I’m just back from a trip to Washington, D.C., where people take politics so seriously that politicians’ speeches are broadcast in full on the radio (e.g., a full half hour was devoted to a talk by Joe Biden to some Democrats in Florida; anywhere else in the U.S., a Vice-President would have to be Raptured or undergo a sex-change operation in order to merit 30 minutes of uninterrupted radio time). A handful of friends there asked me what I thought about the various “flat tax” proposals being put forward. Most of these folks have worked in Washington their entire lives and therefore have no understanding of what it might be like to work in a private company selling goods and services to private customers. So they asked “Would a flat tax make it easier to run a business?”
My reply was that most of the costs of the present system to me relate to figuring out how much my income actually is, rather than multiplying that income by one or more rates. Different capital goods must be depreciated on different schedules. Expenses must be categorized. Losses are sometimes deductible (ordinary business) but sometimes not (loss from renting out real estate, unless one is working full time in real estate). All of this costs me about $2500 per year in accounting fees and a couple of weeks that could have been spent generating additional income rather that poring over statements. The cost/hassle would be the same under a flat tax.
So I’m not motivated to advocate for a flat tax, but I do advocate that we eliminate home mortgage interest deductibility (subsidizing one of the most unproductive corners of the economy (a worker who goes home to a fancy house is no more productive than a worker who goes home to a simple house)) and allow businesses to choose whatever depreciation schedule they like for capital expenses, including immediate write-off of 100 percent (could simplify compliance by allowing a company simply to look at its checking account balance annually and infer the previous year’s income).
In general, all of the tax talk seems like a bit of a distraction. If we re-tweaked the income tax code would it then become profitable for companies to hire America’s 15 million unemployed folks? If the problem is that these workers aren’t educated or skilled enough and that they require health insurance in the world’s most expensive country for health care, a change in income tax policy isn’t going to make a big difference.
I’m not opposed to eliminating the mortgage interest deduction, but I wonder what the fairest scheme for rolling it back would be. Do you have a proposal? It seems to me that dropping it immediately and cutting the rate slightly might be sufficient, but I suspect that many home owners might prefer something a little less drastic.
I think “flat tax” has come to implicitly include the idea that various deductions would be dramatically rolled back; otherwise you just flatten the marginal rate schedule and nothing gets simplified. But, the need for simplification doesn’t have a natural constituency. Mega corps and law firms naturally prefer it like it is now.
A simplification of the business tax code would be great, especially because so many individual (lone) business “owners” fall under it. The restrictions around qualifying a home office for example are absurd. All it takes is ONE personal item in your home office to disqualify it. Also, I use my laptop 75 percent for work but if audited I will need to produce a log of my use of this equipment. So technically I need to record every time I begin using it for work, every time I take a break to check personal email/websurf, every time I return, etc.
billb: What’s the fairest scheme for rolling back the mortgage interest deduction? I would just rip the Band-Aid off and do it starting in tax year 2012 (leave it in place for 2011 since people may already have budgeted for it). Interest rates are so low that people can refinance and pay a net that was pretty similar to what it would have been with higher interest rates and a deduction. I don’t think Americans will be forced out of their McMansions by this.
If something is a dumb idea, and I think the mortgage interest deduction was proved (Real Estate Collapse of 2007-2008) to be a spectacularly dumb one, doing it 80% next year, 50% in 2013, 25% in 2014, etc. is still dumb. If there is to be an effect on the value of high-end houses (average houses shouldn’t be affected much since the average person does not get much benefit from the mortgage interest deduction compared to the standard deduction), let’s take the hit in one month and not have to watch a (another?) slow depressing slide over several years.
Separately, in case you hadn’t noticed, the government needs more money! Warren Buffett keeps reminding us of all the good that the wise folks in Washington, D.C. could do if only we sent them more $$ (Buffett’s own money is being sent to Africa by the Gates Foundation, which is yet another reason why people who aren’t Buffett need to send the U.S. government more).
The mortgage interest rate deduction were created with the Tax Reform Act of 1986. Prior to that all interest on personal loans was deductible from 1913 onward including credit card debt. The number of economic swings we’ve had in either direction since 1913 is probably close to a dozen. So you’re obviously just trolling.
The point of the flat tax is to remove all deductions, loopholes, etc. and everyone pays the same rate on what they earn. Businesses use cash accounting for calculating income. Money that comes in is income, money that goes out is a loss. That is the vision I see being sold to people. You’re right, I don’t see how they would implement it in practice for a business unless they allowed businesses to write off capital expenses on any schedule they chose.
Realistically, it will never happen anyway. Politicians just can’t stay away from messing with the tax code to create incentives for various behaviors.
Ryan: I did not mean to imply that the mortgage tax deduction was responsible for our most recent “economic swing”. Only that it contributed to the real estate bubble that burst in 2007-2008. As you have helpfully pointed out, the idea was new in 1986, I think that adds weight to my argument that we should get rid of it. The U.S. managed to have a sufficient number of houses for hundreds of years, despite the lack of this tax subsidy. Introducing the tax subsidy helped created a bubble that inflated for about 20 years and then burst with spectacular consequences for people who were not even participating in this unproductive corner of the economy (e.g., people who rented apartments and went to work every day in a factory).
