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I. Introduction

Currently, much attention is focused on the potential negative economic effects of allowing the Budget Control Act of 2011 to go into effect and the expiration of the tax policy changes enacted in 2001, 2003, 2008, and 2009—a confluence of events referred to as the fiscal cliff. Regardless of how policymakers act to resolve the various issues that comprise the fiscal cliff, including its potential negative effects on the tepid U.S. economic recovery, fiscal policy will remain an important issue as the United States must reform its structurally unsustainable fiscal policies to reign in growing deficits. Tax reform will certainly need to be one of the components of fiscal policy reform. Indeed, recent years have seen renewed interest in fundamental reform of our nation's corporate and personal income tax system. This interest has been prompted by a variety of factors. There is of course widespread recognition that the U.S. income tax is a complex, highly inefficient, and costly way of raising revenues to finance government expenditures. Beyond this familiar concern, the reports of several recent commissions focusing on deficit and debt reduction—most prominently the proposal made by the National Commission on Fiscal Responsibility and Reform (2010) (the Simpson-Bowles report) and the alternative plan proposed by the Debt Reduction Task Force of the Bipartisan Policy Center (2010) (the Rivlin-Domenici report)—have argued that additional tax revenues are going to have to play a role in solving our nation’s looming fiscal problems, even if this role is secondary to spending reductions and cost-reducing reforms of the Social Security, Medicare, and Medicaid programs. Accordingly, both plans included proposals on how to reform the income tax system.

One way such additional revenues could be raised—without the distortionary economic effects and political difficulties of raising income tax rates—is by eliminating or curtailing various preferences or “tax expenditures” under the current income tax, holding tax rates constant. The second largest individual income tax expenditure, as defined by the Joint Committee on Taxation (JCT) (2012), is the home mortgage interest deduction (MID). The MID is, of course, an extremely popular and thus highly politically sensitive provision; indeed, the MID was one of the few provisions that was deemed to be untouchable during the deliberations preceding enactment of the landmark Tax Reform Act of 1986 (TRA86), a highly successful effort at fundamental tax reform that is widely believed to be the most sweeping reform of the income tax since its enactment (McLure and Zodrow, 1987). Nevertheless, given the severity of the fiscal problems currently faced by the United States, many recent tax reform proposals have included measures that would curtail or even eliminate the home MID. For example, the report of the National Commission on Fiscal Responsibility and Reform (2010) recommends that the MID be replaced with a 12 percent nonrefundable tax credit for interest paid on mortgages on a principal residence, with the amount of the mortgage for which the credit is available capped at $500,000; MIDs for second or vacation homes (those that are not rental properties) and home equity loans would also be eliminated. Similarly, the report of the Debt Reduction Task Force of the Bipartisan Policy Center (2010) recommends that the MID be replaced with a 15 percent refundable tax credit for up to $25,000 of home mortgage interest expense on a principal residence (which equals the annual interest paid on a $500,000 home mortgage loan with a 5 percent interest rate), and also recommends eliminating the MID for second or vacation homes. These proposals follow in the path outlined by the more comprehensive report of the President’s Advisory Panel on Federal Tax Reform (2005), which recommended that the MID be converted to a 15 percent credit, subject to loan caps ($227,000–$412,000) that varied across states depending on housing costs. Finally, some more sweeping reform proposals, including the Simpson-Bowles “zero plan” that would eliminate all income tax expenditures, call for complete elimination of the MID.

This paper examines the economic effects of such proposals to eliminate or curtail the MID. We use the Tax Policy Advisers (TPA) model, a dynamic, overlapping generations, computable general equilibrium (CGE) model of the U.S. economy developed by the authors, to simulate both the short run and long run macroeconomic effects of such proposals, including their effects on the housing market, such as changes in housing prices, housing investment and the housing capital stock, and the mix of owner-occupied and rental housing. We also estimate the changes in tax liability by age and income group due to these changes in the MID, taking into account differences across households in whether they itemize and in the marginal tax rate at which the MID is taken, as well as the portfolio reallocations that would be expected to occur as households decide to pay down mortgage debt once the tax advantages of the MID are reduced or eliminated (Poterba and Sinai, 2011). In addition, we estimate how the reforms would affect the housing user cost of capital, and include estimates of the effects of eliminating or curtailing the MID for a few representative households.

Finally, we also perform some rough supplemental “off-model” calculations to estimate the effects of the simulated reform-induced reductions in housing prices on the number of households with negative equity—that is, the number of households that are characterized as “underwater” since their home mortgage debt exceeds their house value—as well as the numbers of these homes that might be expected to end up in foreclosure proceedings.

The paper proceeds as follows. The next section provides some background information on the MID. Section III provides a brief overview of the TPA model, including the characteristics of the initial equilibrium and the parameter values used in the simulations. Section IV presents and discusses the simulation results, while Section V provides the off-model calculations. The final section concludes.

This material may be quoted or reproduced without prior permission, provided appropriate credit is given to the author and Rice University’s Baker Institute for Public Policy. The views expressed herein are those of the individual author(s), and do not necessarily represent the views of Rice University’s Baker Institute for Public Policy.