60,000 home would be worth about £900,000 and the £160,000 home would be worth about £700,000.
If the British experience is anything to go by, we are employing bad tax policy to divert money into homes to protect the real estate industry against a three to six month slowdown in home sales. If our economy cannot survive a minor hiccup such as that, we may as well declare bankruptcy now.
It’s hard to find other examples because most of the OECD countries allow no benefit for home mortgage interest. The prevailing philosophy is that they should nothing to encourage leveraging something as critical as home ownership.
Three things can be predicted, however. First, the revenue from cutting the deduction would not be nearly as great as projected by the people who want to use the funds to reduce tax rates. Second, the real estate industry will spend a lot of money to lobby Congressmen and the debate will turn into dueling bumper stickers. Third, only The Economist will present a reasoned analysis of the proposed legislation (which 95% of the American people will ignore) and the proposal will pass or fail for all the wrong reasons.
I will make a disclaimer before I make my recommendation. My wife and I get no tax benefit from the deduction, so we have no dog in the fight.
I say we should do away with the mortgage interest deduction, take the short term hit, and let the real estate market sort itself out. Just don’t spend the money on other pointless tax incentives.
[i] Which brings to mind the statisticians who drowned in a stream with an average depth of three feet.
[ii] Statistically, the widow’s mite story still holds true. Poorer families give a higher percent of their income, even if they receive no tax benefit.
[iii] Statistically, the story of the Aggies and the weed eater is as valid after Obergefell as it ever was.
[iv] As a true tax nerds, I volunteer to run an AAARP TaxAide site as part of my retirement fun. One of the saddest experiences in that happy time is the young couple running up against this reality. (Or worse, because often there is no benefit.)
[v] AMT is too complex to explain here. Generally, though, it allows mortgage interest deductions whereas the “regular” tax phases them out. Since regular tax is credited against AMT, at some income level the AMT becomes irrelevant.
Death and Taxes 