I share billb’s concerns about an instantaneous removal the mortgage tax deduction. I’m not sure what average is but I know in the more expensive markets (I live in Oakland, CA. So we’re high end adjacent) most homes would be devalued by such a maneuver because of the deduction loss. Seems a bit extreme and immediate way to remove wealth (and not only from the “wealthy”).
Alan: If we accept your objection then we can never cut back any government subsidies. No matter how many Americans die from obesity we will have to continue subsidizing corn, for example. Similarly because we did a bunch of misguided things with housing we will have to do them forever. You might be right in terms of practical politics (if so, buy shares of companies in younger countries!), but I don’t think it is a desirable goal for our society to be locked into government subsidies for things other than, say, education for poor kids.
Interest rates are so low that people can refinance and pay a net that was pretty similar to what it would have been with higher interest rates and a deduction.
You can only do this if your house is not “upside down”. The bank won’t refinance a $200,000.00 mortgage if your house is now only worth $150,000.00…sadly the case for many folks. For many of us, the mortgage deduction, combined with charitable gifts is the only to get a small refund each year.
There’s a reliance argument here. I get at least $1000/yr. off of my federal tax bill due to the mortgage interest deduction. Due to the decrease in interest paid over the life of my loan, the government will get maybe $25,000 from me if it drops the deduction on the floor in 2012. That doesn’t seem fair since I factored this deduction into the planning of my house purchase. I’m not really sure I’m down with a ~10% devaluation in my house price.
Also, you seem to have misunderstood the importance of the 1986 change in the law. Before then, all personal loan interest, including mortgage interest, was deductible. After the law was changed, only mortgage interest was deductible. It’s not a modern innovation.
I was aiming for concern more than objection. :^)
I think we share the same goal. Government subsidies are overused, including the mortgage interest deduction. I’m trying to think of a way to actually have a phased approach that doesn’t burden those “holding the bag” when it goes into effect. California also has proposition 13 to unwind. Both should be repealed but would wipe away so much wealth all at once. Beyond being untenable politically it seems nigh on punitive.
Eliminating the mortgage deduction totally makes sense. It’s massively distorting.
Yet cut it off, and everyone who spends over 35% of income on their mortgage (in CA, basically everyone under 50) would simultaneously become a panic seller, knowing they can no longer afford their mortgage. This race for the exits would make the 2000 Nasdaq peak look tame. Instant price collapse, all sellers, no buyers. The price collapse would put everyone under water, triggering another huge default wave.
I know that even a 10-year phaseout would lead me to sell immediately, trying to get out ahead of everyone else, since the deflationary pressure is so obvious. If this is equally obvious to others, then again you get a race for the exits and consequent price crash and default wave.
This is the price we pay for decades of bad tax policy.
Folks: http://www.taxfoundation.org/research/show/22499.html says that only 2 in 5 Americans takes the mortgage interest deduction (the rest either rent or don’t have enough deductions to itemize). Thus there should not be any way for a change in this tax rule to affect the value of an average house. Obviously there will be some effect on very expensive houses, but this is a democracy and we’ve voted for a government that is vastly larger than the current array of taxes can support. So it is time to pay up and we might as well start with something that can redirect our money towards productive ends.
In his new book, Republic Lost, Larry Lessig argues that we won’t ever see a flat tax because it’d remove too many incentives for Congresspeople to receive fundraising donations: the complicated tax code’s complexity is a feature, not a bug; what better way to solicit donations that to hold sway over millions of dollars of tax benefits that might not be renewed if you don’t get re-elected?
I’d be curious to read your review of Republic Lost. I found the book did an excellent job describing the problem of money in politics (to the point where it’s quite depressing how bad the situation is), but the proposed solutions, by Lessig’s own admission, had pretty low chances of success.
Again, eliminating the mortgage deduction totally makes sense. It’s massively distorting.
The 2-out-of-5 number is national, and unevenly distributed, both geographically and demographically, particularly by age group. So our assertions are not mutually exclusive: under-50 CA homeowners would be largely ruined, bringing destabilizing macro and/or political effects.
I don’t work in the industry, have no bias, and write these cautions out of concern for Californians younger and poorer than myself. I personally would make out fine: simply sell my house, and buy back in at the new equilibrium, 25% lower (the amount by which payments must be reduced if the deduction goes away). But for those already under water, or just starting out, or uncomprehending of the implications until it’s too late to get out — well, they have my sympathy if this happens.
And this effect may not be confined to California, for multiple reasons:
1. 66% of Americans own a home, and 40% of those have no mortgage. In other words, almost exactly 40%, or 2 out of 5, have the ability to take the mortgage interest deduction. Combining this with the Tax Foundation data suggests that everyone who has a mortgage is taking the deduction.
