Journal of Housing Research • Volume 3, Issue 2 273

Measuring the Size andDistributional Effects ofHomeowner Tax Preferences

David C. Ling and Gary A. McGill*

Abstract

This paper examines the size of the current tax expenditure to homeownership,as well as its vertical and horizontal distribution. The authors construct a modelof homeowner tax preferences that includes net implicit income and thatexplicitly models the complex interaction among standard deductions, nonhousingexpenses, and household mortgage debt. Then the authors estimate annual taxsavings from homeowner tax preferences by individual household, by incomeclass, and in the aggregate.

Including the nontaxation of net implicit income in the measurement ofhomeowner tax expenditures substantially increases the estimated aggregatetax expenditure to owner-occupied housing. In addition, once the nontaxation ofnet implicit income is incorporated, total homeowner tax preferences are notgenerally a function of the amount of mortgage interest expense households canclaim as itemized deductions. Finally, the authors find that lower incomehouseholds receive more and higher income households less than their propor-tionate share of the total homeowner tax expenditure.

Introduction

Homeowner tax expenditures or preferences are defined as the differencebetween tax revenues realized under current law and revenues thatwould be earned under a neutral structure of the tax system in whichhomeowners would be treated for tax purposes as landlords (or inves-inves-tors).1 Under such a system, owners would have to report as income the

*David C. Ling is associate professor of finance and real estate, and Gary A. McGill isassistant professor of accounting, both at the University of Florida College of BusinessAdministration, Gainesville, Florida. The authors would like to thank David Crowe, JimFollain, Patric Hendershott, Ed Outslay, Ellen Roche, Susan Woodward, and workshopparticipants at the University of Florida for comments on an earlier draft.

1The Congressional Budget and Impoundment Control Act of 1974 (Public Law 93-344,section 3(a)(3)) defines tax expenditures as “Those revenue losses attributable to provi-sions of Federal tax laws which allow a special exclusion, exemption or deduction fromgross income or which provide a special credit, a preferential rate of tax or a deferral oftax liability.” The act requires that tax expenditure estimates be submitted to the Houseand Senate Budget Committees along with the annual federal budget.

274 David C. Ling and Gary A. McGill

return earned on the equity capital invested in their homes. This equityreturn consists of two parts: the periodic “implicit rental income” orhousing “dividend” and the appreciation in the value of the home (i.e., thecapital gain). From this annual gross income or return on equity,deductions would be allowed for the expenses that were incurred toproduce the gross income, including mortgage interest, property taxes,maintenance, insurance, and economic depreciation. The resulting netimplicit income would be added to the homeowner’s adjusted grossincome (AGI) and subjected to tax.2

Three provisions in the current federal income tax laws account for thepreferential tax treatment that homeowners receive relative to land-lords. First, net implicit income is not added to the homeowner’s tax base;that is, homeowners do not report as income their annual housingdividend or capital gain.3 Second, the homeowner is allowed to deductmortgage interest from AGI. Third, property taxes are also deductiblefrom AGI. Taxable income of the owner-occupant is thus below that of alandlord by the sum of net implicit income, mortgage interest, andproperty taxes.4

The Joint Committee on Taxation (JCT) has estimated that the mortgageinterest and property tax deductions resulted in a tax expenditure toowner-occupied housing of $38.8 billion in 1989 (Joint Committee onTaxation, 1988, 12–13). The estimate of the U.S. Department of theTreasury’s Office of Tax Analysis (OTA) is $42.6 billion (Special Analysis,1989, g-51). The mortgage interest deduction (MID) was estimated toaccount for $30.8 billion (JCT) and $32.2 billion (OTA) of these totals.These published estimates understate true tax savings because they donot include the first homeowner tax benefit listed above: the nontaxationof net implicit income (i.e., the net return on invested equity). Estimatesof the cost of excluding net implicit income from the tax base are notcurrently included in tax expenditure estimates largely, according to theOTA, because they are “difficult to make” (Special Analysis, 1981,

2An extended discussion of net implicit, or “in kind,” income and the proper taxation ofsuch income in a comprehensive income tax system is contained in Aaron (1972).

3Nor are they typically required to recognize accumulated capital gains upon sale of theproperty. Capital gains realized on the sale of an owner-occupied home are typicallydeferred by the subsequent purchase of another home, and tax payers age 55 and olderare allowed a one-time $125,000 exclusion of capital gains associated with the sale of aprincipal residence.

4Alternatively, under current law, a homeowner does not report gross imputed incomenor is he or she allowed to deduct maintenance and real economic depreciation; the latterwould be deductible in a neutral tax system. Thus, homeowner tax preferences can alsobe viewed as the tax savings from a reduction in taxable income equal to gross rentalincome minus maintenance and economic depreciation.

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206).5 Although any measurement of net implicit income will certainlyinvolve error, a reasonable estimate is better than assuming the incometo be zero.

This paper first provides a more complete, static estimate of the housingtax expenditure and its vertical and horizontal distribution than thosereported by the JCT and OTA. This estimate is accomplished by theconstruction and estimation of a model of homeowner tax preferencesthat includes net implicit income and that explicitly illustrates thecomplex interaction among standard deductions, nonhousing expenses,and household mortgage debt. Then, using the 1989 American HousingSurvey (AHS) microlevel data set (U.S. Department of Commerce 1991),the authors estimate annual homeowner tax preferences by individualhousehold, by income class, and in the aggregate.

The static tax expenditure estimate in this paper is not put forward as anestimate of actual tax revenue increases because, like the JCT and OTAestimates, it does not account for market feedback effects or for alter-ations in household behavior (i.e., “general equilibrium”effects) that mayresult from a change to neutral taxation of owner-occupied housing. In aneutral tax system, all households would have less incentive to chooseowning over renting and those that did choose to own would probably ownsmaller houses. Furthermore, removal of homeowner tax preferenceslikely would alter relative before-tax rates of return on various uses of thecapital stock and reduce house prices, at least in the short run. Reduc-tions in homeownership rates, house values, and the quantity of housingservices consumed by owning households would all work to reduce theamount of additional tax revenue that would actually be collected in a taxsystem characterized by neutral treatment of owner-occupied housing.In a later section of this paper, plausible general equilibrium feedbackeffects are incorporated to obtain a better measure of actual revenuegains.

Including the nontaxation of net implicit income in the measurement ofhomeowner tax expenditures has several major implications. First, onnet, this change adds a substantial amount to the JCT and OTA esti-mates of the aggregate tax expenditure to owner-occupied housing; inthis paper, the 1989 total expenditure is estimated at $109 billion, morethan twice the largest JCT and OTA estimates. Second, once thenontaxation of net implicit income is incorporated, it is easy to show thattotal homeowner tax preferences are not a function of the amount of

5This particular quotation was brought to the authors’ attention by Simonson (1989), whoalso points out that the theoretical basis for taxing net implicit income is understood bythe U.S. Department of Commerce; income from owner-occupied housing is one of themajor imputations made by that department when estimating the gross national product.

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mortgage interest expense households can claim as itemized deductions,as long as nonhousing itemized deductions equal or exceed the household’sstandard deduction. Thus, classifying the MID as a tax expenditure ismisleading and contributes to the widespread belief that highly lever-aged owners benefit more than households that do not make extensiveuse of mortgage debt (Hendershott 1988). In fact, this paper demon-strates that the Tax Reform Act of 1986 (TRA86) has introduced asignificant anti-mortgage debt bias for many households by substantiallyincreasing the standard deduction relative to nonhousing itemized de-ductions. The antidebt bias, which can be addressed substantially only bythose owners with enough wealth to pay off their mortgage debt, de-creases the horizontal equity of the homeowner tax expenditure. Eventhose households that have accumulated sufficient wealth to eliminatetheir mortgage debt may not choose to do so owing to portfolio diversifi-cation considerations. Thus, these households still face an antidebt bias.

Finally, adding the nontaxation of net implicit income and explicitlymodeling the complex interaction among standard deductions, nonhousingitemized deductions, and household mortgage debt also alter the verti-cal distribution of the housing tax expenditure. In particular, it appearsthat lower income households receive more and higher income house-holds less than their proportionate share of the total homeowner taxexpenditure.

The remainder of this section contains a brief discussion of the relevantliterature and an overview of the methodology employed in estimatinghomeowner tax preferences. The next sections include a conceptualframework for analyzing tax preferences; a description of the construc-tion of a microlevel database; the estimation of income tax liabilities, andthe distributional effects of homeowner tax preferences, including con-sideration of the sensitivity of tax expenditure estimates to possiblegeneral equilibrium effects; and a discussion of the likely effects ofeliminating the mortgage interest deduction. A brief summary concludesthe paper.

