The mortgage interest deduction, a tax break long considered a fundamental piece of the American dream, played a major role in the collapse of the housing and financial markets, according to a University of California, Davis, School of Law professor.

Dennis J. Ventry Jr., an expert in tax policy, reached that conclusion in an article for the current issue of the journal Law & Contemporary Problems. The piece is titled, “The Accidental Deduction: A History and Critique of the Tax Subsidy for Mortgage Interest.”

Ventry writes that the deduction, which permits homeowners to reduce their taxable income by the amount of interest paid on a home mortgage, was never intended to promote homeownership. Rather, Congress enacted the subsidy in 1913 as a general deduction for consumer interest. Even though such interest payments were minimal and only a fraction of the debt was deductible under the tax (due to high personal tax exemptions), politicians wanted to differentiate between personal and business expenses of family-run farms and small businesses.

“Over the course of 50 years, however, politicians and the housing industry transformed the subsidy into a sacred cow,” Ventry explains. “Federal programs — such as the Federal Housing Administration and GI Bill — shored up the housing market, restructured capital formation of residential construction and provided affordable mortgages to tens of millions of would-be homeowners.

“At the same time, Congress lowered income-tax exemptions, making more Americans eligible for the deduction and allowing the housing industry to link it to the value of people’s homes and one’s ability to achieve the American dream.

“If you’re a homeowner, your real estate agent and mortgage broker almost certainly told you that you’d get a tax benefit in the form of this mortgage interest deduction and perhaps a property tax deduction To the extent the market incorporates these subsidies into the value of homes, it raises their cost. Indeed, many economists believe they artificially raise housing prices by as much as 25 percent.”

Ventry concludes that the deduction does a lousy job of increasing the number of homeowners. “It might sound counterintuitive, but rather than raise rates of homeownership, the subsidy merely promotes overinvestment in residential real estate and encourages Americans to buy bigger and more expensive homes — sometimes more expensive than they can afford.”

The deduction is the second most expensive tax subsidy today, behind only the tax exclusion for employer-provided health insurance, according to the U.S. Office of Management and Budget.

Ventry acknowledges that the mortgage interest deduction enjoys widespread support among American taxpayers. But he suggests repealing it and replacing it with a tax credit.

“Moving to something like a tax credit would get folks into homes that they cannot currently afford. Right now, the deduction provides an ‘upside-down’ subsidy. That is, it gives 10 times the tax savings to households with income above $250,000 versus those with income between $40,000 and $75,000.

“In the end, the mortgage interest deduction just helps people who would buy a home with or without the tax subsidy. They just buy a bigger house.”