An Analysis of Global HFT Regulation: Motivations, Market Failures, and Alternative Outcomes

April 24, 2014

Recent market events like the “flash crash” of 2010, algorithmic failures at Knight Capital, and the release of Michael Lewis’s book Flash Boys (2014)—with his claims that markets are “rigged”—have heightened scrutiny of high-frequency trading (HFT) and increased demands for more aggressive regulation. However, HFT has several empirically demonstrated benefits, and the current, largely qualitative arguments against it call for careful scrutiny of proposed regulations.

In a new study for the Mercatus Center at George Mason University, Holly A. Bell and Harrison Searles analyze the potential economic benefits of HFT and assess several proposed or adopted regulatory schemes from around the world.


The study surveys the global HFT regulatory environment, and includes an analysis of the intended goals of regulators within each country. Countries and regions chosen for review meet at least one of the following criteria: they have a major HFT market, have recently implemented or proposed significant HFT regulation, or have an emerging HFT market.

The study describes the goals of HFT regulators as falling into two broad categories:

  • Shared (or market integrity) goals. These goals are shared by traders, exchanges, and regulators. They include market integrity factors such as secure, reliable, and orderly markets that enable effective price discovery and limit manipulation and abuse.
  • Divergent (or “fairness”) goals. These goals are not necessarily shared by traders, exchanges, and regulators. They include perceptions of “fairness” and the generation of tax revenue. Particular regulatory strategies and tactics proposed to accomplish divergent goals include slowing down or eliminating HFT, implementing financial transaction taxes, reducing order-to-trade ratios, discouraging short-term trading while encouraging longterm investing, and requiring algorithms to continue trading regardless of market conditions.


  • There is little evidence that a market failure exists requiring additional aggressive regulation of HFT, or that government intervention will achieve market integrity or “fairness” goals better than existing market incentives.
  • Empirical evidence shows that HFT reduces trading costs, provides better investment performance for long-term investors, improves liquidity, and offers more flexibility and options for smaller retail investors.
  • Countries implementing policies that curb the use of HFT have experienced diminished liquidity.
  • Many regulatory proposals have unclear definitions of HFT that fail to differentiate it from algorithmic trading and other technology-driven markets.
  • A number of existing regulations and cooperative nonregulatory solutions are in place to ensure the integrity of financial markets where HFT is used. These include circuit breakers, HFT neutralizing algorithms, and erroneous order detection systems. 


  • Regulators that seek to govern HFT activities should clearly define the activity they intend to regulate; otherwise such regulations could have unintended consequences for financial markets as a whole.
  • Aggressive HFT regulations in certain markets could push financial activities and capital into growing and emerging HFT markets, such as those of Japan and Singapore. Therefore, regulators should be careful to gather empirical evidence of a market failure before enacting new regulations targeting HFT.
  • Regulators should be wary of implementing HFT regulatory policies designed to standardize market integrity practices. Such measures could potentially hamper risk management innovation and create a punitive environment that discourages public self-reporting of system or trading problems.

The Deduction of State and Local Taxes from Federal Income Taxes

March 6, 2014

Taxpayers who itemize their deductions are allowed to deduct state and local taxes from their federal taxable income. This deduction is limited to either income or sales taxes, but not both. Personal property taxes, such as local taxes on housing and real estate, can also be deducted. The main benefit of this deduction is to provide some tax relief to taxpayers living in states with higher taxes, since they have less disposable income. However, this benefit also points to the main cost of the deduction: it subsidizes higher taxes and spending at the local level, since taxpayers in those states will not feel the full burden of the taxes. Instead, the burden of these taxes is in some sense “exported” to taxpayers in other states, since federal tax rates must be higher than otherwise to fund the same level of federal spending. 

