TAX NEWS - 2010

US tax incentives

DALLAS — Most homeowners are happy to use the tax deduction for mortgage interest, even though it will cost the federal treasury about $103 billion in lost revenue this year.

Almost all lawmakers support the mortgage interest deduction — which has been called "America's favorite tax shelter" — and homebuilders and real estate agents say it's critical for promoting homeownership.

But widespread concern about federal indebtedness has focused attention on tax incentives that cost so much that some critics question whether America can afford them.

The mortgage interest deduction is the third-most-expensive tax incentive and has been estimated to cost only slightly less than the tax treatment of employer-sponsored health care ($110 billion) and 401(k) retirement plans ($106 billion), according to figures from the congressional Joint Committee on Taxation.

Added up, the more than 200 tax incentives available will cost the federal government about $1.1 trillion this year — about $200 billion less than the federal budget deficit.

The incentives are also known as tax "expenditures," because they work the way other government expenditures do.

Congress has created tax incentives to encourage health coverage and retirement plans, boost the incomes of lower-income families and subsidize an ever-growing list of domestic industries. But the primary experience that most Americans have with tax incentives comes with homeownership.

"This country needs to come to grips with the reality that we have limited resources," said Edward D. Kleinbard, a professor of law at the University of Southern California and a former chief of staff to the Joint Committee on Taxation, which computes the cost of tax legislation for Congress.

"We have to make hard choices," Kleinbard said, "and tax expenditures are getting close to a free pass compared to explicit spending."

Yet tax expenditures are rarely mentioned when Congress discusses the path to fiscal discipline. Lawmakers from both parties regularly refer to tax expenditures as "tax relief" — meaning that attempts to repeal or change them can be painted as a tax increase.

Spending cuts are most likely to be front and center as lawmakers consider ways to shrink record budget deficits and curb U.S. borrowing. But experts who scrutinize the federal budget insist that Congress can't solve the problem with spending cuts alone — not when the $1.1 trillion in tax expenditures is double what the government will spend on Medicare in 2010.

"If you exclude half of your expenditures from review, you are unlikely to get that debt under control," said Rep. Lloyd Doggett, D-Texas.

A deduction for mortgage interest was permitted when Congress established the modern income tax in 1913.

At the time, relatively few Americans owned homes. Nonetheless, the mortgage incentive was part of a wider deduction for interest payments and wasn't envisioned as a spur for homeownership, according to the Congressional Research Service. Nearly 37 million American tax filers now use the interest deduction, according to the Joint Committee on Taxation.

Not every homeowner can claim the deduction, because its value is tied to how much mortgage debt a homeowner has.

For people with lower-cost homes, the deduction isn't enough to make a difference on their taxes, so they use the standard deduction. Renters don't get an equivalent subsidy. But people who buy higher-priced homes have a way to shrink their tax bills.

"We pay a lot in taxes, and before we owned a house we didn't have a whole lot to write off," said Keith Plaskett, a product director for a Microsoft supplier. "I certainly would protest anything that would involve removing things we could write off."

Plaskett, 35, and his wife, Crystal, recently bought a four-bedroom house in Las Colinas, Texas. They enjoy the nearby golf courses and the proximity to Dallas/Fort Worth International Airport, because both travel a lot for work. Every house in the neighborhood was designed by an architect, and house prices range from $260,000 to about $1 million.

Plaskett said he had planned to buy a home eventually but pulled the trigger in April 2009 because of the homebuyer tax credit, a subsidy that was separate from the interest deduction and that saved him $4,700.

Plaskett doesn't need the interest deduction to afford his house, but it has been a nice sweetener. He and his wife never received a tax refund until they were able to deduct their mortgage interest, which amounts to about $10,000 for a full year, Plaskett said.

"I can understand the government would realize a lot more revenue" if the deduction weren't available, Plaskett said.

"But homeowners have relied on being able to write off the interest for decades. Especially for people nearing retirement age and still paying a mortgage, I think that is throwing gasoline on a fire right now."

Older couples aren't the ones who benefit the most from the deduction, according to data compiled by the National Association of Homebuilders. The average mortgage deduction is highest for homeowners between the ages of 35 and 45.

The deduction is an even better deal for homeowners whose earnings are higher: more interest to deduct from income taxed at a higher rate.

Writing in Slate in 2005, Jason Furman, now deputy director of the White House's National Economic Council, endorsed a proposal to scrap the interest deduction, describing its upper-income bias as "the richer you are, the better the deal."

In its 2011 budget, the Obama administration proposed limiting the mortgage interest deduction for families with incomes higher than $250,000. The National Association of Realtors said the change could trigger "yet another crisis in home values, even as we struggle to recover from the first." (Economists agree that home prices would drop if the deduction were removed, because the subsidy is built into the price of housing.)

The deduction allows younger families to buy in higher-price areas where large mortgages are common, according to the homebuilders association. On average, those people would experience a tax increase if the deduction were repealed or replaced with a tax credit, according to research by economist Eric J. Toder of the Tax Policy Center.

The homebuilding and real estate industries say the deduction is a vital part of promoting homeownership. Yet economists have long questioned the link between homeownership and tax assistance.

A 2002 study by Harvard economist Edward L. Glaeser found that the interest deduction encouraged people to borrow more for housing but had minimal impact on the rate of homeownership.

Rep. Sam Johnson, R-Texas, said there may be pressure to scale back tax incentives as part of a deficit-reduction measure, but it would be as difficult for lawmakers as for constituents.

"Many of these tax expenditures are very popular, and doing away with them might hurt you at home," said Johnson, a senior Republican on the House Ways and Means Committee.

Many Americans resent the complexity of the tax code, just as they complain about big government programs such as Medicare and Social Security. Yet many more people have grown accustomed to tax incentives, just as they have come to rely on the entitlement programs.

Though some tax incentives have been created in recent years, many are permanent features of tax law. Like Medicare and Social Security, tax incentives aren't subject to regular review by Congress.

"It's a way of engaging in spending programs that are in many cases socially useful or desirable, but that can be done in a way that attracts less public scrutiny and which does not have to be reappropriated every year," said Kleinbard, the former taxation committee chief.

"Both sides have reason to like it."

The most drastic policy option — wiping out all tax incentives — is not politically feasible, say Doggett and other lawmakers.

Furthermore, it wouldn't raise enough revenue to reduce deficits to a sustainable level if Congress extended most of the Bush tax cuts, according to the Tax Policy Center. Those tax cuts are slated to expire in January.

Lawmakers and economists say a more likely solution would come from a comprehensive tax overhaul effort. Reducing tax incentives could raise enough revenue that individual and corporate rates could be lowered, making the whole effort more appealing to voters.

More ideas could come from a bipartisan commission appointed to advise Congress on ways to cut the deficit. Some of the panel's Democratic appointees, including Senate Majority Whip Richard Durbin of Illinois, have said that the panel should look at tax incentives as well as spending cuts.

"You could probably trim them by a couple hundred billion dollars as part of a tax reform effort," said Leonard E. Burman, a Syracuse University professor and former Treasury tax official in the Clinton administration.

"But it's never politically easy," Burman said. "Even though people say they want the tax system to be simpler, they want to pay less taxes, too."