The Mortgage Interest Deduction: Revenue and Distributional Effects

THE MORTGAGE INTEREST DEDUCTION: REVENUE AND DISTRIBUTIONAL EFFECTS Austin J. Drukker, Ted Gayer, and Harvey S. Rosen August 24, 2018 ABSTRACT TAX POLICY CENTER | U RBA N IN S TI TU TE & B ROOKINGS INSTITUTION II Conventional estimates of the size and distribution of the mortgage interest deduction (MID) in the personal income tax do not fully account for potentially important responses in household behavior. As noted by Gervais and Pandey (2008) and Poterba and Sinai (2011), among others, were the MID to be eliminated, households would sell financial assets such as stocks and bonds to pay down their mortgage debt, and the smaller holdings of these taxable assets would offset some of the revenue gains from taxing mortgage interest. Conventional estimates that do not fully account for this rebalancing will therefore overstate the increase in revenues associated with eliminating the MID and will also overstate the progressivity of eliminating the MID, because households with higher levels of non-residential assets might respond by selling their taxable, non-residential assets. This paper builds on previous work that estimates the consequences of removing the MID using a framework that allows for the possibility of portfolio rebalancing. Unlike previous studies, we analyze data for several years—every third year from 1988 to 2015, inclusive. This reduces the likelihood that our estimates are due to the idiosyncrasies of some particular year, and allows us to investigate how and why the differences between estimates with and without a portfolio response have evolved over time. We then turn to the distributional implications of eliminating the MID, again looking at multiple years. A noteworthy feature of our distributional analyses is that we focus on both wealth and income as classifying variables. Our main findings are: (i) The revenue loss associated with the MID is smaller if one allows for rebalancing, with the ratio of the rebalancing-adjusted revenue loss to the conventionally estimated revenue loss varying from 75 percent in 1997 to 92 percent in 2009. While not dramatic, these are non-trivial effects. (ii) During our sample period, changes in the ratio of the two revenue loss estimates were due primarily to changes in the relative stocks of assets to mortgage debt as opposed to changes in rates of return and the tax system. (iii) Portfolio rebalancing attenuates the increase in progressivity associated with elimination of the MID. (iv) Other things being the same, the reduction in the eligible mortgage cap embodied in the Tax Cuts and Jobs Act of 2017 is unlikely to have much impact on either the revenue or distributional implications of the MID. ABOUT THE TAX POLICY CENTER The Urban-Brookings Tax Policy Center aims to provide independent analyses of current and longer-term tax issues and to communicate its analyses to the public and to policymakers in a timely and accessible manner. The Center combines top national experts in tax, expenditure, budget policy, and microsimulation modeling to concentrate on areas of tax policy that are critical to future debate. Copyright © 2018. Tax Policy Center. Permission is granted for reproduction of this file, with attribution to the Urban-Brookings Tax Policy Center. CONTENTS TAX POLICY CENTER | U RBA N IN S TI TU TE & B ROOKINGS INSTITUTION III ABSTRACT II CONTENTS III ACKNOWLEDGMENTS IV INTRODUCTION 1 THE POLICY ENVIRONMENT AND PREVIOUS LITERATURE 4 DATA AND METHODS 7 REVENUE EFFECTS OF THE MORTGAGE INTEREST DEDUCTION 11 DISTRIBUTIONAL IMPLICATIONS OF THE MORTGAG E INTEREST DEDUCTION 15 CONCLUSIONS 19 APPENDIX A 20 APPENDIX B 22 APPENDIX C 23 Tax calculation model 23 Data r elating to househo lds' fina nc es 23 Tax rat es 24 NOTES 28 REFERENCES 31 ABOUT THE AUTHORS 33 ACKNOWLEDGMENTS TAX POLICY CENTER | U RBA N IN S TI TU TE & B ROOKINGS INSTITUTION IV We have received useful suggestions from Thomas Barthold, Leonard Burman, Will Dobbie, Daniel Feenberg, William Gale, William Gentry, Scott Jacquette, Mark Mazur, Kevin Moore, James Poterba, Louise Sheiner, Todd Sinai, Eric Toder, and Alan Viard. Drukker and Gayer received support for this work from the Laura and John Arnold Foundation. Rosen received support from Princeton University’s Griswold Center for Economic Policy Studies. The views expressed are those of the authors and should not be attributed the Urban-Brookings Tax Policy Center, the Urban Institute, the Brookings Institution, their trustees, or their funders. Funders do not determine research findings or the insights and recommendations of our experts. Further information on Urban’s funding principles is available at http://www.urban.org/aboutus/our-funding/funding-princip les; further information on Brookings’ donor guidelines is available at http://www.brookings.edu/support-brookings/donor-guidelines. INTRODUCTION TAX POLICY