When discussing taxation in the United States, it is important to consider all levels of taxation rather than just focusing on one at a time, such as federal income taxes, because these tax levels affect each other. One way in which these taxes interact is found in the federal income tax code, whereby taxpayers who itemize deductions are able to deduct a variety of state and local taxes when calculating taxable income. In most years it is one of the five largest tax expenditures in the individual income tax, and it is thus one of the largest “tax expenditures” as defined by government agencies, such as the Office of Management and Budget.1 OMB estimates that in fiscal year 2012, this deduction reduced federal tax revenue by about $45 billion, and this amount will roughly double over the next five years. As a result, this deduction has had a large impact upon the overall tax system of the nation at all levels of government, which warrants further analysis of its overall desirability. 

Two Concerns For Equity

The distribution of the benefits of this tax expenditure, as well as the costs of removing it, can be thought of in two ways. First, there is the question of which taxpayers within the distribution of income benefit the most. According to estimates by the Joint Committee on Taxation for 2012, almost 95 percent of the benefits of this deduction go those earning over $75,000 per year, and over half (55 percent) of the benefits are for those earning over $200,000. The average deduction for those in the over $200,000 income group is over $5,000, while it is only about $250 for those in the $50,000 to $75,000 group (around the national median).2 These averages only include those taxpayers that claimed the deduction, which is only 27 percent of all taxpayers since most do not itemize their deductions. 

Second, there is the distribution of benefits across the 50 states, based on how high taxes are in each state. States with higher taxes will have more filers claiming this deduction, and therefore the deduction will also be a larger share of the state’s income. These high-tax states also tend to be high-income states, implying that there is a transfer from low-income to high-income states through this deduction. By looking at the total deductions in this category as a percent of adjusted gross income, we can see that there is wide variation across the states. The states with the lowest state and local tax deductions (Alaska, Wyoming, South Dakota) claim deductions amounting to less than two percent of their adjusted gross income, while the highest tax states (New York and New Jersey) claim over nine percent of their adjusted gross income. The figure below plots the correlation between the total deduction for state and local taxes and per capita adjusted gross income for 2010 for all 50 states and DC.3

Redistribution Or Offset For Higher Taxes?

During the 1985 tax debate, NYU law professors Brookes Billman and Noel Cunningham offered an economic justification for the deduction: state and local taxes reduce an individual’s income and ability to pay federal taxes, which should then be considered by the federal tax code.4 After all, if federal taxes should be based on an individual’s ability to pay, then local taxes could reasonably be considered as reducing one’s ability to pay federal taxes.

Economist Bruce Bartlett took a contrary position to Billman and Cunningham, arguing that this deduction is a subsidy to high-tax states from low-tax states, and high-tax states tend to have higher per capita incomes. He also found that, in general, the deduction is associated with higher state and local taxes because the federal government is paying a portion of these taxes, with most estimates suggesting state and local taxes are about 13 to 14 percent higher.5 In this case, more services may be provided publicly, even if it is more efficient to provide them privately. This deduction also influences the types of taxes that state and local governments use, biasing them toward choosing taxes that are deductible rather than those that are most efficient.6 More recent estimates confirm that state and local spending “could fall in the absence of deductibility,” indicating that the deduction does indeed increase government spending.7

Furthermore, the ability-to-pay reasoning of Billman and Cunningham overlooks where state and local taxes go, since taxes are not only collected, but spent. Unless one views all government spending as complete waste, it is a reasonable assumption that the local taxes are providing some services to those that pay them (though likely not equal to the full value of taxes paid in many cases). Thus, local taxes don’t reduce an individual’s willingness to pay by the full amount of the tax, or possibly even at all. The local taxes an individual pays are returned to the individual as local government services, minus the costs and wastes associated with government provision of services. 

For example, in cities where garbage collection is provided by the local government, the property or sales taxes that fund this service are deductible. For cities where garbage collection is provided privately, the fees paid to the garbage company are not tax deductible. But from an economic perspective, these two situations are identical and should be treated the same in the tax code. The current tax code gives preference to city-provided garbage collection, which potentially violates both equity and efficiency. The tax code also biases municipalities towards providing services, such as garbage collection, even though it may be more efficient for these services to be provided privately.