The Recent Literature

Follain and Ling (1991), Pierce (1989), and Woodward and Weicher(1989) provide partial equilibrium analyses of the revenue and equity (ordistributional) effects of existing and proposed changes to the federal taxtreatment of homeowner tax preferences. Pierce concludes that elimina-tion of the mortgage interest deduction would improve both horizontaland vertical equity and would increase federal tax revenue.

Measuring the Effects of Homeowner Tax Preferences 277

Woodward and Weicher argue that elimination of the MID, along withthe continued nontaxation of net implicit rental income, would decreasetax equity among owners because only when the treatment of interest issymmetrical—both taxable and deductible-—does the tax code not skewthe benefits of homeownership toward those wealthy households that canafford to equity-finance a large portion of their housing purchases.Furthermore, Woodward and Weicher conclude that elimination of theMID would raise little additional tax revenue.

Follain and Ling agree that elimination of the MID would raise littlerevenue and would codify an antidebt bias (not eliminate a prodebt bias,as suggested by Pierce). The antidebt bias would decrease horizontalequity between cash-constrained households with only wages and sala-ries and households with similar total incomes but whose AGI alsoincludes income from other capital and financial assets. Unlike Woodwardand Weicher, however, Follain and Ling conclude that elimination of theMID likely would improve vertical equity across income classes becauseTRA86 virtually has already eliminated the value of the MID for manylow- and moderate-income households. Unless these homeowners arerecent buyers with relatively high leverage rates, the MID eliminationwould have a negligible effect on their tax preferences. Moreover, to theextent that higher income households do not replace all of their mortgagedebt with equity, they would find their homeowner tax savings reduced.Thus, Follain and Ling suggest that MID elimination actually mightimprove vertical equity by making homeowner tax savings a less steeplysloped function of income.

The conflicting findings of Pierce and Follain and Ling are primarilygenerated from two sources. First, Pierce does not, whereas Follain andLing do, include the nontaxation of net implicit income as a homeownertax preference. This explains why Pierce concludes that the amount ofthe homeowner tax savings is positively related to the amount of house-hold mortgage debt. Second, Pierce’s findings are based on actualmicrolevel tax return data, whereas Follain and Ling base their calcula-tions on 45 representative household cohorts (15 income classes andthree filing statuses). By construction, the housing and nonhousingexpense and tax liability variables for these representative householdsare averages and thus conceal the true variability in homeowner taxpreferences that exists within even similarly situated tax payer groups.Thus, Pierce’s work benefits from the strength of its microlevel database,but lacks an important component in the determination of the size anddistribution of homeowner tax preferences. By including net implicitincome, the work of Follain and Ling uses an improved measure ofhomeowner tax savings, but may suffer from a limited database.

278 David C. Ling and Gary A. McGill

Recently, Berkovec and Fullerton (1990) and Hendershott and Won (1992)examined housing tax policy with portfolio-based general equilibrium mod-els. The structure of these models emphasizes the simultaneous interactionamong household portfolio and tenure choices, business financing, andinvestment in tangible capital. Thus, the advantage of a general equilib-rium approach is that feedback effects from a change in housing taxpolicy—primarily changes in tenure choice, quantity demanded, andbefore-tax interest rates—are determined endogenously. The disadvan-tages of a general equilibrium approach include substantially increasedcomplexity and possible loss of tractability because of the increasednumber of required parameter assumptions.

Hendershott and Won (1992) analyze TRA86 with 400 representativehouseholds. Berkovec and Fullerton (1990) focus on the welfare effectsthat would likely result from the increased taxation of owner-occupiedhousing. The latter paper is the first attempt to employ a microlevel dataset in a general equilibrium simulation model of household portfolio andtenure choice.

Several specific differences between Berkovec and Fullerton’s paper andthis paper are worth noting. First, Berkovec and Fullerton’s resultsspeak more to the effect of housing tax policy on efficiency and risksharing between the government and individual property owners than tothe size and distribution of homeowner tax preferences across and withinincome groups. Second, these authors use the 1983 Survey of ConsumerFinances with data on 3,578 households. This paper is based on data fromthe 1989 AHS, which provides data on 58,932 households. It is significantthat the present authors use data collected after 1986 because TRA86greatly reduced the value of mortgage interest and property tax deduc-tions for many households by increasing the standard deduction andgreatly curtailing the number and amount of nonhousing itemizeddeductions.6 The 1989 AHS data permit the authors to analyze withmicrolevel data the complex interaction among standard deductions,nonhousing itemized deductions, and housing deductions, and the extentof the TRA86-induced antidebt bias described by Follain and Ling (1991).

Third, Berkovec and Fullerton’s model estimation is based on data thatare several generations removed from actual household level data. Morespecifically, for their tax calculations they use a U.S. Department of theTreasury data set that was constructed by matching 1983 tax returns

6State and local sales taxes are no longer deductible at the federal level; consumerinterest deductions have been phased out; miscellaneous itemized deductions are nowsubject to a 2-percent floor; and the floor for medical deductions has been increased to7.5 percent from 5 percent. Thus nonhousing itemized deductions are, for many taxpayers, limited to charitable contributions and state and local income taxes.

Measuring the Effects of Homeowner Tax Preferences 279

with other data sets to assign nontax data such as house value and rentpaid. In essence, this technique constructs a single household observation bycombining data from several “statistically similar” households.7 More-over, Berkovec and Fullerton’s household income tax liabilities are notdirectly calculated; rather, they are predicted from regression coeffi-cients estimated using the matched U.S. Department of the Treasury file.Imputation by regression assigns mean values of income tax liabilities toindividual households, which, in turn, reduces the variation of taxliabilities and therefore homeowner tax savings among households.

Imputed income tax liabilities make it difficult to address the issue ofhorizontal equity, one of the primary objectives of this paper. However,the authors avoid the potential problems associated with the use ofstatistically matched information because virtually all the household-specific information required to study horizontal equity is contained inthe AHS data. Furthermore, income tax liabilities are calculated sepa-rately for each household, thereby avoiding the variance-reducing prob-lems associated with imputation by regression.

Finally, in Berkovec and Fullerton’s model, debt is homogeneous; that is,they use a single interest rate for all households and all types ofborrowing. The AHS data used in this study contain detailed informationon all mortgage interest rates and loan balances for each household.These detailed, household-specific mortgage data are obviously helpfulin analyzing the likely effects of disallowing or curtailing the mortgageinterest deduction.

Methodology

To estimate the revenue and distributional effects of homeowner taxpreferences, the authors merged the strengths of the approaches em-ployed by Pierce (1989) and Follain and Ling (1991) by using a microleveldata set and a model of homeowner tax preferences that includes netimplicit income. More specifically, the authors use the 1989 AHS, whichcontains microdata on households, including size, income, house value,and monthly housing costs. The AHS data are supplemented with dataon nonhousing itemized deductions from the Internal Revenue Service(IRS) Individual Tax Model File, an individual tax return data filepublished by that agency.

For purposes of summarizing estimated homeowner tax savings and foranalysis of horizontal and vertical equity, households are classified into

7See Rodgers (1984) for a discussion of the limitations associated with statisticalmatching techniques.

280 David C. Ling and Gary A. McGill

15 income classes and three household types: married, single, and headof household. However, aggregate tax liability estimates for these45 household cohorts are based on the specific components of individualhouseholds’ tax returns, rather than on averages within householdcohorts. Thus, use of the refined methodology provides more accurateestimates of the tax revenue and equity effects of homeowner taxpreferences than is possible using the aggregate or representative house-hold approach employed by Follain and Ling.

Measuring the Annual Tax Expenditure to Homeownership

This section begins with a general discussion of the federal income taxsavings afforded owner-occupants.8 A short numerical example of theanalytical model is presented at the end of the section to help clarify thediscussion.

A Conceptual Framework for Measuring the Tax Expenditure

To clarify the nature of the homeowner tax savings, the followingvariables are used as defined

AGI—Adjusted gross income as a renterNHE—Nonhousing itemized (Schedule A) expensesEXEMPT—Total dollar amount of personal and dependency exemptionsi(e)—Before-tax rate of return available on nonhousing assets of equalrisk to the housing investmenti(d)—Before-tax cost of mortgage debt financingδ—Loan-to-market value ratio (leverage rate)P—Nominal market value of the housePT—Property taxesRi—Net implicit (before-tax) rate of return on the equity capital investedin the houseNII—Net implicit income, equal to Ri multiplied by the current amountof housing equity

Taxable income of owner-occupants who effectively lease to themselvesis less than owners who lease to others by an amount equal to the sum ofnet implicit income, mortgage interest, and property taxes. Homeownertax preferences can also be measured in terms of what household taxliabilities would be if the tax payer (or household) rented the same house.

