Home-Loan Subsidy Leaves U.S. Exposed to Fiscal Storms
To understand the fiscal storm bearing down on the U.S., consider this: Federal spending now accounts for 23 percent of the economy, the highest level since the 1940s, while tax revenue stands at 15 percent, the lowest level since the 1950s. Anyone who can balance a checkbook understands the ramifications of that asymmetry.
Some of the imbalance has to do with the economic decline, which has sapped tax receipts and increased government spending on food stamps, jobless benefits and the like. Much of it, as the Congressional Budget Office reports today, is a structural problem. Left unchecked, the U.S. will continue to run outsized deficits and federal debt, which will exceed 70 percent of gross domestic product by the end of this year, will approach 200 percent of GDP by 2037. Interest payments alone are estimated to reach as much as $1 trillion annually within the decade.
Putting the nation on a more sustainable fiscal path will require hard choices and shared sacrifice by everyone -- including the middle class. One way to begin is by gradually scaling back some of the lucrative individual income-tax breaks, known as tax expenditures, that help lower tax bills primarily for wealthier individuals at a cost of more than $1 trillion a year. Replacing these expenditures with targeted 15 percent tax credits would save the U.S. $2.8 trillion over the next decade, according to the Tax Policy Center, with the biggest share of the burden falling on higher earners.
Many Americans are enjoying historically low effective tax rates -- the actual rate paid after factoring in countless deductions, exclusions, exemptions and credits. This spending through the tax code subsidizes such things as mortgage interest, health insurance, retirement savings, charitable contributions, state and local taxes, and child care.
The effect is dramatic. A middle-class family of four earning the median income (about $75,648) falls into the 15 percent tax bracket, yet in 2011 paid federal income taxes at an actual rate of 5.6 percent -- a level not seen since the Eisenhower administration. On average, a median-income family saves about $3,175 per year through tax expenditures, according to the Tax Policy Center.
Tax expenditures aren’t necessarily bad. As currently structured, though, they reward the wealthiest, distort behavior and, according to many economists, drive up the price of housing, health insurance and other tax-protected items. Wealthier earners enjoy the fruits more than lower earners because they are more likely to owe income taxes, itemize their returns and fall into higher tax brackets, which confer a bigger break.
For instance, someone in the 35 percent tax bracket gets 35 cents back for every dollar in mortgage interest paid, while someone in the 15 percent bracket gets 15 cents back. Households in the top 20 percent income bracket (those earning more than $103,000) received two-thirds of the benefits of tax expenditures in 2011, saving an average of $30,000.
Unlike with most issues in Washington, there is bipartisan support for eliminating or scaling back tax expenditures, particularly when coupled with lower overall tax rates. The bipartisan fiscal commission headed by former Republican Senator Alan Simpson and former Clinton administration official Erskine Bowles, and another panel headed by former Clinton budget director Alice Rivlin and former Republican Senator Pete Domenici, both call for repealing $1.1 trillion worth of tax breaks and using the revenue for deficit reduction, lower tax rates and targeted credits.
President Barack Obama has called for limiting the benefit of tax expenditures for the wealthy to the value the breaks have for those in the 28 percent tax bracket. In other words, Obama would return to high earners 28 cents for every dollar paid in mortgage interest, even if they are in the 35 percent tax bracket. His plan would raise about $288 billion over the next 10 years. House Budget Chairman Paul Ryan’s fiscal 2013 budget would curtail tax expenditures for the wealthy, though he hasn’t said which ones he would target, and he would use the savings to cut tax rates rather than reduce the deficit.
The approaches differ in the details, yet all share a common principle: Tax benefits should be more proportional, so that the rich pay more and lower-income earners pay less. That’s not the case with the mortgage-interest deduction, one of the most popular tax breaks, which costs the U.S. about $89 billion a year. The deduction, which saves homeowners an average of $559 a year, is a regressive benefit. Its average value rises from $91 for those earning less than $40,000 to $5,459 for those earning more than $250,000.
Homeowners can deduct interest paid on mortgages of as much as $1.1 million and an additional $100,000 for home-equity loans. They can also apply the deduction to multiple residences. Several studies have found little evidence that the tax break promotes homeownership. The rate of U.S. homeownership is similar to that of Canada, Australia and the U.K., none of which currently offers a deduction. The break instead propels people to buy more expensive homes, leaving them less money to invest elsewhere and artificially driving up housing prices.
Given the fragility of the housing market, any major changes should happen gradually. The U.S. should first restrict the deduction to a single residence and exclude home-equity loans. The deduction should also be phased out, perhaps in $100,000 increments over a period of 10 years, and replaced with a 15 percent refundable tax credit. By making the credit refundable, homeowners who owe no tax would still be able to benefit. In essence, they would save 15 percent on the interest owed on home loans.
The U.K. phased out its mortgage-interest tax relief over a 12-year period in 2000. Economic studies show that homeownership rates haven’t suffered, nor have housing prices. A U.S. tax credit may even help a larger number of lower- and middle-income families afford homes. With the major tax expenditures projected to cost almost $12 trillion over the next decade and federal debt expected to reach 93 percent of GDP over the same period, action is clearly needed.
Today’s CBO report makes painfully clear the consequence of doing nothing: reduced national savings, higher interest rates, more foreign borrowing, slower income growth and the potential for a fiscal crisis in which borrowing costs skyrocket. The unfortunate reality is that everyone will have to bear the pain to avoid such an outcome. Replacing the countless deductions, exclusions and exemptions with tax credits will at least make the burden more equitable, with those most able to afford higher taxes paying a fairer share.
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