Tax Rates And Macroeconomics Effects

Eliminating the deduction for state and local taxes will likely lead to increased macroeconomic activity by removing the economic distortions listed above. It will also potentially lead to more federal tax revenue, though this depends on how individuals react to what would be, in effect, a tax increase. A better policy would be to simultaneously decrease tax rates at the same time that this deduction is eliminated, generating additional economic activity without increasing the amount of revenue concentrated at the federal government.

Estimating the economic and tax-revenue effects is a difficult matter. Two recent studies by the Tax Foundation attempt to examine the effects of removing the deduction for state and local income, sales, and property taxes. These estimates should not be taken as definitive point estimates, but as indicative of the direction of the effects. For the state and local income and sales tax deduction, they estimate that eliminating the deduction combined with an across-the-board cut in individual income tax rates by 5.8 percent (i.e., the 10 percent rate would drop to 9.42 percent) would result in an increase in total employment by around 300,000 jobs.8 They found similar effects for the property tax deduction, though this would also require a decrease in business property taxes because “capital (even owner-occupied housing) is quite sensitive to taxes.” 9


Removing the federal tax deduction for state and local taxes would make taxes more equitable throughout the nation, as both high-tax and low-tax states are treated equally by the federal government. It may also provide an efficiency boost for states and localities, as they abandon some services that could be better provided by private companies. The removal of this deduction would also allow federal marginal tax rates to be cut across the board, providing a secondary boost to the economy while still remaining revenue-neutral at the federal level.


  1. For a discussion of the largest individual and corporate tax expenditures, see Jeremy Horpedahl and Brandon Pizzola, “A Trillion Little Subsidies: The Economic Impact of Tax Expenditures in the Federal Income Tax Code” (Mercatus Research, Mercatus Center at George Mason University, Arlington, VA, October 25, 2012). 
  2. See Table 3 of Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2012–2017 (Washington, DC, February 1, 2013), JCS-1-13. The JCT estimates do not provide any further details on the about $200,000 group, but due to AMT and phase-outs of deductions, it is likely that the benefits are not flowing to taxpayers with extremely high incomes. 
  3. Deduction totals include property taxes and either income or sales taxes. Tax data from Internal Revenue Service, SOI Tax Stats—Historical Table 2, updated April 23, 2013, /SOI-Tax-Stats---Historic-Table-2. 
  4. Brookes D. Billman Jr. and Noel B. Cunningham, “Nonbusiness State and Local Taxes: The Case for Deductibility,” Tax Notes 28 (September 2, 1985): 1105–1120. 
  5. Bruce Bartlett, “The Case for Eliminating Deductibility of State and Local Taxes,” Tax Notes 28 (September 2, 1985): 1121–25. 
  6. Martin Feldstein and Gilbert Metcalf, “The Effect of Federal Tax Deductibility on State and Local Taxes and Spending,” Journal of Political Economy (1987): 710–36. 
  7. Gilbert Metcalf, “Assessing the Federal Deduction for State and Local Tax Payments,” National Tax Journal 64 (June 2011): 565–590. 
  8. Michael Schuyler and Stephen J. Entin, “Case Study #4: The Deduction of State and Local Income Taxes or General Sales Taxes,” Tax Foundation Fiscal Fact, no. 382 (August 2013). 
  9. Stephen J. Entin and Michael Schuyler, “Case Study #2: Property Tax Deduction for Owner-Occupied Housing,” Tax Foundation Fiscal Fact, no. 380 (July 2013).

The Tax Exclusion for Retirement and Pension Plans

September 17, 2013

The US federal tax code contains a number of provisions designed to encourage individuals to save for retirement. These provisions allow individuals to avoid or defer taxes if they choose to set aside a portion of their income for future consumption. When all of these provisions are combined, they are the second largest “tax expenditure” category as defined by the Joint Committee on Taxation. The exclusion of retirement savings from taxation causes some economic distortions, which we will discuss in this paper. However, unlike some other tax expenditures, there is a strong economic rationale for not taxing savings. Higher rates of investment lead to higher rates of economic growth, and it may be sound policy for the tax code to encourage this behavior, even after considering the economic costs. Excluding retirement income from taxation may also make the tax system more efficient, even though most other tax expenditures reduce efficiency. 