8The importance of the relationship between nonhousing itemized deductions and thestandard deduction when measuring the tax benefits of homeownership was firstemphasized by Hendershott and Slemrod (1983).

Measuring the Effects of Homeowner Tax Preferences 281

As a renter of the same space, the household would not have mortgageinterest and property tax expenses to deduct. In addition, its AGI wouldbe greater as a renter than as an owner-occupant because the equity thatwas invested in the tax-free housing asset at the rate of Ri would now beinvested in nonhousing assets at a rate of i(e). If Ri = i(e), the tax liabilityof a renting household would equal that of a landlord. Thus, one can thinkof owner tax savings as the reduction in income tax liabilities owninghouseholds receive relative to similarly situated renters or relative tolandlords.9

Households That Would Itemize as Renters

To consider further the housing tax expenditure and its reliance on theamount of debt financing, the first case considered is one in which thenonhousing itemized expenses (NHE) for a renting household exceed thestandard deduction (SD); thus, the household chooses to itemize. Theequation used to determine taxable income for itemizing renters (TIR) is

TIR = AGI – NHE – EXEMPT. (1)

AGI includes the income generated by household wealth that is investedin nonhousing assets at the rate of i(e). For an owner, a portion of thiswealth is invested in the tax-free housing investment. Therefore, taxableincome for a similarly situated owner (TIO) under the current tax systemis determined as

TIO = TIR – [i(e)(1 – δ)P + i(d)δP + PT] (2)

The first term within the brackets [i(e)( 1 – δ)P] represents the reductionin taxable income due to the forgone interest income on nonhousingassets. The remaining two terms [i(d)δP and PT] represent the mortgageinterest and property tax deductions. Annual homeowner tax savings(ATS) are therefore equal to ti(TIR – TIO), where ti is the averagemarginal tax rate over this income range for this household type. That is,

ATS = ti[i(e)(l – δ)P + i(d)δP + PT]. (3)

9In some cases, a preferred measure of the economic effects of homeowner tax preferencesis the efficiency (or deadweight) loss associated with the annual tax savings. Thisefficiency loss can be measured as the difference between estimated tax savings and theamount a household would be “willing to pay” for the tax preferences. Estimatingefficiency losses requires, among other things, assumptions about the tastes and prefer-ences of households for housing and other goods (i.e., utility functions) and is beyond thescope of the current paper.

282 David C. Ling and Gary A. McGill

The size of the annual tax savings is proportional to the tax bracket of thehousehold; a zero-tax bracket owner is treated the same as a renter.10

As emphasized by Hendershott (1988, 4), a household with sufficientwealth can either finance its house purchase with a fixed-rate mortgageand invest its own wealth in mortgage-backed securities, or it can put itsmoney into the house (i.e., lend to itself). The before-tax costs of debt andequity are approximately equal in either case. If i(e) = i(d) = i, then

ATS = ti(iP + PT). (4)

It is important to note that ∂ATS/∂δ = 0 (i.e., changes in the loan-to-valueratio do not affect the amount of the tax savings). Thus, as long asNHE > SD, the deductibility of mortgage interest does not result in aprodebt bias for owner-occupants. Rather, interest deductibility simplycauses the after-tax costs of debt and own-equity financing to be approxi-mately equal [exactly equal if i(e) = i(d)] for these households.11

It is worth emphasizing that if the mortgage interest deduction werecompletely eliminated, then

ATS = ti[i(e)(1 – δ)P + PT] (5)

and ∂ATS/∂δ = – ti i(e)P (i.e., increases in δ would reduce the owner’s taxsavings). Thus, the independence of the ATS (and the cost of home-ownership) from the method of financing requires the full deductibilityof mortgage interest.12 If interest earned on financial assets is taxable,but mortgage interest paid is not fully deductible, debt financing is moreexpensive than equity financing.

Households That Would Not Itemize as Renters

The second case considered is when NHE < SD, so that a rentinghousehold would choose not to itemize. In this case,

andTIR = AGI – SD – EXEMPT (1)'

10A constant ti is used here for expository convenience. For the empirical work, taxliabilities for both owners and renter/investors are estimated using the tax tableapplicable to the household’s taxable income and filing status.

11If i(e) ≠ i(d), then ∂ATS/∂δ = ti[i(e) – i(d)P.

12 This point is also stressed by Woodward and Weicher (1989).

Measuring the Effects of Homeowner Tax Preferences 283

The first line in (4)' indicates that if the addition of mortgage interest andproperty tax expenses to NHE is still not sufficient to warrant itemiza-tion, annual tax savings are equal to the nontaxed return on investedequity. Notice that homeowners, especially those with limited amountsof mortgage debt, receive preferential tax treatment even if they do notitemize their deductions.

When total itemized deductions are less than the standard deduction,additional borrowing reduces tax savings because “deductible” equityfinancing is replaced with nondeductible mortgage debt. Once mortgageinterest and property tax expenses plus NHE are large enough to justifyitemization, additional (or marginal) debt financing does not affect thesize of the tax savings.

It is important to note that even if housing-related expenses plus NHEare large enough to justify itemization, the total annual tax savings of ahousehold for which NHE < SD is less than the tax savings of a householdthat would itemize as renters [compare the second line in (4)' with (4)].Because itemization requires giving up the standard deduction, anamount equal to SD – NHE of the household’s housing deductions is“wasted” in that this amount does not reduce taxable income below whatit would be if the household retained its renter status. Furthermore, taxpayers for whom NHE < SD actually face an antidebt bias, even ifmortgage interest is deductible and the before-tax costs of debt andequity are identical; the SD – NHE portion of their housing deductionsis effectively written off at a zero-percent tax rate.

A Numerical Example

Consider a married household with wage and salary income of $30,000per year and assets of $60,000.13 Assume that the mortgage interest rateis 10 percent and that assets invested in taxable financial securities (ofequivalent risk to the housing investment) yield a 10-percent pre-tax rate

13Although many households with AGIs of $30,000 have not accumulated $60,000 innonpension wealth, the assumption is used here simply to allow consideration of the case

of 100-percent equity financing of the house purchase.

284 David C. Ling and Gary A. McGill

of return. Property taxes are $840 per year, the household pays federaltaxes at a 15-percent marginal rate, and the standard deduction is$5,000.

The effects of NHE and leverage rates on the homeowner tax savings ofthis household are summarized graphically in figure 1. If NHE are equalto the $5,000 standard deduction, such that the household could itemize

as a renter, then [from equation (4)] the household receives the full $1,026benefit of its housing-related deductions [0.15 × ($6,000 + $840)].Furthermore, the size of the owner tax preference is invariant withrespect to how the housing investment is financed.

A different pattern of homeowner tax savings would emerge if NHE wereequal to $1,000. First, such a household never receives the full benefit ofits housing deductions. Even if the household has no outstanding mort-gage debt, its annual tax savings is $900, or $126 less than the savingsavailable to the household with NHE = $5,000. This reflects the value ofthe wasted property tax deduction. Second, the amount of the tax savingsactually decreases as the amount of debt financing is increased over asignificant range because taxable interest income on financial assets is

Measuring the Effects of Homeowner Tax Preferences 285

replacing the nontaxable returns earned on the equity invested in thehouse. At some point, increases in the amount of debt financing willgenerate enough deductible mortgage interest expense to justify itemiza-tion. At this point, additional dollars of mortgage interest expense will befully deductible, equating the marginal costs of debt and own-equityfinancing. In the current example, this happens at a leverage rate of54 percent. Beyond when δ = 0.54, annual tax savings remain constant at$420, far below the $1,026 amount realized by households with NHE > SD.

Although the marginal costs of debt and equity are equal for δ > 0.54, theaverage cost of debt (and equity) financing is greater for households withNHE < SD. This is important because housing is a “lumpy” investment,and therefore the decision to convert from renter to owner status depends(in part) on the average costs of debt and equity financing.14

The preceding examples demonstrate that because TRA86 has substan-tially reduced nonhousing expenses relative to standard deductions,many households may receive little or no benefit from their mortgageinterest deductions. The corollary to this is that complete elimination ofthe mortgage interest deduction would have little or no effect on theincome tax liability of these households or on the decision of the house-hold to own or rent its housing.

