Some Tax Deductions Are More Equal than Others

If you were to randomly ask a sample of 100 Americans from around the country why the mortgage interest deduction was implemented in the tax code, I'd wager that the bulk of the answers would range from "I don't know" to "they were designed to give a tax break to the rich." 

Both answers suggest ignorance of facts, but the former is at least honest.  The latter is just regurgitation of a leftist talking point by those feigning knowledge on the subject.

The truth is a bit different than popular perception on this matter. 

Few, if any, among that small sample would offer the correct answer.  That is, that the mortgage interest deduction has been a part of the tax code since 1913, when the 16th Amendment was first implemented, and that there was fairly sound reason for it.

Essentially, such interest payments have been deductible in the modern American tax era as an effort to preserve market neutrality in the lending market, in spite of taxation. The idea is that if a lender loans money to a borrower and charges interest, the lender will increase lending rates in proportion to the taxes required to be paid on the income earned by lending the money.  This income is taxed at the corporate tax rate, which is currently 35%.  This inflates the cost of investment to the borrower relative to the cost of taxation to the lender, which might act as a disincentive to invest in a home, or more practically in 1913, a farm.

Only it still doesn't act as a disincentive to invest in a home today, because the investor is still able to deduct the interest paid from his income.

If that, in principle, doesn't make sense, here are a couple of examples which might explain why it might.

Take this first example.  Say someone purchases a $500K home.  He puts the requisite $100K down, meaning that in the first year of ownership, he will pay nearly $18K in the first year on the $400K loan (at an assumed 4.5% rate).

Today, the lender is taxed for this $18K of income at a 35% rate, meaning the government collects $6,300 in revenue from this loan.  In real terms, the price of the interest would otherwise be $11,700 to a consumer to get a return the lender desires, absent taxation to the lender.  For the borrower, this $18K is deductible from his income tax.  Let's assume this borrower earns $300K annually, and that this $18K deduction would reduce his tax liability such that the cost of the loan would actually be nearer to the $12K price of the loan, again, absent taxation.

Some might say that this deduction acts as "incentive" to purchase more expensive homes.  A better way to frame it, however, would be that it doesn't act as "disincentive" for more expensive home purchases.  As Curtis Dubay of the Heritage Foundation explains, "stopping a disincentive to invest is not the same as creating an incentive or providing a subsidy."

There are still others who might say that this borrower's deduction amounts to the taxpayers' "subsidizing" more expensive homes.  However, to suggest that the $6K that the borrower got back is actually the rightful property of the federal government, with the other taxpayers as its proxies, rather than the property of the homeowner as fundamentally understood in the tax code since its inception, is anything but a free-market argument.

Now, I will be the first to tell you that the tax code is bloated, full of deductions which are suspicious in nature, and practically, that the progressive income tax is among the greatest affronts to individual liberty in American history.  There can be no argument that there's more of Marx in it than of Madison.  The 16th Amendment granted license for the federal government to tax individuals discriminately and without defined limitations, leading to the redistributionist monstrosity that we have today.  I would be 100% in agreement with a more simplified system -- a flat tax, for example, which applies to all Americans equally.

But we should not pretend that the current call to curtail the mortgage interest deduction is anything but a means to "soak the rich."  In this case, it's meant to target higher-income earners who might purchase an expensive home relative to their high income in the future.

There is proof that I'm correct.  There has been selective acceptance about the proposed curtailing of this deduction.  Good, many say.  Taxpayers shouldn't subsidize homes for the rich, and all that.  But there's no outrage about the proposed expansion of another deduction which serves, much more holistically, the exact same purpose (and then some) for millions upon millions of other Americans.

I'm speaking, of course, about the standard deduction.

Let's take a second example.  Let's say you purchase a home for $187K, and you put your 20% down, leaving a roughly $150K loan that you pay interest upon.  You'll be paying a little over $6,500 in mortgage interest in that first year.  Assuming your other deductions don't bring you and your spouse above the current standard deduction for married filers at $12,700, TurboTax or some tax professional will prompt you not to itemize that $6,500.  You should just take the standard deduction.

Assuming you have no other deductions (that's unlikely, but it's equally unlikely that you're itemizing deductions rather than taking the standard deduction since 70% of Americans opt for the latter), this is the same result as the government "pretending" that you paid $6,200 more in mortgage interest than you did.  If you earn, say, $85K annually, this amounts to roughly $1,550 more in tax refund than you would have received had you simply itemized your mortgage interest deduction. 

The person in the second example is: A) paying a much lower effective tax rate than the higher-income earner in the first example, even if you consider the first person's deductions, and B) getting roughly 2% of his income back from the federal coffers because of an arbitrary tax deduction which is not predicated upon any principle of market neutrality, but on the basis of good, old fashioned government redistribution.

The second person can claim all he likes that he's subsidizing the home of the first.  But any fool can tell you that the opposite is closer to the truth.

The first person is among the top 5% of income earners. The top 5% of income earners pay roughly 60% of all income tax to the federal coffers, despite only earning a 36% of shared adjusted gross income.  Even with all his sinister deductions firmly in place (and with the help of the current Alternative Minimum Tax, when applicable), he's helping to provide the lion's share of government revenue.

But here's an additional bit of food for thought.  The proposed House GOP tax bill nearly doubles the standard deduction to $24,000.  There's not a lot of squawking about this.  Why?  The simple answer is because it will likely function as a tax cut for the majority of middle America.  But you don't hear higher-income earners screaming that they're forced to "subsidize" an additional bit of money into the pockets of middle-class earners.   

Inversely, I've heard plenty of commentary that curtailing the mortgage interest deduction is a good thing, despite the fact that it very obviously will function as a tax hike for many higher income earners in areas of the country which have higher-priced real estate, and that keeping the mortgage interest deduction, as is, somehow amounts to taxpayers "subsidizing" their high-priced homes.

Utter nonsense. 

It's true that not all tax deductions are created equal.  For example, I can see the rationales in the arguments that state and local tax deductions amount to subsidizing high-tax state policies.  But, as aforementioned, there's an equally good argument that the standard deduction amounts to the middle class being subsidized by higher income earners.  The point is, unless we opt for true reform of the tax code, eliminating state and local income taxes will specifically act as a tax hike for high-income earners in higher-tax states, just as raising the standard deduction amounts to a specific tax cut for the middle class.  Indeed, if 70% of Americans take the standard deduction today, doesn't it stand to reason that those same Americans will be able to deduct an extra $11K+, altogether arbitrarily, if the standard deduction is nearly doubled?

I am for the proposed increase in the standard deduction, mind you.  This is a simple plea. 

Do not be suckered into supporting selective tax hikes in order to achieve tax cuts for what we presume to be the masses. We conservatives, in unison, should be calling for the shrinking of government, entitlement reform, and tax cuts for working Americans which leaves more of their earned money in their own pockets.  We do nothing but muddle our efforts by playing into Washington's redistributive rhetorical shenanigans.

William Sullivan blogs at Political Palaver and can be followed on Twitter.