When an employer chooses to compensate employees with contributions to a retirement or pension plan, rather than with wages, that compensation is not taxed in the current year. Instead, the income will be taxed in the future when employees choose to withdraw it, presumably when they are in a lower tax bracket. Similarly, investment income in tax-protected plans, such as dividends and capital gains, is not taxed until it is withdrawn. 

Traditional employer-sponsored, defined-benefit pensions were the first major plans of this type to be excluded from taxable income, but over the years many other similar kinds of retirement savings have also achieved tax exclusion. Important additions were Keogh plans for the self-employed, contributions to Individual Retirement Arrangements or Accounts (IRAs) beyond employer-sponsored plans, and defined-contribution plans set up by the employer, such as 401(k)s. While these programs have important technical differences, the basic economic function is the same: contributions are made with pre-tax income and grow tax free, and the tax is paid in the future when withdrawals are made. The more recent Roth IRA operates differently from the rest, as it is funded with post-tax dollars and only the gains are tax free, but the intended economic effect of encouraging retirement savings is the same.

These exemptions result in a loss of revenue for the federal government. The Joint Committee on Taxation estimates that in FY 2013, about $117.2 billion in income tax revenue was not collected from the “net exclusion of pension contributions and earnings,” and the Congressional Budget Office has a slightly higher estimate of $137 billion once the forgone payroll tax revenue is included.1 While much of that tax revenue is simply deferred, rather than avoided, the lost payroll tax revenue (i.e., Social Security and Medicare taxes) which employers would have paid on wages is completely forgone. These estimates place the exclusion of retirement savings as the second largest tax expenditure, behind only the tax exclusion of employer-provided health insurance.2

Do Tax Incentive Increase Savings? 

A primary question on the tax exclusion of retirement savings is whether they encourage individuals to save more than they otherwise would. The primary economic benefits associated with this tax exclusion can only be achieved if savings increase on net. The macroeconomic benefit of an increase in net savings is greater long-run economic growth from more capital accumulation. The potential benefit to individuals is the long-run increase in savings if, for behavioral reasons, they will save too little from their own perspective.3 While the same result might be achieved by mandating more saving for retirement, perhaps by increasing Social Security taxation and benefits, the tax exemption may be a more attractive policy because it does not involve direct taking and giving but merely encourages citizens to provide for their future retirement.

For there to be an increase in net saving, savers actually have to decrease their current consumption and standard of living in lieu of future consumption and standard of living. Because of this condition, the incentives provided by the tax deferral may not encourage genuine savings. Instead, it may merely encourage deposits and contributions into the account in ways that don’t require reducing one’s present standard of living. Some individuals probably would have saved for retirement even without the tax incentive; thus, looking at the aggregate amount deposited in these accounts is misleading. As a result, we need to investigate how much savings increased as a specific result of the tax benefit. The Journal of Economic Perspectives devoted a symposium to this question with contributions from the leading scholars in this debate. While the empirical evidence is mixed, there does seem to be strong evidence that there is some net increase in savings from tax incentives, even if the magnitude is debated.

Other Tax Exclusion Concerns

While it is important to know whether a tax exclusion has a positive effect on savings, that alone is not enough to justify a tax policy. The costs of the economic distortions introduced by the policy must also be considered. One cost may be that individuals put their savings in forms that are different from what they would choose independent of these incentives. Individuals with savings in the form of 401(k) accounts have much less freedom to choose their investments than those with savings in traditional brokerage accounts, and those with traditional defined benefit pensions have essentially no choice in how their assets are invested. This could lead to serious principle-agent problems between employers and employees, with employers or their chosen brokerages not making the best investment decisions from the perspective of the employees. 