The Tax Expenditure Model

Three major tasks are performed in estimating homeowner tax prefer-ences. First, a refined microlevel database is constructed from existingarchival information. Second, the 1989 federal income tax liabilities ofhomeowners are calculated for each household by applying the currentfederal income tax structure and actual 1989 household leverage rates tothe enhanced AHS database.15 Tax liabilities are then calculated underthe assumption that net implicit income from housing is included in AGIand mortgage interest and property tax expenses are not otherwisedeductible. The difference between these two tax liabilities is a static

14In the numerical example, the marginal after-tax costs of debt financing are equal to8.5 percent [(1 – 0.15) × 10.0 percent] for both households once the second household’sitemized deductions exceed the standard deduction ( δ = 0.54). However, the (weighted)average cost of debt for any δ is higher for the second household because only a portionof total mortgage interest is deducted at the 15-percent tax rate. If the mortgage in thecase example is $42,000, $3,160 [$5,000 – ($1,000 + $840)] or 75 percent ($3,160/$4,200)of the MID is deducted at the zero-percent tax rate. Thus, the weighted average rate atwhich the household deducts mortgage interest is 3.75 percent [0.75 × 0.0% + 0.25 × 15%]and the after-tax cost of mortgage debt is 9.62 percent [(1 – 0.0375) × 10.0%].

15“Current federal income tax structure” here and throughout the paper refers to the taxsystem in place for the 1989 tax year.

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measure of the annual tax savings derived by a household from homeownertax preferences within the income tax structure. Finally, the distributionof homeowner tax preferences across income classes is analyzed, both inabsolute dollar terms and relative to the percentage of the total taxburden of owner households that each income class currently pays.

Construction of Microlevel Database

In order to estimate homeowner tax benefits accruing to specific house-holds, information on both housing costs and tax liability must beobtained or estimated. The starting point is the AHS, which is conductedby the U.S. Department of Commerce on a regular basis. The AHScontains detailed microdata on households, including geographic loca-tion; number, age, and marital status of occupants; income type and level;tenure status; original and current home values; and property taxpayments. Detailed mortgage information is also collected, including thenumber and amount of mortgages, mortgage interest rates and pay-ments, and original and remaining terms. Each survey observation(household) is weighted so that national estimates can be made.

Although the AHS data do not contain income tax liability information,most of the raw data required for estimating income tax liabilities arepresent.16 Existing variables report detailed information on numerousincome items, including total household income, salary income for eachrelated and nonrelated occupant (up to 15 persons), family relationships,ages, nonwage income sources, and nature of nonwage income (e.g.,Social Security, alimony, investment income). Missing tax calculationinformation primarily includes measures of nonhousing expenses. Busi-ness and investment expenses are not reported, but the reported incomeinformation is net of these expenses. Consequently, AGI can be estimatedwithout loss of precision.

Nonhousing itemized deductions are, for most tax payers, now limited tocharitable contributions and state and local income taxes. The dollaramount of these two personal expenses is estimated from microlevel IRStax return data. More specifically, a simple linear regression is estimatedfrom the 1985 Individual Tax Model File, which assumes that eachnonhousing expense potentially itemizable on Schedule A, is a linear

16Although subject to some error, the AHS income data are surprisingly close toindependent estimates of income. For example, AHS estimates of total money income are86 percent of independent estimates from GNP accounts and the Social SecurityAdministration. AHS wages and salaries are 92 percent of independent estimates(Hadden and Leger 1990).

Measuring the Effects of Homeowner Tax Preferences 287

function of filing (marital) status, number of exemptions, and AGI.17

These explanatory variables are also contained in the AHS data. Thus,estimates of regression coefficients from the IRS data can be used toimpute nonhousing expenditures, and the precision of these estimateswill exceed those possible using only broad averages of NHE across evenlarger groups of tax payers.18 The enhanced database that is constructedthus contains detailed household-level housing information as well asinformation regarding the actual financial and tax situation of thehousehold.19 Mean values by income class of selected variables arereported in table 1.

Estimated Tax Liabilities: Current Law Versus a Neutral Tax System

To estimate tax liabilities under 1989 federal tax law as per equations (1)and(1)', the authors first determine the filing status and the number andtype of dependents for each household/tax payer.20 The salaries of thehousehold head and spouse are added together, and this information iscombined with “other income” to determine AGI.21 EXEMPT is set equalto $2,000 multiplied by the number of dependent relatives, children, andpersonal exemptions for the household head and spouse.

17The 1985 Tax Model File has 108,840 records (tax returns) that were sampled from the101.7 million individual tax returns filed in 1985. Each observation contains over 200variables, including all the major Form 1040 items and various additional informationsuch as geographic location. Each observation in this file is assigned a weight represent-ing the number of tax returns in the population the sampled return represents. Thus, thissample is intended for use in making national level estimates.18For the 1985 tax year, charitable contributions were reported as either adjustmentsfrom income or itemized deductions depending on ability to itemize. Thus, the estimatedequation for these expenses includes nonitemizers as well as itemizers. However, theestimate of state and local income taxes can only be constructed for itemizers and may bebiased upward.

19The authors recognize that imputation of nonhousing expenditures by regressionassigns mean values to the estimated variables that, in turn, reduces the variance ofcalculated homeowner tax savings among similarly situated households. However, thequality of the imputations used is relatively high; one simple regression model is able toexplain 54 percent of the variation in state and local income taxes and 29 percent of thevariation in charitable contributions.

20Any child under age 23 residing in the household is treated as a dependent, regardlessof income (following exceptions allowed full-time students). Other related householdmembers are treated as dependents if their income is less than $2,000. Nonrelativehousehold members are not treated as dependents.

21Welfare and child support income are not included in AGL and Social Security receiptsare included only subject to the potential taxation rules of current tax law.

Tab

le 1

. Mea

n V

alu

es o

f S

elec

ted

Va

ria

ble

s fo

r O

wn

ers:

by

In

com

e C

lass

fro

m 1

989

Su

pp

lem

ente

d A

mer

ica

n H

ou

sin

g S

urv

ey (

AH

S)

Da

ta

(1)

(2)

(3)

(4)

(5

) (6

) (7

) (8

) (9

) (1

0)

(11)

Ave

rage

Ave

rage

Ave

rage

H

ome

Val

ue

A

vera

geA

vera

ge

Ave

rage

Ave

rage

Non

-W

aste

dH

ousi

ng

Ave

rage

N

um

ber

of

H

ome

AG

IaA

GI

Hou

seh

olds

b

Val

ue

to I

nco

me

Lev

erag

e

Mor

tgag

e

Pro

pert

yT

ax

Sta

nda

rd

Hou

sin

g

Hou

sin

gfR

atio

Ave

rage

Rat

ioc

Rid

Inte

rest

(Mil

lion

s)($

)($

) ($

) (%

) (%

) (%

) ($

) ($

) ($

) ($

) ($

)D

edu

ctio

n

Exp

ense

e

Exp

ense

f

0–5.

000

1,57

5 8.

22

60,8

76

14.7

9.

71

509

593

4,37

8 0

4,37

79.

1668

24,

716

5,00

0–10

,000

7,

598

4.71

66

,839

9.

1 15

.2

723

27

4,68

910

,000

–15,

000

12,8

26

4.37

66

,790

5.

2 22

.1

8.66

1,

112

711

4,69

1 10

1 4,

590

15,0

00–2

0,00

0 18

,235

4.

86

74,4

35

4.1

22.7

8.

45

1,21

3 82

0 4,

765

391

4,37

420

,000

–25,

000

23,1

63

4.42

72

,261

3.

1 33

.5

8.29

1,

942

802

4,67

8 88

5 3,

793

25,0

00–3

0,00

0 27

,788

4.

68

76,2

44

2.7

42.7

8.

07

2,47

4 84

2 4

,728

1,

448

3,28

130

,000

–35,

000

32,9

27

3.82

78

,089

2.

4 41

.4

8.00

2,

847

868

4,74

2 2,

105

2,63

735

,000

–40,

000

38,0

23

3.83

90

,650

2.

4 40

.6

8.01

3,

417

967

4,84

4 2,

747

2,09

740

,000

–45,

000

42,8

22

3.37

99

,175

2.

3

43.8

7.

73

3,80

0 1,

112

4,94

9 3,

343

1,60

545

,000

–50,

000

48,0

17

2.88

10

7,77

6 2.

2 42

.8

7.37

4,

100

1,15

6 4,

962

4,02

3 93

950

,000

–60,

000

55,2

83

4.63

11

5,11

0 2.

1 44

.3

7.11

5,

009

1,26

0 5,

073

4,92

3 15

060

,000

–75,

000

67,1

30

3.97

12

8,63

3 1.

9 40

.2

6.98

4,

843

1,41

4 5,

088

6,48

4 (1

,396

)75

,000

–100

,000

87

,398

3.

33

170,

067

1.9

40.6

6.

91

7,61

4 1,

991

5,08

9 9,

216

(4,1

27)

100,

000–

120,

000

108,

486

1.38

19

6,36

3 1.

8 44

.4

6.69

13

,500

2,

435

5,05

4 11

,989

(6

,935

)12

0,00

0+

152,

856

1.34

26

0,52

2 1.

