Confusion about mortgage interest deductions and ultimate lenders

In South Africa, interest payments on a mortgage are only tax deductible if the interest cost was incurred in the production of income. If you borrow to finance a property to rent it out, that interest cost can be deducted against rental income. If you live in the property you are financing, you are not generating any income and therefore you don’t get to deduct the interest cost from other, unrelated sources of income.

In the US, the situation has been different. Some have argued that the interest deduction for mortgages in respect of owner-occupied  residential property was partly responsible for the property price bubble. It certainly makes buying a house more affordable, but some argue that this creates distortions, imposes a significant cost on the fiscus and overwhelmingly benefits the rich. The larger your mortgage the larger the tax deduction – the antithesis of a progressive tax system.

Casey Mulligan is a generally misguided economist who thinks the US’s current labour problems reflect a decrease in the supply of labour as people choose to rather stay at home and not work and not a massive deficit of demand. With that introduction, you might be skeptical about his post that the mortgage interest deduction is a good idea.

In general, you’d probably be right. There are several reasons it really is a bad idea, but most of all since it is a huge and unnecessary tax break for the rich.

Felix Salmon, who blogs over at Reuters also thinks the article is bunk. Much of what he says is sensible, including demonstrating inaccuracies with Mulligan’s statements around sales taxes on property.

But Salmon says something that really is a little silly:

But never mind that, because soon we’re getting to the meat of Mulligan’s argument:

One person’s mortgage interest payment produces interest income for another person or a business. The lender may well owe taxes on the interest income.

More home-mortgage borrowing means more home-mortgage lending, and the latter means more interest income that can be taxed. In theory, home-mortgage borrowing could even add revenue to the Treasury if the lender is in a higher tax bracket than the borrower (or if the borrower is not itemizing her tax deductions).

This is quite possibly the silliest thing I’ve seen the Economix blog ever print. Confidential to Professor Mulligan: mortgages are made by banks, and the margins on mortgage lending are razor-thin: it’s simply impossible for the taxes on the profit a bank makes from a mortgage to exceed the amount of the tax deduction on that mortgage. Oh, and right now, most mortgage lending is done by the government, in one form or another. How much tax are Fannie and Freddie paying on the mortgages they write?

Salmon seems to think it is banks that lend money. Stay with me here, I haven’t lost my mind. Banks facilitate lending between surplus and deficit units in the economy. Banks can only lend out money if they in turn borrow it from depositors. (With the small exception of their own equity, which given the gearing of our fractional reserve banking system can be safely ignored.) Banks act as an administrative, aggregating and credit-simplifying middle-man between depositors and borrowers.

The “fine margin” they make is actually a red herring. If we lived in a world where banks didn’t profit from an interest rate spread, but rather lent in aggregate at the same rates at which they borrowed (adjusted for credit risk) and charged an explicit admin fee for both sides, we wouldn’t be confused about who is earning interest and who is providing a service. The lenders in Mulligan’s model are the depositors, who do in fact earn interest on their balances and do in fact pay tax (unless tax exempt) on their interest earnings.

Similarly, Freddie and Fannie raise funds through borrowing from the true ultimate lenders. They are also middle-men.

So, do I agree with Mulligan? No. But Salmon’s arguments about interest margins and profit for banks are hopelessly misguided and reflect a misunderstanding of how money works in an economy.

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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