Another concern is that most of the benefits of the tax treatment of retirement savings accrue to those with the highest incomes. Toder, Harris, and Lim of the Tax Policy Center estimate that about 80 percent of the benefits for tax incentives for retirement savings go to the top income quintile.5 Those in the top income quintile almost always benefit the most from tax expenditures, largely due to the fact that they pay the most taxes; however, the 80 percent benefit for this category of tax expenditures is higher than other major categories, such as the mortgage interest deduction (about 68 percent goes to the top quintile) and healthcare-related tax expenditures (about 42 percent goes to the top quintile).

Can a Loophole Make the Tax System More Efficient? 

While tax expenditures or “loopholes” are generally regarded as making the tax system less efficient overall, the exemption for retirement savings may be an exception. In fact, this exemption may make the tax system more efficient both by making the current system function more like a consumption tax and by partially correcting the double taxation of capital within the current tax code. 

Since individuals can choose when they wish to realize the tax by delaying consumption, this may very well be a desirable feature of tax incentives for retirement savings. A tax on consumption is generally more economically efficient than one on income since it does not discourage production.6 The Congressional Budget Office even admits that it may not make sense to count this category as a tax expenditure: “because a consumption tax would exclude all savings and investment income from taxation, the exclusion of net pension contributions and earnings would be considered part of the normal tax system and not a tax expenditure.” 7

However, this desirable feature is only obtained by adding yet another layer of complexity to the income tax. If a consumption tax is what is desired, then proponents should make their goal changing the income tax into a consumption tax rather than creating unnecessary complexity within the system that we have. Nevertheless, we may consider this layer of additional complexity a second-best solution in a world where most federal revenue is still derived from taxes on income.

A second efficiency benefit of this tax exemption is that it serves as a partial correction for the current double taxation of capital income in the United States. With the highest corporate tax rate in the developed world, the United States must be particularly attentive to the impact of its tax system’s effect on capital formation.9 Currently, capital income is taxed when corporations earn income, and the same income is taxed again when it is paid to individuals in the form of dividends or capital gains. The exclusion of taxes on retirement income, specifically dividends and capital gains, means that the double taxation is eliminated for some capital income. In the absence of a corporate income tax, this tax exemption may make less economic sense, but given current corporate taxes in the United States, it has a sound economic logic.


In the end, the federal tax code allows for a deferral of income tax on contributions to a retirement or pension plan, which provides an incentive for people to save for their retirement. People choose to save more because they probably will be in a lower-income tax bracket during their retirement and also because they will be able to accrue the benefits of invested funds that would have otherwise been taxed away. Despite the complexity that this deduction adds to the tax code and some economic costs, this deferral brings the income-tax function closer to a more economically efficient consumption tax. It also mitigates the problem of the double taxation of capital for the tax-deferred contributions. 

The Tax Exemption of Employer-Provided Health Insurance

September 10, 2013

The Federal government does not tax health insurance when employers provide it to their employees as part of a compensation package. This tax expenditure is the largest “loophole” in the federal tax code, resulting in nearly $300 billion in forgone revenue in Fiscal Year 2012, according to the Office of Management and Budget. Even worse for the economy, the tax exemption for employer-provided health insurance creates significant distortions in the labor and health insurance markets. 

A new study from the Mercatus Center at George Mason University looks at the major unintended consequences of the tax exemption of employer-provided health insurance and the problems created by its market distortions. The study concludes that taxing health insurance and simultaneously lowering marginal tax rates would better serve most Americans and the overall economy.

Key Findings 

Many of the United States’ current health-care-related problems—from lack of choice and competition to rising costs—stem in part from the tax exemption for employer-provided health insurance. 

Eliminating the tax exemption cannot be a stand-alone change; the resulting tax increase on all working Americans should be offset with an equivalent reduction in tax rates.

  • This would eliminate many distortions to the health insurance market without a net increase in taxes.
  • This combination of reforms would also yield higher economic growth and a more flexible labor market, which in turn would increase tax revenue in the long run.

