The report of the President's Tax Reform Panel has been out two weeks now, and has been the subject of commentary across the country. See Panel Website Report Links, Money.cnn, Economic Policy Institute (increased burden of proposals on working Americans), bloomberg.com (discussing Republican split on priorities), Denver Post story praising report, SmartPros (brief overview), CCH (description) and Start Making Sense blog (scroll down to Nov. 7, 2005 entry).
Most think the Panel's report is unlikely to be adopted as the appropriate way to reform the tax system. Even the Treasury merely announced that it would take the report into consideration as it began its own review. A notable problem with the report is that the Bush administration charged the Panel to devise a revenue-neutral plan assuming that the Bush tax cuts, including reduction of taxes on dividends and capital gains that benefit the wealthiest multimillionaires the most, are made permanent. As a result, the Tax Reform Panel's proposals are actually tax cut proposals.
In spite of that inappropriate charge, some of the specific tax revenue enhancers (included in the proposals to accommodate additional tax cuts for the wealthy--especially the elimination of the AMT and practical elimination of taxes on capital income of the wealthy) may have some merit. The one that has received the most negative attention (see here, for example ) is quite possibly one of the best ideas in the report--limiting the tax benefit for interest paid on home mortgages. Under current tax law, interest may be deductible when paid on home mortgages up to $1.1 million.
The Tax Reform Panel has proposed that the amount of mortgage as to which there is a tax benefit from interest paid should be limited to the average mortgage in the geographic region. The result would be that in regions where house prices are particularly high (such as Southern California), more interest on home mortgages would be eligible for the benefit than in regions where house prices are more moderate (such as rural Kansas). Under the principle of democratic egalitarianism that I have espoused in this blog, this limitation on the tax benefit from home mortgages is a reasonable one. It means that the benefit will be better targeted to ordinary Americans and less of a subsidy to purchases of luxury homes by wealthy Americans. If the subsidy for home ownership is to be maintained at all, this is an appropriate limitation.
(There are, of course, strong fairness arguments for removing the subsidy altogether. In effect, it favors taxpayers who are homeowners over taxpayers who must rent. The availability of the benefit from interest likely drives home prices up proportionately, though the exact amount of the effect is difficult to pinpoint. It may therefore reduce the possibility of home ownership at the margins.)
The Tax Reform Panel has also proposed that the benefit from interest paid on home mortgages should be provided via a credit mechanism rather than a deduction. Again, this change supports democratic egalitarianism, for two reasons.
First, the current benefit is in the form of a deduction that is only available to those who itemize. Because most taxpayers in the lower four income quintiles use the standard deduction rather than itemizing, they are unable to take advantage of the deduction. The result is that taxpayers with higher incomes tend to be the ones who can and do take advantage of the home mortgage interest deduction. In that sense, the deduction is regressive and reduces the overall progressivity of the tax system. That is why I argued, in my article proposing reforms to the AMT to protect ordinary taxpayers and appropriately tax wealthy taxpayers, that the home mortgage interest deduction should be a preference under the AMT that is limited by average home prices. See Congress Fiddles While Middle America Burns: Reforming the AMT (and Regular Tax), 6 Fla. Tax Rev. 811 (2004).
Second, deductions are more valuable to taxpayers in higher income brackets than they are to taxpayers in lower income brackets. A taxpayer who pays $5,000 in home mortgage interest and whose federal income tax marginal interest rate is 15% will have a deduction of only $750. But a wealthy taxpayer who is in the top 35% bracket and pays $15,000 in home mortgage interest on a larger home mortgage will have a deduction of $5,250 ($1750 on each $5000 of mortgage interest). If home mortgage interest were creditable rather than deductible, the tax benefit would not depend on a taxpayer's marginal interest rate. Instead, the mortgage interest credit would be a dollar-for-dollar reduction in the amount of a taxpayer's income tax liability and would thus more equitably benefit lower income taxpayers.
The mortgage interest deduction is one of the most costly tax expenditures in the current income tax and especially benefits high-income taxpayers. Whatever else may be said about the reform proposals put forward by the Panel, the idea of limiting mortgage interest deductions and targeting them more appropriateoly to middle class and lower-income taxpayers is a good one.
The home mortgage interest deduction has been a sacred cow for such a long time that many people have made their plans around it, and there would likely be some deflation of house prices as a result of any change. "The only problem," according to Robert Reich (secretary of labor under Clinton) who wrote a piece here making most of the points noted above, "is that these sensible ideas are probably dead on arrival. Realtors, mortgage lenders and home builders are already screaming bloody murder."
That means limitation of the mortgage interest benefit would be hard to pass as a stand-alone provision, even to finance the elimination of the AMT, as proposed by the Panel. Perhaps Congress should instead consider some version of the proposal for AMT reform outlined in my article above--(1) create an income threshold for application of the AMT that clearly protects ordinary Americans from having to bother with the AMT (somewhere around the income level for the break between the fourth and fifth quintile), and (2) add the mortgage interest deduction (perhaps subject to some minimal allowance of benefit) to the AMT preferences that, when aggregated, prevent wealthy taxpayers from paying their fair share of taxes.
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