Home Mortgage Interest and the Financial Crisis

7/21/2011

By Joseph M. Press, CPA, CFE

While attending the Tri-State Bankers Summit in Big Sky, Montana, I had the opportunity to hear a speech by Mr. Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis. Among other items discussed in the speech, Mr. Kocherlakota made the point that the U.S. tax system promotes leverage on the part of households and financial institutions and concluded that Congress should modify the tax code to reduce the incentives for destabilizing activities by banks and households. Here are some thoughts and historical perspective on the deductibility of mortgage interest and trends in household debt.

Deductibility of Mortgage Interest

The imposition of income taxes began in 1913 with the passage of the 16th Amendment. From the very beginning, interest expense (for most any reason) was deductible. For personal interest expense, this tax treatment was constant until 1986 when personal interest expense deductions were basically limited to home mortgages and investment interest. Stated another way – home mortgage interest has been deductible from 1913 through today.

Household Debt

A look at the trends in household debt show consistent increases by most any metric, until it peaked in 2008 at $13.8 trillion. Home mortgage debt peaked a year earlier at $10.5 trillion. Compare these amounts to 1990 levels of $3.6 trillion and $2.5 trillion, respectively.

Another measure of household debt is Outstanding Debt as a Percentage of Disposable Personal Income.

[An astounding increase from 2000 to 2007 when this measure peaked.]

Mr. Kocherlakota’s position that the U.S. tax system promotes leverage on the part of households is well taken. I have observed and firmly believe that if you want more of something – subsidize it and if you want less, tax it. However, how is a 98-year-old tax provision allowing the deduction of mortgage interest responsible for the recent run up in household debt levels?

There are clearly other and more significant factors at play, which should be identified before we attempt to reduce household debt through changes in the tax code.

The speech can be found at http://www.minneapolisfed.org/news_events/pres. The above statistics are from the Joint Committee on Taxation Staff report “Present Law and Background Relating to Tax Treatment of Household Debt.”