Eliminating the tax exemption would allow employers to increase employees’ pay by the same amount (about $12,000 annually, on average) that they currently spend on health insurance. 

  • Workers could use this extra income to shop for health insurance that best meets their individual needs.  
  • It would eliminate “job lock,” where employees feel “locked in” to their current job because they will lose their health insurance if they quit to search for a new job, by allowing workers to keep their health insurance if they change jobs.
  • It would also likely leave workers with more money, even after buying insurance.


Among the greatest economic distortions created by the tax exemption for employee-provided health care: restricting workers’ freedom to leave one job to find another better suited to their capabilities; limiting workers’ ability to choose the health insurance that best suits their needs; and limiting competition and driving up costs in the health insurance market. 

Labor Market Distortions

Job Lock. Americans fear how losing or changing jobs will affect their health care and are thus less likely to leave one job to search for another that better suits their skills. Negative effects include: The ultimate result is lower returns for investors, including retirees.

  • Employers have more leverage over employees; voluntary employee turnover is reduced by 25 percent in businesses providing health insurance, one study found.
  • Small businesses are at a competitive disadvantage in recruiting labor, as they typically must pay more for insurance benefits, and therefore are less likely to provide health insurance than large firms. 
  • Businesses and workers are less efficient, as resources are unable to flow to their most productive outlets.

Higher Health Care Demand, Higher Costs

 The tax exemption for employer-provided health insurance has increased the number of employers that provide health insurance; it has also increased the amount of health coverage purchased.

  • This increase in demand for health insurance and health care has contributed to the rise in health care prices in recent decades and further increases the job lock effect.

Less Choice, Less Competition

American workers have little direct involvement in decisions about purchasing their health insurance. Instead, large employers, representing large segments of the population, purchase health insurance for employees.

  • This reduces health insurance choices for all Americans and introduces equity concerns about who makes important economic decisions. 
  • It also makes the health insurance market less competitive.


Reform the tax code to eliminate the tax exemption for employer-provided health insurance. Offset the significant tax increase that results from closing this loophole with an equivalent decrease in marginal rates.

  • To make the elimination of the exemption tax neutral, marginal tax rates would need to be lowered significantly. 
  • For a hypothetical family making $75,000 per year (roughly the median household income for a family of four) and currently in the 10- and 15-percent brackets (see table in full study), marginal rates would need to be lowered to about 7 percent and 12 percent, respectively, to keep the level of tax revenue the same.
  • Similarly, the payroll tax rate would be applied to a larger base of income and, therefore, should also be lowered from 7.7 percent to 6.7 percent to raise the same revenue.

Interactions with the Affordable Care Act

This study’s proposed reforms should be beneficial regardless of the future status and outcome of the Affordable Care Act (ACA).

  • If the ACA remains law: the stated goals of the ACA include increasing transparency and controlling costs in the health care market, both of which are furthered by the reforms proposed in this study. 
  • If the ACA is repealed: the study’s proposals will be beneficial for correcting labor- and health care-market distortions. 

    The Home Mortgage Interest Deduction

    January 8, 2013

    The home mortgage interest deduction is the largest explicit tax deduction for households in the federal income tax code. Politicians have been reluctant to even consider removing this deduction, believing it to be one that provides significant benefits to middle-class taxpayers and encourages homeownership. These benefits are greatly over- stated: most taxpayers do not benefit from this deduction at all or receive a very small benefit. The only taxpayers who do receive a large benefit are those in the upper income brackets. Taxpayers and the entire economy would be better served by removing the mortgage interest deduction and lowering marginal tax rates to offset the change.

    The mortgage interest deduction is a tax deduction by which the federal government allows taxpayers who own their homes to lower their taxable income by the amount of interest paid on loans for a principal residence or a second home. As such, the mortgage interest deduction, like other deductions in the tax code, allows taxpayers to subtract the costs of certain items of consumption from their taxable income—thereby providing an implicit subsidy (i.e., a lower tax bill). The purpose of such a deduction is usually to encourage activities that result in more future taxable income or to create incentives for taxpayers to participate in certain behaviors that are considered desirable. In the case of the mortgage interest deduction, one of the policy goals is to increase levels of homeownership in the United States. The existence of deductions in the tax code necessitates a trade-off between different government services, providing incentives toward certain behaviors, higher taxes, and perhaps even larger deficits.


