Fundamental Tax Reform: Options for the Mortgage Interest Deduction

Publication Date: August 2005

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Banking and finance

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Abstract:

In the 109th Congress, tax reform has become a major legislative issue. In January 2005, President Bush appointed a nine-member bipartisan panel to study the federal tax code and to propose options to reform the code for the purpose of simplification and/or overhaul. Some legislative proposals for fundamental tax reform would change the tax base such that income tax credits and deductions, like the mortgage interest deduction, would be eliminated. Two bills (H.R. 25 and S. 25) propose a national sales tax that would eliminate the current federal income tax system, including the mortgage interest deduction. Three other bills (H.R. 1040, S. 812, and S. 1099) propose a flat tax on wages. As proposed, H.R. 1040 and S. 1099 would eliminate the existing income tax system, including the mortgage interest deduction. S. 812 would eliminate the existing income tax system, but would preserve the deduction of mortgage interest.

The mortgage interest deduction, which is one of the largest sources of federal tax revenue loss with an estimated annual cost of $72 billion, is intended to encourage homeownership. Empirical studies suggest that the mortgage interest deduction subsidizes mortgage lending which has more impact on housing consumption than homeownership rates. Other homeownership subsidies, like down-payment assistance programs, are proven to be more effective at increasing homeownership among lower-income families and are less expensive than the mortgage interest deduction.

There are many options relating to the mortgage interest deduction and most are very controversial. If the deduction were eliminated as a result of fundamental tax reform, the resulting effects would depend on a variety of variables. These variables include the nature of tax reform, the resulting changes in the tax base and tax rates, changes in interest rates, and other economic variables. If the deduction were eliminated without other tax policy changes, federal income tax revenues would increase, the tax base could be broadened, and the federal budget deficit could be reduced. Modifications to the mortgage interest deduction could take any one of several approaches. Congress could choose to allow the deduction for only one residence, rather than two, or reduce the allowable principal debt, which is currently $1 million. These changes would reduce the amount of tax revenue loss associated with the provision. Congress could choose to improve equity by allowing more low income households to claim mortgage interest, either as an above-the-line deduction or as a tax credit. Finally, the mortgage interest deduction could remain unaltered. It would continue to be a benefit to more than 37 million taxpayers and provide more than $70 billion in annual tax savings to homeowners.

This report, which will be updated to reflect legislative developments, describes the deduction for home mortgage interest and provides an economic analysis of the deduction and concludes with an analysis of the possible changes to the mortgage interest deduction in the context of tax reform and the potential impacts of those changes.