7 49

.4

6.59

17

,714

3,

081

5,15

8 17

,814

(1

2,65

6)

Tot

al/A

llg

35,8

5559

.90

94,6

7532

.88.

103,

297

1,04

24,

795

2,90

61,

890

Sou

rce:

Au

thor

s’ t

abu

lati

ons

and

esti

mat

es f

rom

th

e A

mer

ican

Hou

sin

g S

urv

ey, 1

989

Nat

ion

al F

ile

supp

lem

ente

d w

ith

non

hou

sin

g ex

pen

se e

stim

ates

fro

m t

he

Inte

rnal

Rev

enu

e S

ervi

ce 1

985

Indi

vidu

al T

ax M

odel

Fil

e.a A

GI

is a

dju

sted

gro

ss in

com

e.

b Nu

mbe

r of

hou

seh

olds

is b

ased

on

th

e A

HS

su

rvey

sam

ple

proj

ecte

d ba

ck t

o th

e po

pula

tion

bas

ed o

n h

ouse

hol

d w

eigh

ts.

c Lev

erag

e ra

tio

is t

he

hou

seh

old’

s ou

tsta

ndi

ng

mor

tgag

e de

bt d

ivid

ed b

y th

e es

tim

ated

hom

e va

lue.

d Ri is

th

e av

erag

e be

fore

-tax

req

uir

ed r

etu

rn o

n in

vest

ed h

ousi

ng

equ

ity

Ri =

(1

– t i)i

(e),

wh

ere

t i is t

he

mar

gin

al t

ax r

ate,

an

d i(

e) is

bef

ore-

tax

retu

rn o

n a

nin

vest

men

t o

f s

imil

ar r

isk

an

d is

set

equ

al t

o 9.

71%

, th

e av

erag

e 19

89 y

ield

of

GN

MA

mor

tgag

e-ba

cked

sec

uri

ties

.e N

onh

ousi

ng

item

ized

ded

uct

ion

s a

vail

able

for

ded

uct

ion

on

Sch

edu

le A

, For

m 1

040.

f Was

ted

hou

sin

g e

xpen

se r

epre

sen

ts t

he

dif

fere

nce

bet

wee

n t

he

hou

seh

old’

s st

anda

rd d

edu

ctio

n a

nd

its

non

hou

sin

g it

emiz

ed d

edu

ctio

ns,

i.e.

, th

e am

oun

t of

hou

sin

gde

duct

ion

s t

hat

wil

l be

abso

rbed

bef

ore

prov

idin

g an

y be

nef

it b

eyon

d s

impl

y u

sin

g t

he

stan

dard

ded

uct

ion

.g T

otal

s a

nd

dif

fere

nce

s m

ay b

e of

f by

1 b

ecau

se o

f ro

un

din

g.

288 David C. Ling and Gary A. McGill

----

Measuring the Effects of Homeowner Tax Preferences 289

Taxable income of owning households (TIO) is calculated by allowing thegreater of total itemized deductions or the standard deduction.22

Nonhousing itemized deductions (NHE) are imputed by regression fromthe IRS tax file, as previously discussed. Property tax payments (PT) arecontained in the AHS database. Interest payments [i(d)P] on any first,second, or third mortgages are calculated from detailed AHS mortgageinformation.

Regular tax liabilities are determined using actual tax rate schedules forthree possible filing statuses: single, married filing joint, and head ofhousehold.23 These computed tax liabilities are reduced by any allowablepersonal tax credits, including the earned income credit, the credit for theelderly, and the child care credit.

Two adjustments are required to produce a static estimate of what anowner’s federal income tax liability would be if the owner were treated asa renter/landlord. First, personal expenses available for Schedule Aitemization are reduced by the amount of mortgage interest and propertytax payments. This adjustment will not increase taxable income by thefull amount of interest and property tax payments unless NHE ≥ SD.Second, AGI is increased by the dollar amount of net implicit income,including the annual appreciation in nominal value. NII is set equal tothe net before-tax return on housing equity (Ri), multiplied by the currentamount of housing equity. The latter is equal to the estimated currentvalue of the property (including land), minus the book value of anyoutstanding mortgages [(1 – δ)P].

As suggested by Hendershott (1988), the before-tax yield on mortgage-backed securities is a reasonable measure of the opportunity cost(before-tax) of invested equity [i(e)] for wealthy households. The yield onGovernment National Mortgage Association (GNMA) mortgage-backedsecurities (Ginnie Mae's) averaged 9.71 percent in 1989. However, Ri foran individual household cannot be directly observed because the periodiccomponent depends on household preference functions (including riskaversion parameters) and whether the household is currently consumingan equilibrium quantity of housing. Arguments can be made as to whybefore-tax housing returns (Ri) could be either greater than or less thanthe 9.71 percent before-tax opportunity cost.

For example, Hendershott and Won (1992) and Scholes and Wolfson(1991) argue that in a competitive equilibrium, owning households will

22The standard deduction is adjusted for taxpayers age 65+ to include the “extra”standard deduction amount allowable in 1989.

23All households containing married couples are assumed to file a joint return. A verysmall percentage of married tax payers actually file separate tax returns.

290 David C. Ling and Gary A. McGill

adjust their housing consumption so that expected after-tax housingreturns are equal to the expected after-tax returns on nonhousinginvestments of equal risk. This equilibration of expected after-tax re-turns requires that the before-tax returns on tax-preferred assets be biddown relative to fully taxable yields. This argument implies that the netbefore-tax rate of return on housing equity is less than the before-taxreturn available on nonhousing assets of equal risk, i.e., Ri < i(e). Thus,while ti[i(e)(1 – δ)P] is an explicit measure of the tax savings associatedwith the nontaxation of equity capital invested in the house, it mayoverstate the “true” tax savings if homeowners pay an implicit tax in theform of a lower pre-tax rate of return on their housing investment. If ownerhousing is assumed to be completely nontaxed, then Ri = (1 – ti)i(e) forwealthy households that are consuming an equilibrium quantity of housing.

Conversely, market imperfections, such as income or wealth constraintsand relatively high transaction costs associated with moving, may causesome households to consume less than the desired or optimal quantity ofhousing. For these households, the before-tax rate of return on housingequity may exceed the before-tax opportunity cost, that is, Ri may exceedi(e). Furthermore, it could be argued that lower wealth, highly leveragedhouseholds require a before-tax return in excess of i(e) to compensate forthe increased variability of the equity return that cannot be fullydiversified away at the portfolio level; that is, their housing risk premiumincludes compensation for unsystematic as well as systematic risk.

To present a conservative estimate of net implicit income, the authorsassume for all households that Ri = (1 – ti)i(e), with i(e) set equal to the9.71 percent average yield on Ginnie Maes. That is, it is assumed thathouseholds are not cash constrained, that they are consuming an equilib-rium quantity of housing, and that the amount of other owner assets issufficient to adequately diversify property specific risk. Average Ris byincome class are reported in column 6 of table 1. Less conservativeassumptions would produce higher estimates of Ri and NII.

Total tax liability estimates are displayed in table 2. Current-lawtotal tax revenues from owner-occupied households are estimated at$260.8 billion. Holding constant interest rates, house values, and thehousing (and financing) decisions of households, tax revenues in aneutral system would be $369.7 billion, which implies an annual taxexpenditure to owner-occupied housing of $109 billion. Although it usesa conservative estimate of Ri, this tax expenditure estimate is more thantwice the size of the largest JCT and OTA estimates and a third larger

AG

Ib

($)

Tab

le 2

. To

tal

Ta

x L

iab

ilit

ies

of

Ow

ner

s b

y I

nco

me

Cla

ss:

Cu

rren

t V

ersu

s A

lter

na

te T

ax

Sy

stem

sa

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

(10)

(11)

Dif

fere

nce

Tax

Dif

fere

nce

Per

cen

t N

eutr

al

from

P

erce

nt

Lia

bili

ty

from

P

erce

nt

of

Cu

mu

lati

ve

Tax

C

urr

ent

of

Cu

mu

lati

ve

Wit

hou

t C

urr

ent

of

C

um

ula

tive

Tot

al

Per

cen

t T

otal

P

erce

nt

MID

e T

otal

P

erce

nt

(%)

(1)

Cu

rren

tT

axL

iabi

lity

c

($)

(%)

Lia

bili

tyd

(4)

– (1

)($

)($

)(%

)($

)(%

)(c

)

(8

) –

(1)

(%)

(%)

0–5,

000

525

0.0

00.

02,

473

5,00

0–10

,000

0.

2 0.

2 3,

631

10,0

00–1

5,00

0 2

,205

0.8

1.0

5,52

715

,000

–20,

000

5,6

95

2.2

3.2

10.5

27

2,47

32.