    In the aggregate, the home mortgage interest deduction substantially lowers the amount of taxes due from US households and thus lowers government revenue. For fiscal year 2011, the Office of Management and Budget estimates that the total amount of tax revenue lost was around $72 billion. The only “tax expenditures” (as the Office of Management and Budget calls them) that were larger were due to the non- taxation of employer contributions to health insurance and retirement plans.[1] But as figure 1 shows, for the typical tax- paying household, the tax benefits of the mortgage interest deduction were quite small. With median household income in the United States around $50,000, a typical family claiming the mortgage interest deduction received somewhere between $100 and $200 in tax savings for the entire year.

    This difference between the aggregate and household savings can be explained by two facts. First, only a fraction of taxpayers claim the deduction. In tax year 2010, the Joint Commit- tee on Taxation estimates that about 21.7 percent of taxpayer returns took the mortgage interest deduction. Second, of the small number of returns claiming the deduction, a disproportionate amount of the benefits went to high-income house- holds. Over 40 percent of the $72 billion went to households with adjusted gross incomes over $200,000, and another 35 percent went to households with incomes between $100,000 and $200,000. That leaves just about 25 percent of the $72 billion going to households with incomes under $100,000. Figure 2 shows the number of households that claimed the mortgage interest deduction in 2010.

    The bottom line is that most households would not be significantly harmed by removing the mortgage interest deduction. The 78 percent of households not claiming the deduction wouldn’t be harmed, and most stand to benefit if tax rates are lowered. For the typical household receiving $100 or $200 in tax savings per year (i.e., those in the figure 1 income categories between $30,000 and $75,000), the losses could easily be offset by slightly lowering marginal tax rates. High- income households would be harmed by removing the mort- gage interest deduction, but this represents a way to raise tax revenue without raising tax rates and thereby discouraging productive activity. To the extent that lower marginal tax rates encourage more economic activity, households in all income groups would be better off.


    Many defenders of the home mortgage interest deduction claim, as their central argument, that it makes housing more affordable for middle-class families. However, because of the nature of the tax system, this deduction does not necessarily provide incentives to everyone—nor does every debtor who pays interest on a mortgage pay lower taxes. The reason is that not all tax-filers use the itemized deductions that allow them to deduct their interest payments, and those who deduct are concentrated in the higher tax brackets while those who take the standard deduction are concentrated in the lower brackets. Moreover, it is important to recognize that the mortgage interest deduction is not precisely a deduction on home ownership. Homeowners are not allowed to take it against the part of the home they own (the down payment and prior repayment of principal). Instead, they can only take it against the part of the home they borrow. For these reasons, the mortgage interest deduction is an inefficient tool for increasing homeownership, since its primary effect is to encourage Americans who would have already been able to afford a house to take on even more debt.

    Empirical evidence supports the claim that the mortgage interest deduction has little effect on homeownership rates in the United States. Between 1960 and 1997, homeownership rates stayed within a narrow range of 62 to 66 percent, despite the fact that the implicit tax subsidy fluctuated dramatically.[2] During the recent housing bubble, the homeownership rate rose to 69 percent, but it has since returned to the historical range.[3] This rise appears to have been unrelated to the mort- gage interest deduction, though it was almost certainly related to other housing policies that encouraged the bubble. More sophisticated analysis suggests that the homeownership rate would be modestly lower without the deduction, by around 0.4 percent.[4]


    If the main proposed benefit of the mortgage interest deduction, increased homeownership, is small or nonexistent, the case for the deduction is significantly weakened. But the case is weakened further when we consider the costs of the mortgage interest deduction. Beyond the obvious cost of less government revenue from some taxpayers (and thus higher taxes on others to maintain a given level of government spending), there are several economic distortions that result from this deduction.

