Why the Tax Code Is So Hard to Unravel

If you want to understand why the tax code is so hard to overhaul, consider the case of the mortgage interest deduction. The issue is so sensitive that the House and Senate are dealing with it in completely opposite ways.

To its many defenders and beneficiaries, the mortgage interest deduction symbolizes and subsidizes the American Dream. It promotes homeownership, which gives people a stake in stronger neighborhoods and safer streets. And, of course, homeownership is the ticket to the middle class.

By allowing homeowners to write off their mortgage interest expenses — thus reducing their taxes — the government purportedly encourages all these good things. The cost in lost tax revenue is considered money well spent. In 2017, that would be $64 billion, according to the Office of Management and Budget.

Case closed? Not exactly. For years, many economists have argued that the standard narrative about the deduction is mostly a self-serving fairy tale. The reality, they say, is that the subsidy promotes oversized homes and higher real-estate prices. Upper-middle-class households are the main users of the deduction, which barely — if at all — raises the homeownership rate.

"People are being bribed by the government (through the mortgage interest deduction) to buy exceptionally big homes," says economist Jonathan Gruber of the Massachusetts Institute of Technology. In effect, there's a subsidy for McMansions. Homeowners rely more on debt, because some interest expense can be written off.

Gruber recently did a study with economists Henrik Kleven of Princeton and Amalie Jensen of the University of Copenhagen that seems to prove the point. Like the United States, Denmark has a mortgage interest deduction. In 1987, the Danes reduced the deduction's generosity. If the deduction increased homeownership, a reduction should have diminished it. That didn't happen.

"The mortgage deduction has a precisely estimated zero effect on homeownership," the study concluded. "Just under 60% of the population are homeowners, a number that has stayed remarkably constant over time," it said. This stability suggests that factors other than sheer economics — culture, psychology, geography — influence homeownership.

The erosion of the subsidy did have an effect but not on homeownership. What did decline was the size of homes people bought and the amount of debt they assumed.

The same dynamic applies to the United States, Gruber says. For decades, the homeownership rate has hovered around 64%. It spurted briefly to nearly 70% during the 2000's housing "bubble" but has reverted to 64%.

Reducing or eliminating the deduction would cause homebuyers to purchase smaller homes with less debt — a good thing, Gruber says. People could use the extra cash to save for retirement, to pay for children's college or to cover daily expenses.

It's a compelling case. You might think that the mortgage deduction's days are numbered. Perhaps they are, but it seems doubtful. The messy reality is that, regardless of its actual impact on the economy and personal housing decisions, millions of Americans believe they benefit from the deduction.

Start with all 76 million homeowners. If, as many economists think, the deduction props up real estate prices, then removing the deduction would likely weaken prices. This would help first-time buyers or those moving to bigger homes. But it would hurt home-sellers. It's hard to imagine many of them cheering the deduction's demise.

Next, consider that about 34 million taxpayers take the mortgage interest deduction, according to the Congressional Joint Committee on Taxation. Although that's only about a fifth of all tax filers, they're concentrated in the upper middle class. Roughly three-quarters of the richest fifth of Americans rely on the mortgage deduction to cut their taxes. They're bound to fear its loss will not be compensated by other tax reductions.

Finally, there are all the businesses that depend on housing: builders, real estate agents, mortgage brokers, furniture and appliance companies, to name a few. They have a stake in larger homes. Think higher prices, fatter real estate commissions, bigger mortgages and more construction.

Against this backdrop, it's not surprising that the House and Senate deal with the mortgage interest deduction differently. Although phasing out the deduction would be the best policy — ending the housing subsidy — the proposal before the Senate Finance Committee would preserve the status quo. In effect: Don't disturb this political hornet's nest.

Meanwhile, the House proposal would reduce the subsidy by allowing the interest deduction only on loans up to $500,000, a 50% decline from the current limit of $1 million.

Just how these opposite proposals can be reconciled is anyone's guess. But there is a larger point.

No matter how dubious or outmoded, tax breaks work themselves into the nation's economic and social fabric. They are hard to unravel, because people depend on them — and protect them.