32.

355

10

00.

00.

03,

107

2.9

5.1

26 125

0.1

0.1

3,32

33.

08.

22,

329

0.4

0.7

0.4

4,83

24.

412

.65.

952

258

1.2

20,0

00–2

5,00

0 7,

165

2.

7 6.

0 11

,495

4,

330

16.6

7,

679

514

1.5

2.7

25,0

00–3

0,00

0 10

,474

4.

0 9.

9 15

,605

5,

132

4.7

4.0

21.3

11,5

381,

064

3.1

5.8

30,0

00–3

5,00

0 11

,145

4.

3 14

.3

15,7

96

4,65

1 4.

3 25

.6

12,5

43

1,39

7 4.

1 9.

835

,000

–40,

000

13,8

61

5.3

19.6

19

,896

6,

034

5.5

31.1

15

,589

1,

728

5.0

14.8

40,0

00–4

5,00

0 14

,393

5.

5 25

.1

21,0

12

6,61

9 6.

1 37

.2

16,3

43

1,94

9 5.

7 20

.545

.000

–50.

000

50;0

00–6

0,00

015

,009

30,5

855.

830

.921

,991

6.4

43.6

7.5

28.0

11.7

42.6

43,9

0513

,320

12

.255

.836

,120

5,53

516

.144

.060

,000

–75,

000

37,2

62

14.3

56

.9

50,5

97

13,3

35

12.2

68

.0

42,5

85

5,32

3 15

.4

59.5

75,0

00–1

00,0

00

45,5

69

17.5

74

.4

61,4

54

15,8

85

14.6

82

.6

51,9

28

6,35

9 18

.4

77.9

100,

000–

120,

000

25,5

49

9.8

84.2

34

,096

8,

547

7.8

90.5

29

,318

3,

769

10.9

88

.812

0,00

0+41

,319

15.8

100.

051

,719

10,4

009.

510

0.0

45,1

693,

850

11.2

100.

0

Tot

alf

260,

755

369,

726

295,

237

34,4

82

Sou

rce:

Au

thor

s’ t

abu

lati

ons

and

esti

mat

es f

rom

th

e A

mer

ican

Hou

sin

g S

urv

ey, 1

989

Nat

ion

al F

ile,

su

pple

men

ted

wit

h n

onh

ousi

ng

expe

nse

est

imat

es f

rom

th

eIn

tern

al R

even

ue

Ser

vice

198

5 In

divi

dual

Tax

Mod

el F

ile.

a Fed

eral

tax

liab

ilit

ies

in m

illi

ons

of d

olla

rs; d

iffe

ren

ces

mea

sure

d re

lati

ve t

o cu

rren

t la

w.

b AG

I is

adj

ust

ed g

ross

inco

me.

c Cu

rren

t ta

x li

abil

ity

is t

he

regu

lar

1989

indi

vidu

al t

ax li

abil

ity

afte

r cr

edit

s.d N

eutr

al t

ax li

abil

ity

is t

he

tax

liab

ilit

y w

hen

net

impu

ted

inco

me

is in

clu

ded

in g

ross

inco

me

and

mor

tgag

e in

tere

st a

nd

prop

erty

tax

es a

re n

ot a

llow

ed a

s de

duct

ion

s.e T

ax li

abil

ity

wit

hou

t m

ortg

age

inte

rest

ded

uct

ion

(M

ID)

is t

he

sam

e as

th

e cu

rren

t ta

x li

abil

ity

calc

ula

tion

exc

ept

any

mor

tgag

e in

tere

st d

edu

ctio

n is

not

all

owed

.f T

otal

s an

d di

ffer

ence

s m

ay b

e of

f by

1 b

ecau

se o

f ro

un

din

g.

Measuring the Effects of Homeowner Tax Preferences 291

6,98

217

,594

2,58

5

108,

970

292 David C. Ling and Gary A. McGill

than that of Follain and Ling (1991).24 Using a “rate of return” approachthat is conceptually similar to the one used in this paper, but withaggregate data, Simonson (1991) estimates the tax expenditure fromthe nontaxation of NII to be $34 billion in 1987. The authors’ 1989estimate of this first (of three) components of homeowner tax savings is$66 billion.25

Distributional Aspects of Homeowner Tax Preferences

Distributional effects may be addressed by examining average homeownertax preferences across income groups. Column 3 of table 3 containsestimates of average tax expenditures per owner household by incomeclass. Overall, homeowner tax savings average $1,819. However, savingsvary greatly by income, ranging from $301 for the $0 to $5,000 incomeclass to $7,734 for the highest income class considered. The top curve infigure 2 graphically depicts these average total tax savings as a functionof income (not including income classes above $100,000).

Movement to neutral taxation of owner-occupied housing would bedetrimental to owners in all income classes (table 2, column 5). Withoutconsidering which income classes bear the cost of financing currenthomeowner benefits in the form of higher taxes, one would conclude thathigher income households would fare the worst because their homeownertax savings would be reduced the most in absolute terms. However,relative to their current share of taxes paid by all owning households,upper income households would be less adversely affected than low- andmoderate-income households.

To see this requires comparison of columns (2) and (6) in table 2.Households with AGIs of less than $30,000 receive 21.3 percent of the$109 billion tax expenditure, though they pay just 9.9 percent of total

24The primary explanation for the difference between Follain and Ling’s estimate of totalhomeowner tax savings and the estimate used in this paper is that Follain and Lingcalibrate their model to the $2.9 trillion total housing stock value estimated by the Boardof Governors of the Federal Reserve System (1989) for 1987. This estimate does notinclude the value of the homeowner’s land. In contrast, the current authors use the valueestimates of homeowners for both land and structure, which produces a total housingstock value of approximately $5.6 trillion (average house price of $94,675 multiplied by59.9 million owning households).

25The Bureau of Economic Analysis (BEA), U.S. Department of Commerce, estimates NIIon owner-occupied housing on the basis of gross rent and typical expenses on renter-occupied housing. For 1987, NII was estimated by BEA at a negative $13 billion (U.S.Department of Commerce 1988). Using an approach similar to that taken by BEA,Simonson (1991) estimates NII at $7 billion.

Measuring the Effects of Homeowner Tax Preferences 293

Table 3. Average Tax Liabilities of Owners by Income Class:Current Versus Alternative Tax Systemsa

(1) (2) (3) (4) (5)

TaxCurrent

Differencefrom fromTax

Current Difference

Current(2) – (1)

Law: CurrentAGIb Lawc

($)

TaxNeutral

Lawd

($) ($) ($) No MIDe (4) – (1)

0–5,000 0 301 301 0 05,000–10,000 112 771 659 117 610,000–15,000 504 1,265 761 533 2915,000–20,000 1,171 2,165 994 1,224 5320,000–25,000 1,620 2,599 979 1,736 11625,000–30,000 2,238 3,334 1,096 2,465 22730,000–35,000 2,914 4,130 1,216 3,279 36535,000–40,000 3,619 5,194 1,575 4,070 45140,000–45,000 4,277 6,244 1,967 4,857 57945,000–50,000 5,216 7,642 2,426 6,114 89850,000–60,000 6,599 9,473 2,874 7,793 1,19460,000–75,000 9,385 12,743 3,358 10,725 1,34175,000–100,000 13,704 18,481 4,777 15,616 1,912100,000–120,000 18,544 24,747 6,203 21,279 2,736120,000+ 30,728 38,462 7,734 33,591 2,863

Allf 4,353 6,172 1,819 4,929 576

Source: Authors’ tabulations and estimates from the American Housing Survey, 1989National File, supplemented with nonhousing expense estimates from the InternalRevenue Service 1985 Individual Tax Model File.aFederal tax liabilities in dollars; differences measured relative to current law.bAGI is adjusted gross income.c Current tax liability is the regular 1989 individual tax liability after credits.dNeutral tax liability is the tax liability when net imputed income is included in grossincome and mortgage interest and property taxes are not allowed as deductions.

eTax liability without mortgage interest deduction (MID) is the same as the current taxliability calculation except any mortgage interest deduction is not allowed.

f Totals and differences may be off by 1 because of rounding.

owner tax liabilities. Conversely, households with AGIs greater than$75,000 receive just 31.9 percent of the estimated $109 billion taxexpenditure, although they pay 43.1 percent of total homeowner taxliabilities under current law. Households with between $30,000 and$75,000 in AGI receive 46.7 percent of the total tax expenditure to ownerhousing—an approximately even exchange for bearing 46.9 percent ofthe current tax liability. Figure 3 depicts the relationship between shareof homeowner tax expenditures and share of owner tax liabilities undercurrent law and clearly demonstrates that lower income households (onaverage) actually receive a disproportionate share of the total tax expen-diture when controlling for their percentage share of the current taxliability; whereas higher income households receive less than their

($)

294 David C. Ling and Gary A. McGill

Figure 2. Average Owner Tax Savings by Income Class,Measured Relative to a Neutral Tax System

0-5 10-15 20-25 30-35 40-45 50-60 75-1005-10 15-20 25-30 35-40 45-50 60-75

Adjusted Gross Income+ Current Law Current Law w/o MID

Source: Authors’ tabulations and estimates from the American Housing Survey, 1989National File, supplemented with nonhousing expense estimates from the InternalRevenue Service 1985 Individual Tax Model File.

proportionate share of the total tax expenditure. Thus, from this perspec-tive, the adverse effects from the removal of all homeowner tax prefer-ences, including the nontaxation of NII, would be borne most heavily byhouseholds with AGI below $35,855 (the population mean).26

A variant of the Suits Index (Suits 1977) is used to assess more formallythe vertical distribution of homeowner tax preferences. The Suits Index,as typically employed, provides a measure of the average relationshipbetween the cumulative percentage of the total tax burden borne by a tax-paying population as income increases and the cumulative percentage oftotal income earned by that population. The normal range of the index isfrom –1 to +1, with –1 indicating extreme regressivity of the entire taxsystem, +1 extreme progressivity, and 0 indicating proportionality.