    One distortion is that more of society’s resources, human and physical, are devoted to high-income residential housing construction than would otherwise be the case.[5] This cost was seen on a grand scale in the housing boom and bust of the past decade, but it occurs on a small scale all the time. Recent empirical research suggests that the mortgage interest deduction increases the size of homes purchased but not the overall rate of homeownership.[6] This fact is consistent with the above research on homeownership rates but also demonstrates that more capital is being allocated to residential housing than the market would allocate. When the capital structure of the economy is altered, resources are not allocated efficiently and economic growth is hindered.

    A second economic cost is the alteration of the distribution of income in the country. Because this deduction favors those with high incomes, high marginal tax rates, and many other itemized deductions, the distribution of income is skewed in favor of the wealthy when compared with a simpler tax code. This outcome may further the popular notion that the entire system is rigged in favor of the wealthy. In addition, the misallocation of capital to the construction of high-income houses is to the benefit of the wealthy and skews the structure of the economy in their favor.

    The final major cost of the mortgage interest deduction is the cost of lobbying and rent-seeking associated with the deduction. Because the large benefits of this deduction are concentrated on a small group of taxpayers, a variety of lobbying and pressure groups are willing to expend resources to preserve this deduction in Congress and in the court of public opinion. While this spending is beneficial to the recipients of the benefit, from a social perspective it is pure economic waste and leads to lower growth for the economy as a whole.

    Where we cannot be sure of the subsidy having an economic cost is in the general level of housing prices. Contrary to many claims that removing the mortgage interest deduction would reduce the price of houses, economic research suggests that it is likely to have little effect.[7] As discussed above, the rate of homeownership has remained relatively constant for almost four decades, despite fluctuations in the implicit subsidy. Furthermore, the deduction primarily affects high-income earners, so we should expect that the subsidy primarily inflates the prices of high-income housing rather than the general level of housing prices. Most within and under the median income do not benefit from the deduction (figure 2), and the benefits are on average small, even for those taking the deduction (figure 1).


    There are three main routes toward ending the home mort- gage interest deduction. The first is simply ending the deduction and using the increased tax revenue as more revenue for the federal government. The second is ending the deduction and decreasing the general level of income taxation by an amount that corresponds to the increased tax revenue. The third is similarly stopping the deduction and replacing it with a tax credit that would be enjoyed by taxpayers upon the purchase of their first home.

    A major benefit of the first two possible routes is that both of them would end the federal government’s subsidization of homeowners. A benefit of the first proposal is that it could help stem the tide of red ink seeping from the federal government, and do so without threatening programs that better advance the general welfare. However, this money might amount to a net tax increase, which could harm economic growth in the short and long run. Therefore, our favored approach, on efficiency and equity grounds, is to eliminate the deduction and simultaneously lower marginal rates so the typical homeowner is no worse off.


    1. For an overview of the major tax expenditures in the current federal tax code, see Jeremy Horpedahl and Brandon Pizzola, “A Trillion Little Subsidies: The Economic Impact of Tax Expenditures in the Federal Income Tax Code” (Mercatus Working Paper, Arlington, VA: Mercatus Center at George Mason University, October 2012).

    2. Edward L. Glaeser and Jesse M. Shapiro, “The Benefits of the Home Mortgage Interest Deduction,” Tax Policy and the Economy 17 (2003): 37–82.

    3. US Census Bureau, “Housing Vacancies and Homeownership,”

    4. Harvey S. Rosen, Kenneth T. Rosen, and Douglas Holtz-Eakin, “Housing Tenure, Uncertainty, and Taxation,” Review of Economics and Statistics 66, no. 3 (1984): 405–416.

    5. Lori L. Taylor, “Does the United States Still Overinvest in Housing?” Economic Review, Federal Reserve Bank of Dallas, Second Quarter 1998: 10–18.

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