Exploring mortgage interest deduction reforms: an equilibrium sorting model with endogenous tenure choice

Abstract

In most equilibrium sorting models (ESMs) of residential choice across neighborhoods, the question of whether households rent or buy their home is either ignored or else tenure status is treated as exogenous. Of course, tenure status is not exogenous and households' tenure choices may have important public policy implications, particularly since higher levels of homeownership have been shown to correlate strongly with various indicators of improved neighborhood quality. Indeed, numerous policies including that of mortgage interest deduction (MID) have been implemented with the express purpose of promoting homeownership. This paper presents an ESM with simultaneous rental and purchase markets in which tenure choice is endogenized and neighborhood quality is partly determined by neighborhood composition. The public policy relevance of the model is shown through a calibration exercise for Boston, Massachusetts, which explores the impacts of various reforms to the MID policy. The simulations confirm some of the arguments made about reforming MID but also demonstrate how the complex patterns of behavioral change induced by policy reform can lead to unanticipated effects. The results suggest that it may be possible to reform MID while maintaining the prevailing rates of homeownership and reducing the federal budget deficit.