2. The remaining 3 out of 5 are not in the housing market — they either rent, or are retirees that own free and clear. Since they do not buy or sell, they are outside the pricing equation, further increasing the price impact of those who do use the deduction.
3. We know from recent history that general house price levels are massively affected by the travails of even a minority of homeowners. This minority-actor effect is not only true generally in microeconomics, but also easy to see anecdotally in housing: the post-2006 price crash arose from a delinquency rate that remained under 10% nationally, yet brought prices down dramatically almost everywhere, which had macro effects).
The research required to debate this persuades me that an abrupt cutoff would be even more devastating than I first thought, and would have national, not regional, impact.
Again, eliminating the mortgage deduction totally makes sense. It’s massively distorting. I just don’t see how to get rid of it under current conditions.
The best proposal for the home mortgage deduction issue is a modest one: cap the size of the mortgage that can be deducted. That may actually have a chance of going being enacted.
Ray: The home mortgage interest deduction is already capped at the interest on $1M in debt used to buy a house.
Looks like this columnist is making the same point:
http://www2.timesdispatch.com/news/oped/2011/nov/01/hinkle-perrys-flat-tax-not-quite-simple-ar-1425017/
I’ll join the chorus saying to phase out the HID. Suddenly getting rid of a bad policy can be as bad as letting it sit forever.
“Flat tax” is often used rhetorically to mean a simple tax system. I wouldn’t mind a very very simple yet still progressive tax system. Say, get rid of the corporate tax entirely and make it all payable when the shareholder realizes dividens or capital gains, which are taxed just like wages.
Yeah, y’all don’t get me wrong, I’m all for a simpler tax system, but I’m with dominik in thinking that Larry Lessig has a good argument that the complexity of the tax system won’t change until the campaign finance system changes. I’m only about 2/3rds through his book, so I’ve just gotten the list of symptoms not the cure so far.
Here’s another set of facts:
http://www.nahb.org/news_details.aspx?newsID=13651
Jim: Thanks for the link. I learned from it that the National Association of Home Builders is very supportive of the idea that every American should own a house, even if the government has to pay for it. But I still don’t think the idea is good for economic growth. For one thing, people who own houses are less mobile and have a tougher time moving to where the jobs are.
You’re welcome…I figured you would enjoy that set of “facts”.
But I’m not sure eliminating the mortgage deduction does much, especially with only 2 in 5 claiming it. I surely don’t see how eliminating it simplifies the tax code.
On the other hand, if they do away with the Alternative Minimum Tax at the same time, I’m all for it.
>> people who own houses are less mobile and have a tougher time moving to where the jobs are. <20-year straight-line phaseout of the deduction would do the trick. It’s so slow that owners can’t easily forecast the consequences, so they won’t sell. Meanwhile, one hopes that eventual economic growth might ease the blow. Most of all, it’s politically palatable, because the politicians that vote for it know they’ll be long gone before the phaseout starts to bite.
… especially if their home price just collapsed because the interest deduction was phased out too fast. 🙂 But I do agree with your point that renting greatly increases flexibility, which helps both individually and in aggregate — esp if it is suddenly no more expensive than buying.
A >20-year straight-line phaseout of the deduction would do the trick. It’s so slow that owners can’t easily forecast the consequences, so they won’t sell. Meanwhile, one hopes that eventual economic growth might ease the blow. Most of all, it’s politically palatable, because the politicians that vote for it know they’ll be long gone before the phaseout starts to bite.
Adam: home prices in California would not collapse if the interest rate deduction were eliminated. Cash buyers make up a greater proportion of home sales source and with the lower sale prices younger people who finance are not paying more than 30 percent of their income on their mortgage. I am in my 30s and pay < 15% of my income on mortgage + ins+ taxes. Several of my friends paid off their mortgage. I think you are overstating the impact.
This interest tax relief sounds like MIRAS, which was phased out here in the UK in 2000:
http://en.wikipedia.org/wiki/Mortgage_Interest_Relief_At_Source
“allowed borrowers tax relief for interest payments on their mortgage.”
It’s phasing out didn’t help the UK avoid a housing bubble.
In my eyes the bubble has been mostly been prevented from bursting since 2008 by reductions in interest rates (0.5% since March 2009). Home owners have just been suffering from inflation eeking away at the property value since then as house prices stagnate (See PDFs linked from http://www.nationwide.co.uk/hpi/review.htm). Obviously there are other factors, but when interest rates rise (now not until 2013 according to The Telegraph http://www.telegraph.co.uk/finance/economics/interestrates/8583344/UK-interest-rates-will-not-rise-until-2013-BNP-Paribas.html) we’ll see whether inflation has eaten up the bubble or if there’s scope for them to fall further.
To correct myself, MIRAS was abolished, rather than ‘phased out’.
All but one of the posters here seems to think that mortgage interest wasn’t deductible before 1986.
It has been deductible for nearly 100 years.
Personally I would rather see all interest deductible again like it was before 1986. Then you wouldn’t have all the mess about loans that are or are not for improvements to your primary or non-primary residence.