Friday, June 22, 2007

Should mortgage interest costs be tax deductable?

On my first day of vacation, traveling from Halifax to Calgary (on my way to Tofino), I began reading the Friday copy of the Globe and Mail and I found a small (and rather hollow) article, “ Actuaries call for tax breaks on home mortgage interest ”, as a way to increase the net wealth of babyboomers. For fun, let’s walk through the implications of the actuaries’ suggestion.

On a $200,000 home, with a borrowing cost of 6.0%, the interest paid on a 25 year mortgage pays about $183,293; multiply that number by your tax rate (say 35%) and you have a whopping amount of savings (just over $64,000 over 25 years). This type of plan would have several effects (follow the step by step causality): (i) it would lower the cost of purchasing homes because the effective interest paid (and thus the mortgage) is lower; (ii) this would increase the demand for housing (for a given level of income), (iii) which would intern increase the price of the new and existing housing stock; as demand responds to the lower carrying cost of owning a home, higher demand would increase prices. Homeowners, therefore, would win! Not only do they now have a huge tax deduction, but the net worth of their home would rise, increasing their net wealth. How much would housing prices rise by such a policy? Well, I would think it would rise by exactly the amount of the savings from the tax deduction once the change has been fully priced in … which could take anywhere for 2 to 4 years.

Overall, this policy would effectively transfer wealth from the government, or equivocally from every tax payer, to every homeowner. Because this policy would make homes more expensive, it would only benefit existing homeowners over time (and in the very short-term new home owners would get a deal until demand pressures pushed up prices).

Furthermore, it would (over time) increase rental costs. Although the tax deduction is only on primary residence, overtime, the price increases of primary residence would change the opportunity cost of renting units or selling them as primary residences – just think of the transformation of apartments to condos as an example.

In the end, what this looks like is a transfer of wealth from non-homeowners and corporations (or stock-holders) to homeowners. Does this sound like taking from the poor and giving to the rich? Well, I think it does a little. Perhaps think about it this way: instead of giving homeowners a $64K refund on their mortgage costs, we could use that money to pay a nurse's full year’s salary (for ever 25 homes we could employ one RN for 25 years), or even better increase the Old Age Security payments to the poorest elderly? If we are really concerned about helping babyboomers who have not saved enough money for retirement, I think we can think of better policies then this one. Personally, I think that Government programs like the Old Age Security could be broadened or beefed up.

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