Tax‐Induced Portfolio Reshuffling: The Case of the Mortgage Interest Deduction

Abstract

Several provisions of the Tax Reform Act of 1986 had an indirect impact upon the demand for home mortgage debt. These include the elimination of the deductibility of interest on consumer credit, the increase in the standard deduction, and the reduction in the number of expenses that can be itemized. These provisions and the 1983–1989 panel sample of the Survey of Consumer Finances provide an opportunity to study the responsiveness of the demand for home mortgage debt to its tax status relative to the tax treatment of equity‐financed investments in housing and consumer credit. The results are strongly supportive of a highly elastic demand for mortgage debt with respect to its tax price. The best point estimate of this elasticity is –1, but substantial variation is found among certain groups. More generally, the results provide strong support for the phenomenon of portfolio reshuffling.

Who Cares About Mortgage Interest Deductibility?

“…Since the inclusive measure allows for more assets to be used to offset mortgage debt than the conservative measure, the price elasticity implied by the former is naturally higher than for the latter. It is interesting to note that Dunsky and Follain (2000), using the 1986 U.S. tax reform, estimate the elasticity of mortgage demand to be about -1.13, which is in the range of the elasticities implied by our measures of assets that would be used to lower mortgage debt following the removal of mortgage interest deductibility.…”

“…Our preferred measure, which excludes all assets whose return may be either untaxed or tax-deferred, is around 60 percent of the OMB figure. In addition, it is interesting to note that the elasticity of mortgage demand estimated by Dunsky and Follain (2000) lies in the range of the elasticities implied by our proposed measures.…”

Taxation and the Financial Crisis

“…Analyses for the UK (Hendershott et al 2003) and the USA (Dunsky and Follain 2000) confirm that mortgages fell significantly relative to home value after reforms reducing the value of mortgage interest relief. Of course, other factors are also at work, notably regulatory limits on maximum loan-to-value ratios of realistic appraisals.…”

The sensitivity of homeowner leverage to the deductibility of home mortgage interest

“…Follain, Ling, and various associates have used the change in the effective deductibility of mortgage interest induced by the 1986 tax act to test the hypothesis that household leverage is sensitive to the tax penalty on debt (Follain and Ling [6], Ling and McGill [13], Follain and Dunsky [5], and Dunsky and Follain [4]). In each case, the leverage of individual households was found to be related significantly to the effective deductibility of mortgage interest.…”