26A similar argument can be made with respect to the Social Security system, which manyargue is regressive. However, when benefits are taken into account, the Social Securitytax is actually quite progressive.

6000

5500

5000

4500

4000

3500

3000

2500

2000

1500

1000

500

0

+

An

nu

al T

ax S

avin

gs

Measuring the Effects of Homeowner Tax Preferences 295

Figure 3. Percent of Total Owner Tax Expenditure Versus Percent ofTotal Owner Tax Liability

0-5 10-15 15-20 25-30 35-40 50-60 75-100 120+5-10 15-20 20-25 30-35 40-45 60-75 100-120

Adjusted Gross Income

% of Total Taxes + % of Homeowner Tax Expenditure

Source: Authors’ tabulations and estimates from the American Housing Survey, 1989National File, supplemented with nonhousing expense estimates from the InternalRevenue Service 1985 Individual Tax Model File.

An index of the relationship graphically depicted in figure 3 can beobtained; that is, a measure of the relationship between the cumulativepercentage of the total homeowner tax expenditure received by owninghouseholds as income increases and the cumulative percentage of thetotal tax burden borne by owning households. In this application, theSuits Index will equal zero if, on average, the cumulative percentage ofhomeowner tax expenditures is equal to the cumulative percentage ofhomeowner taxes paid.27

A – 0.19 value for the Suits Index indicates that the distribution of the

holds receive a disproportionate share of total homeowner tax prefer-ences relative to the share of federal income taxes that they pay. This

5,000 (Suits 1977). Parameter L can be measured as L = §1/2[(Ti + Ti–1)(Yi –Yi–1)], where

Ti is the accumulated percentage of the total housing tax expenditure received by incomegroups 1 throug h i, and Yi is the accumulated percentage of the total federal tax liability

borne by all homeowners; i is summed over the total number of income groups.

+ —–

full expenditure is indeed regressive; that is, lower income house-

27The authors calculate the Suits Index as S = 1 – L/K. Statistically, K is always equal to

20%

15%

10%

5%

0%

Per

cen

t of

Tot

al

($)

296 David C. Ling and Gary A. McGill

distribution would change only slightly (Suits Index decreases to –0.28)if the mortgage interest deduction is eliminated (and households do notadjust their leverage rates). This indicates that the distribution ofmortgage interest deduction benefits is approximately proportional tohomeowner tax burdens rather than skewed to higher income owners.28

Horizontal equity requires that owning households with equivalentincomes receive equivalent amounts of homeowner tax savings. Thus, auseful measure of horizontal equity in this context is the variation inhomeowner tax savings within a given income group (Ehrenburg 1975;Anderson 1985, 1988). In particular, as a measure of horizontal equity,the coefficient of variation is used. Coefficient of variable is defined asCVj = SDj/Rj * 100, where SDj is the standard deviation of the full taxexpenditure and Rj is the mean tax expenditure for income group j.Dividing the standard deviation of the expenditure by the mean value foreach income group produces a measure that is scale-free and thus allowscomparisons between different income groups (with similar ranges ofincome). Higher CVj values represent greater horizontal inequity.

The first column of table 4 reveals that the coefficient of variation of thefull owner expenditure is a decreasing function of income class. Manylow- and moderate-income households receive little value from theirmortgage interest deductions (because NHE is less than SD), yet areforced by wealth constraints to use an amount of mortgage debt that doesnot allow them to maximize the value of their homeowner tax savings.However, numerous low- and moderate-income tax payers are olderhouseholds with little or no mortgage debt and are thus better able tomaximize the value of their homeowner tax savings. Thus, more variabil-ity in tax savings exists for these income groups. However, the antidebtbias is diminished as incomes rise (and NHE increases relative to SDs).Thus, for higher income groups, the size of the tax preference primarilyreflects the amount of housing consumed, not the method by which it isfinanced. For almost all income groups, the coefficient of variation in-creases, especially among the middle-income classes, if the MID iseliminated and households do not alter their loan-to-value ratios (column2). This again is a function of similarly situated homeowners facingdifferent financing constraints.

Dynamic Versus Static Estimates

The $109 billion total homeowner tax expenditure calculation is a staticestimate of the actual federal income tax revenue that would be raised if

28Examination of the distribution of the MID tax expenditure alone produces a SuitsIndex value of –0.007, confirming that, on average, the benefits of the MID are propor-tional to the amount of taxes paid under current law.

Measuring the Effects of Homeowner Tax Preferences 297

Table 4. Horizontal Equity of Homeowner Tax Savings:Coefficient of Variation by Income Classa

AGIb

($)

(1)

FullExpenditurec

(2)Expenditure

withoutMIDd

(3)

Difference(2) – (1)

0–5 227.7 227.7 0.05–10 128.4 129.5 1.1

10–15 122.7 126.9 4.215–20 112.7 117.9 5.220–25 110.7 121.3 10.625–30 101.4 119.9 18.530–35 101.9 124.3 22.435–40 89.2 112.4 23.240–45 76.7 100.7 24.045–50 65.9 94.7 28.850–60 60.1 91.4 31.360–75 54.9 75.9 21.0

75–100 63.1 83.6 20.5100–120 69.2 76.0 6.8

120+ 88.7 91.4 2.7

Alle 135.2 137.4 2.2

Source: Authors’ tabulations and estimates from the American Housing Survey, 1989National File supplemented with nonhousing expense estimates from the InternalRevenue Service 1985 Individual Tax Model File.aCoefficient of variation reported as a percentage. Higher CVj values represent greaterhorizontal inequity.

bAGI is adjusted gross income, reported in thousands of dollars.cFull Expenditure is the difference between current tax liability and neutral taxliability(see table 2).

dExpenditure without mortgage interest deduction (MID) is the difference betweencurrent tax liability without the mortgage interest deduction and neutral tax liability.

eTotals and differences may be off by 1 because of rounding.

owner-occupied housing were “fully” taxed because it abstracts frompossible general equilibrium feedback effects. Most importantly, the$109 billion estimate holds constant household tenure choice decisions,housing values, loan-to-value ratios, and the level of before-tax interestrates in the economy.

The available empirical evidence suggests that the tenure choice decisionis fairly insensitive to taxes and interest rates. For example, Hendershottand Won (1992) estimate that TRA86 raised the aggregate equilibriumhomeownership rate by only 0.4 percent despite a significant increase inthe cost of renting relative to owning. Berkovec and Fullerton (1990) also

298 David C. Ling and Gary A. McGill

conclude that demographic factors, not taxes and interest rates, are themain determinates of homeownership rates.

However, Hendershott and Won, Berkovec and Fullerton, and othersconclude that interest rates and housing values are sensitive to major taxpolicy changes. In particular, Berkovec and Fullerton estimate that fulltaxation of owner-occupied housing would reduce the value of the hous-ing stock by 3 to 6 percent (the former figure assuming a closed economy,the latter an open economy). Their largest estimated decline in the levelof before-tax interest rates is 71 basis points. These estimates assumerevenue neutrality; proceeds from the full taxation of owner-occupiedhousing are distributed to households in the form of reduced statutorytax rates.

