This paper examines the impact of the combined U.S. state and federal mortgage interest deduction (MID) on homeownership attainment, using data from 1984 to 2007 and exploiting variation in the subsidy across states, over time and due to inter-state moves. We test whether capitalization of the MID into house prices offsets the positive effect on homeownership. We find that the MID only boosts homeownership attainment of higher income households in less tightly regulated housing markets. In more restrictive places typically larger coastal cities an adverse effect exists. The MID is an ineffective policy to promote homeownership and improve social welfare. The mortgage interest deduction (MID) presents an important tax subsidy for U.S. homeowners. In 2007, an additional dollar of mortgage interest generated on average 26 cents in tax savings.2 This subsidy constitutes a very substantial revenue loss for the U.S. Treasury: the MID is the second largest U.S. tax expenditure, valued at an estimated $104.5 billion in foregone tax revenue in fiscal year 2011 (Office of Management and Budget, 2010).3 Given the magnitude of the MID subsidy, the assessment of its effectiveness in terms of promoting homeownership is of first order policy relevance.

In addition to the federal subsidy, the MID taken on state income taxes can be substantial as well, with some states providing a net state subsidy in excess of 9 cents per dollar of mortgage interest. However, there are large differences across U.S. states in this tax subsidy: states such as California, Delaware, Maine, Massachusetts and North Carolina rely heavily on personal income taxation to raise revenue, permitting the deduction of mortgage interest, while other states such as Florida, Nevada, South Dakota, Texas, Wyoming and Alaska levy no personal income tax at all (Minnesota Department of Revenue, 2009). There is also substantial variation over time. For example, Arizona, New York and Wisconsin experience roughly a doubling of the net state subsidy rate between 1984 and 2007.