One of the Catfood Commission's big ideas is to get rid of the home mortgage deduction, and just lower income taxes for everyone. This has a facile attractiveness, and the idea has been batted around before, but there's a bomb in there which wouldn't defuse easily.
The deduction may well have been a bad idea, or at least not managed well, but the housing market is a fragile one. Small changes in tax policy can have large repercussions.
The mortgage deduction is a two-edged sword. On the good side, it has helped families afford homes. On the bad side, it has helped inflate real estate bubbles, which we've seen to be hazardous to the economy.
If there had never been such a deduction, what would the consequences have been? In a historical context, like the 1950s suburban building boom, it would have slowed down suburbanization a bit. Houses would have been harder to afford, so more people would have stayed renters. At the time, it would have looked worse: Less economic growth, inferior housing (since the tax break is after all a subsidy to housing). But we can look back and see the unforeseen consequences of suburbanization: Sprawl, more dependence on the car, more racial segregation, inferior urban schools, and a general breakdown in community spirit.
By the late 1970s, some people were moving back to the cities, leading to "gentrification". Neighborhoods that had declined two decades earlier became fashionable again, and poor people who had moved in were displaced. Since tax policy favored home ownership, apartments were sold off as condos, allowing home ownership (i.e., the tax deduction) without full land ownership.
So if it was a bad idea after all, maybe we should do away with it. But what would happen then?
The housing market works very differently in different places. In some parts of the country, land is cheap, and houses are priced based on how much it would cost to build one. This is common in the area between the coasts, like from Ohio to Texas to Nevada, where there's plenty of buildable land. Top locations might fetch a premium, but you can buy a 3BR house for <$250k. </p>
In other areas, developed years ago, land is expensive, so the house itself represents only a fraction of the value. My neighborhood near Boston, for instance, is rife with tear-downs. It's typical for a 1500-2000 sf house to be purchased for around $700k, torn down, and replaced with a much bigger one (3500-4000 sf) that's marketed for around $2M. These are for the top 1% -- the ones whose real income has dramatically risen over the past three decades. And these houses are often purchased for cash, not mortgaged. (About the only good thing about this trend lately is that since 2007, the new houses have been designed to blend in better -- they're just bigger Colonials. From 1990 to 2007 or so, McMansions ruled, and it was a race to be even uglier than the last.)
What would happen if the mortgage deduction went away? If it ended too quickly, people would have trouble paying, and defaults would lead to a mass of foreclosures. Not good at all. It's the rich who would benefit most from the Catfood Commission's proposed lower tax rate, so the middle class would be squeezed hardest. In theory this could be alleviated by tweaking the tax tables. But you and I know what could pass the incoming House.
Beyond that, home prices in general would fall, since the subsidy would be gone. Now the real fun begins. Put aside sub-primes for the moment. Many homeowners have most of their family equity tied up in the house. Let's say that the house price market were totally level since the house was bought (not a real case, but a simplification for math purposes). If someone paid $500k for a house and put down 20%, then they have a $400k mortgage. Absent the tax subsidy, there'd be less money chasing after houses. In places where the value of a house is largely based on high demand for land, like the coastal cities, the price of a land, and thus a house, would rapidly fall. A 20% drop would wipe out the homeowner's equity. In places with cheap land, the price is closer to the cost of new construction, so it would probably fall less, but there's be even less new construction.
Because the high-land-price areas would lose equity more than the low-land-price areas, removing the tax break would effectively shift wealth towards the lower-cost areas. Which just happen to mostly be red states. Funny about that.
A lot of boomers were hoping to use home equity as part of their retirement savings, kids' college tuition, etc. This would be lost. Even if the deduction were phased out slowly, not immediately, the price of land would fall based upon the anticipated future demand. The whole market dynamic would change. The Catfood Commission accompanies this with cuts to Social Security and other programs that help middle-class retirees. Are we detecting a pattern here? The coupon-cutting class (the term refers to old-time bearer bonds, not store discount coupons) gets lower tax rates, while the mortgage-paying class loses their life savings and safety net.
To be sure, the mortgage deduction is a dangerous drug, and over time it probably should be phased down. But any such change has to be very slow, and probably work its way down from the top income brackets, in a way that doesn't suddenly wipe out home equity and further damage the economy. It will probably need decades to do correctly. Otherwise it's an invitation to more financial disaster.