Plausible ranges of relevant general equilibrium effects are easily incor-porated into the model in this paper to test the sensitivity of the staticestimates. The first row of table 5 reports revenue estimates from the

Table 5. The Sensitivity of Revenue Gains from the Neutral Taxationof Owner-Occupied Housing to General Equilibrium Effects

i(e)aPercent Decrease in

Housing Valuesb

9.71%

8.71%

Revenue Gainc

[Suits Index]d

Revenue Gainc

[Suits Index]d

0% 3% 6%

109 106 103[–0.192] [–0.189] [–0.184]

102[–0.178]

Source: Authors’ tabulations and estimates from the American Housing Survey, 1989National File supplemented with nonhousing expense estimates from the InternalRevenue Service 1985 Individual Tax Model File.a

i(e) is the before-tax return used in computing Ri the average before-tax required returnon invested housing equity [Ri = (1 – ti)i(e), where ti is the marginal tax rate].bFor a given mortgage loan balance, a reduction in house value decreases housing equityand thereby reduces net implicit income.cIn billions of dollars.dThe Suits Index is a measure of the progressivity of the distribution of the taxexpenditure,with –1 representing regressive, +1 representing progressive, and 0 repre-senting proportional.

neutral taxation of owner-occupied housing assuming permanent, across-the-board reductions in housing values of 0, 3, and 6 percent, re-spectively. Before-tax yields are held constant; thus, Ginnie Maes areassumed to yield 9.71 percent. Even a 6 percent reduction in house valuesreduces the estimated revenue effect by only $6 billion, to $103 billion.

99[–0.174]

96[–0.170]

Measuring the Effects of Homeowner Tax Preferences 299

Proportional reductions in house values only marginally affect thevertical distribution of homeowner tax savings, as measured by the slightchanges in the Suits Index (in brackets).

The second row of table 5 assumes that the full taxation of housingreduces before-tax interest rates by an extreme 100 basis points. Thisassumption, coupled with a 6-percent decline in housing values, producesa revenue estimate of $96 billion, which is $13 billion (i.e., 12 percent) lessthan the static $109 billion estimate. Again, the vertical distribution ofthe tax savings as measured by the Suits Index is largely unaffected evenwith these rather extreme feedback assumptions.

Finally, as a practical matter, the politics of such a dramatic change intax policy would likely require compensatory relief in the form of reducedstatutory income tax rates. It is worth emphasizing that owning house-holds could not mitigate the tax effects by adjusting their financialleverage rates; in a neutral tax system, homeowner tax savings would bezero regardless of how the housing investment was financed. Requiredproportional changes in the federal tax rate schedule are estimatedunder the assumption of a revenue neutral change from the current taxtreatment of homeowner tax preferences. Under the assumptions ofa 9.71-percent before-tax return and no change in housing values, the$109 billion in revenue gains from a change to a neutral taxation ofowner-occupants would be eliminated, with a 33.4-percent proportionalreduction in the tax rate schedule (i.e., a shift from the 1989 schedule of15, 28, and 33 percent to 10, 19, and 22 percent, respectively). Therequired proportional rate decrease would be only slightly less for therevenue gains computed under the other assumptions in table 5.

Effects of Eliminating the Mortgage Interest Deduction

Because of the conceptual and data problems associated with thetaxation of NII, most proposals aimed at curtailing homeowner taxpreferences have focused on the mortgage interest deduction. Ignoringfeedback effects, such as changes in ownership rates, house values, andhousing demand, the authors estimate that tax savings would decreaseby $34.5 billion if the mortgage interest deduction were eliminated andhouseholds did not alter their mix of debt and equity financing. Thisimplies a decrease in the total tax expenditure from $109 billion to$74.5 billion.

However, even abstracting from market feedback effects, this$34.5 billion estimate is certainly an overstatement. Elimination ofmortgage interest deductibility would increase the after-tax cost of debtfinancing relative to the (after-tax) opportunity cost of equity financing

300 David C. Ling and Gary A. McGill

and induce households to substitute relatively less expensive equity fordebt. Unfortunately, it is difficult to make even rough estimates of likelychanges in loan-to-value ratios because little is known about the deter-minants of household leverage decisions. Most would agree that manylow- and moderate-income households face liquidity (cash) constraintsdue to a lack of wealth, so these households would be the least able toadjust their leverage rates downward in response to an elimination of theMID. Many might also agree that age is an important determinant.

If upper-income households were to respond to MID elimination bymoving to 100-percent equity financing, no additional tax revenue wouldbe raised from these households; investments in taxable financial assetswould be replaced by additional investments in nontaxable housing

than $75,000 were to completely substitute nontaxable housing equityfor nondeductible mortgage debt, the increase in annual revenues wouldfall from $34.5 billion to $20.5 billion. If households with AGIs greaterthan $40,000 but less than $75,000 were able to reduce by half theirincreases in tax liabilities by partial substitution of equity for debt,additional revenues from MID elimination would decline further, to$12.8 billion.

The bottom curve in figure 2 depicts what would happen to averageannual tax savings if the MID were completely eliminated and house-holds did not adjust their leverage rates downward. The vertical dis-tance between the two curves represents the portion ofthe total homeowner tax expenditure that is currently attributable to the MID (table 3,column 5).

Several points are worth emphasizing. First, even complete eliminationof the MID would have a negligible effect on typical low- and moderate-income households because the vast majority of their homeowner taxsavings come from the nontaxation NII. This can be seen in table 3 bytaking column 5 as a percentage of column 3. The reason most, if not all,of these households’ housing deductions are “wasted” is that they do notreduce taxable income below what it would be if the households wererenting and did not itemize. The effect is made clear by examination ofthe last column in table 1, which presents the average difference betweenstandard deductions and nonhousing expenses for each income class.

Second, although it is acknowledged that many higher income house-holds would reduce their use of mortgage debt if the interest deductionwere eliminated, Woodward and Weicher (1989) seem extreme in theirview that high-income households would replace all of their mortgagedebt with equity. If they did replace all of their debt with equity, then,

equity. Column 9 of table 2 suggests that if households with AGIs greater

Measuring the Effects of Homeowner Tax Preferences 301

given that most low- and moderate-income households would not beaffected by MID elimination, little would be lost or gained. However, ifhigher income households were not able (or willing) to completelysubstitute equity for debt, MID elimination could have substantial equity(and revenue) effects. This is not to be interpreted as an endorsement ofsuch a policy. As previously discussed, MID elimination would introducesubstantial horizontal inequities between those who must rely heavily ondebt financing and those with sufficient wealth to equity finance, at leastto a large extent, their housing purchases.29

Summary

This paper constructs and estimates a model of annual tax expendituresfrom homeowner tax preferences in order to examine the size anddistribution of these expenditures. The authors have employed a microleveldata set and a model of homeowner tax preferences that includes netimplicit income. The model also measures more accurately the value ofhousing-related expenses by explicitly modeling the complex interactionamong standard deductions, nonhousing expenses, and household mort-gage debt.

Including the nontaxation of net implicit income and more accuratelymeasuring the value of the mortgage interest deduction has severalmajor public policy implications. First, on net, these changes adda substantial amount to the estimated tax expenditure to owner-occupiedhousing: the authors estimate the aggregate tax expenditure to havebeen $109 billion in 1989. Second, the interaction of changes inthe standard deduction and in the tax treatment of nonhousing itemizedexpenses has rendered the mortgage interest deduction worthless,or nearly so, for many low- and moderate-income households, thusintroducing an anti-mortgage debt bias to the federal income tax code.Nonetheless, measuring the tax expenditure relative to a neutral systemin which implicit rental income is taxed suggests that lower incomehouseholds receive more than their proportionate share of the total taxexpenditure when controlling for the percentage of the total tax liabilitythey currently pay. Higher income households receive less than theirproportionate share. This perspective on the vertical distribution ofhomeowner tax preferences leads to different and, it can be argued, more

29It is interesting to note that the aggregate loan-to-value ratio for Australia, which hasalmost never had a home mortgage interest deduction and which is a country in manyrespects similar to the United States, is only .125 versus the United States’ .328. InCanada, mortgage interest is not deductible and loan-to-value ratios are lower than in theUnited States. The comparative experiences of these countries may provide some guideas to the likely long-run effects of eliminating mortgage interest deductibility onhousehold leverage rates.

302 David C. Ling and Gary A. McGill

correct conclusions than those arrived at by simply looking at theabsolute size of homeowner tax savings across income classes.

Finally, measuring the tax expenditure to housing relative to a neutralsystem substantially changes the revenue and equity effects that wouldlikely result from reducing or eliminating interest deductibility. Remov-ing interest deductibility would not eliminate a prodebt bias, but wouldactually extend the antidebt bias introduced by TRA86 to all owninghouseholds.

The qualitative results in this paper are not sensitive to the inclusion ofgeneral equilibrium feedback effects. Estimates of both the size and thedistribution of homeowner tax preferences are affected only slightlywhen potential changes in housing stock value, before-tax interest rates,and before-tax returns on housing equity are considered.

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