Last week, I spoke to a group of real estate professionals in the Baltimore, Md., area at the invitation of the mortgage division of Sun Trust Bank. The audience had a keen interest in the potential for the mortgage interest tax deduction to be terminated. It will be. The only question yet to be determined is when and how.
The sovereign debt level in the U.S. has provided the catalyst for a serious review of how the U.S. government funds its operations and how taxation fits into that. This issue is going to be an increasingly recurring and serious theme within political policy discussions for many years.
Although the immediate discussions will focus on marginal changes to the income tax code for corporations and individuals, behind the scenes there will be a different, yet much more important, consideration. And very few anywhere will understand it
The U.S. income tax system is no longer a viable method of funding sovereign needs. Even if marginal rates were increased and the rate of growth of government spending were decreased, the demographic drag caused by the baby boomers retiring, coupled with the economic drag caused by a permanent increase in the marginal costs of energy will preclude the economy from supplying enough revenue through income taxes to support annual budgets and sovereign debt reduction.
In other words, all that can be accomplished now by tweaking the income tax code is to perhaps push off sovereign default by a few years -- nothing more. However, for the time being, that's OK.
What the U.S. is now beginning is not just a national conversation on income tax rates but a fundamental discussion, by necessity, on the concept of taxation itself; what to tax and what not to tax. This conversation centers not on what income to tax but, whether or not income should be taxed at all; and if not what should be taxed.
Income taxes are derived from things that are good for the economy and society, such as labor, savings, and production. At the same time, things that are bad for the economy or society go relatively untaxed. Thus, they are actually subsidized -- think waste, energy consumption and pollution.
More broadly, sovereign funding relies on taxing income and not taxing assets. The mortgage interest tax deduction takes this one step further by actually subsidizing housing at the expense of other asset classes and income earners.
In economic terms, the deduction has caused far more harm than good because it causes a misallocation of capital into consumption vs. production and, as a result, has produced a multigenerational drag on the economy. A deduction for mortgage interest is a tool used by the governors of developing countries to encourage the establishment of an indebted population. Citizens or subjects in debt are far more apt to focus their energies on earning the means to repaying that debt than in challenging the governors' edicts.
As a result, a developing economy and society can be made orderly and productive through these kinds of incentives. During the first few human generations of such policies being enacted, the economy will grow magnificently; think China, today.
However, once an economy becomes established and home ownership rates rise to a level on par with the productive members of that society, continuing to encourage the allocation of resources into home ownership flips from advancing economic efficiency to the opposite.
A mortgage tax deduction encourages people to buy, with debt, a larger residence than they need, and to allocate more resources into maintaining that residence than is economically rational. This robs the economy and the individual of savings that is needed by the productive economy.
It's easy for this phenomenon to be misunderstood and, thus, gamed by politicians. Homes have been sold to people as investments when, in actuality, they are consumption items.
The difference between an investment and a consumption item is very simple: An investment pays you while you pay for a consumption item.
The mortgage interest tax deduction confuses this simple logic; and it causes normal, rational people to consider: is it better to be in debt or not in debt.
The fact that the rationality of mortgage interest tax deduction is finally being recognized is a very positive sign for eventual profound changes to the tax code.
But as the debate over this concept increases, the backers of the interest deduction will go all out to prevent it from being done away with. Those backers in general are the banks and their owners, who are acutely aware of the significance of the deduction in being able to maintain an income tax system vs. an asset tax system.
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