A tax break to jettison

The federal government creates policies that actively try to promote home ownership. This sounds like a great idea to most people. After all, home ownership is as American as baseball and apple pie. While I am a big fan of baseball and apple pie and I am content to leave them on their respective pedestals, policies that promote home ownership deserve more scrutiny, and when they receive this scrutiny, they do not fare well.

In particular, consider a policy that should be repealed. Currently, homeowners can deduct their home mortgage interest payments from their income taxes. This means that a person who pays $20,000 in interest a year on her mortgage loan can subtract $20,000 from the amount of her income that is subject to federal income taxes. This current policy is problematic on several fronts.

Perhaps most obviously, the interest deduction favors the rich. You must take out a mortgage of around $600,000 to pay $20,000 a year in interest. People who buy $600,000 houses generally are pretty well off and they do not need extra breaks. Most people in Arkansas take out mortgages that are small enough that they do not itemize their deductions. Instead, most Arkansans take the standard deduction, which is the amount of income that you are allowed to exclude from income taxes without having to resort to tax loopholes.

The interest deduction encourages people to buy homes in the suburbs, rather than to rent apartments in a city. Homes are not widely available in cities because it is more efficient for one person to own a whole building, rather than for individuals to each own their own apartment. The policy, by keeping people out of cities, creates a number of problems.

First, cities are where the economic action is. Two percent of our land produces over 50% of our output. Further, Harvard economist Ed Glaeser notes that the U.S. would produce 43 percent more output if people throughout the country were as productive as they were in the New York Metropolitan Area.

Cities allow people to be more productive because they facilitate team production. Because there are so many people in one place, a firm will find it easy to hire enough people with the right skills to get a job done. Also, because humans have a great ability to learn from others, cities allow people to build their skills and become more productive. That is, cities have so many talented people that a young worker can find plenty of people to learn from. In addition, a new idea or innovation will spread rapidly across a city because people interact with so many other people.

Finally, consider another advantage of city living. Uemployment spells are less likely to be long-lived in a city than they are in a suburb. In a suburb, a person who gets laid off may not find another suitable job in his small town. However, this person may stay in town because he does not want to leave his friends and extended family behind. In addition, his home will serve as an anchor. If the unemployed person cannot sell his home, he may stay in the small town where he has no job prospects. In contrast, when a person in a city becomes unemployed, the number of numerous suitable jobs in close proximity will be enormous.

In short, encouraging home ownership is one of those ideas that sounds great until you dig a little deeper. Once we get a little deeper, a good case can be made for repealing the income tax deduction for the interest paid on home mortgages. That said, I should qualify my position a bit. Removing the tax loophole will reduce the demand for housing and lower housing prices — or at least reduce the rate at which housing prices grow. While this may be good news for potential homebuyers, it is bad news for those who own expensive homes.

To keep this group from experiencing a financial hardship, policy makers may want to consider phasing out the interest rate deduction, so that the change in the prices of expensive homes does not occur all at once.