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Ending the Mortgage Interest Deduction May Not Hurt Homeowners

Will homeowners be worse off if the deduction for home-mortgage interest is eliminated from the federal tax code? A recent article published by the Federal Reserve Bank of Cleveland suggests that answers to this and other questions posed by potential adjustments to tax policy are not as simple as they might appear.

Writing in the Bank's Economic Commentary, economists Stephen Cecchetti and Peter Rupert say that simply ending the mortgage interest deduction while leaving the rest of the tax code untouched would likely result in significant declines in the value of owner-occupied housing. However, most proposals to eliminate the deduction are part of plans for broader changes in the tax system. These shifts in taxation may not result in large reductions in home values, and increases in the value of other assets may mitigate any adverse effects of declining home prices on homeowners.

Cecchetti and Rupert analyze the elimination of the mortgage interest deduction in the context of a flat tax scheme that would tax all wage income at the same rate. They discuss some of the many countervailing forces that would affect homeowner well-being under such a scheme.

The authors show, for example, how offsetting forces in a flat tax environment may result in a net decline in market interest rates, so that housing would become a more attractive investment as the returns on other investments fall. Further, if interest rates did fall, individuals could refinance their homes, mitigating any loss in home values.

Another important factor to consider in assessing the overall effect of ending the mortgage interest deduction is that different segments of the population would be impacted differently. Cecchetti and Rupert note that higher-income families now enjoy most of the benefits of this deduction, and would be expected to suffer the most from its elimination. Further, wealthier people tend to own larger homes and, to the extent that home prices fall in a flat tax environment, the prices of more expensive ones would fall more.

However, a countervailing influence in these circumstances arises from the fact that those who would experience the biggest decline in housing prices have less of their overall wealth in their homes. Altering the tax code almost certainly would bring with it a shift in investments, from the housing sector to the business sector. In this case, the value of income from other investments would rise, again mitigating any loss in home values.

The authors’ examples demonstrate that changes in tax policy directed at specific areas like home mortgages may have unanticipated, yet far-reaching, effects. To determine the final outcome of such policies, they say, it is important to examine their possible effects throughout the economy.

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