Revenue Costs and Incentive Effects of the Mortgage Interest Deduction for Owner-Occupied Housing

We draw on household-level data from the 2004 Survey of Consumer Finances to analyze how changes in the income tax deduction for mortgage interest would affect the distribution of income tax liabilities and the consumption of housing services. Our primary innovation is to focus on the responses of household portfolios and the homeowner loan-to-value ratio to such tax changes. We estimate that repealing the mortgage interest deduction in 2003 would have raised federal and state income tax revenues by $72.4 billion in the absence of any household portfolio adjustments, but by only $58.5 billion if homeowners drew down a limited set of financial assets to partially pay down their mortgage debt. Allowing for such portfolio adjustments not only reduces the estimate of how much tax revenue would be generated by repealing the mortgage interest deduction, but also attenuates the negative effect of such a tax change on owner-occupied housing demand. Our results underscore the importance of recognizing behavioral responses when estimating the revenue effects of changes in the income tax provisions relating to owner-occupied housing. We are grateful to Igar Fuki and Moises Yi for outstanding research assistance, to Alan Auerbach, Abhijit Banerjee, Peter Diamond, Daniel Feenberg, Edward Glaeser, Roger Gordon, Therese McGuire (the editor), Kevin Moore, Lori Stuntz, Bill Wheaton, George Zodrow, the referees, and the participants in the NBER Tax Expenditure Project for helpful comments and advice, and to the National Science Foundation (Poterba) and the Research Sponsors Program of the Zell-Lurie Real Estate Center at the Wharton School (Sinai) for research support. Sections of this paper are based on Poterba and Sinai (2008).