Tax day is here again and, as usual, talk about tax simplification abounds. Everyone wants the tax code to be simplified—in theory at least. Of course, when we get down to brass tacks and actually talk about changes that could simplify the tax code fairly easily, people get pretty miffed. For example, take a sacred cow of the current income tax code and one that constitutes one of the largest drains on federal tax revenue—the home mortgage interest deduction. How about we start by phasing that baby out?
From an economics perspective, it’s really not all that defensible. Since we don’t include as taxable income the value of the housing services received by homeowner families from their home investment, then there’s really no basis for allowing homeowners to deduct the interest cost of generating that investment income. Whoa, hold on now, some people (including economists) would exhort. Homeownership yields beneficial spillover effects (positive externalities in econspeak) to the rest of the community for which they are not compensated. Homeowners take care of their property better and tend to be more concerned with the well being of the community than renters. As a consequence, homeownership should be encouraged and the home mortgage interest deduction is a way of doing that. Well, there are two responses to that. First, it’s still not clear from the research that it’s homeownership per se that creates the spillovers. It could be related to income or to the time spent residing in the community or something else. Second, even if it is, the average deduction is probably well above the value of such beneficial spillovers so the amounts of deductions should at least be reduced. Moreover, the deduction should probably be changed to a credit, since the value of the spillovers likely does not increase with the price of the home. (In fact, one could make the argument that they decline with the price of the home and hence the amount should decline with the size of the mortgage.)
The same is true of the deductibility of state and local income taxes and property taxes for federal income tax purposes. To the extent that such taxes are basically user fees for the myriad of state and local government services that taxpayers receive, there is really little economic justification for the deductions. I really do hope that the President’s commission on reducing the deficit consider such changes to the code, along with other alternatives. I just wonder how such proposals, if put forth, will be received by the taxpaying public.