Photo: Getty Images/Glow RM
By Sheila Bair
February 28, 2013

I was pleased to hear the President calling for comprehensive tax reform in his State of the Union address. But how serious is Washington about tackling the array of special breaks infused into our tax code? True reform will not succeed unless everything is put on the table. With the housing market still ailing, will Washington have the courage to tackle that most sacred of tax cows, the mortgage interest deduction, or MID?

We Americans love owning our houses and the taxpayer subsidies that help us pay for them. The last time Congress cleaned out the tax code in 1986, this was one of the few special breaks left untouched. But today our cash-strapped government needs to rethink all tax breaks, and the MID costs taxpayers about $100 billion per year.

The underlying rationale for the MID is to promote homeownership. Yet most independent studies find little if any correlation between homeownership rates and the MID. Indeed, Canada does not have an MID, and its homeownership rate is higher than ours. Singapore has the highest ownership rate — over 85% — with no MID. These studies also show that while an MID does not improve homeownership rates, it does impact home affordability. With taxpayers subsidizing their interest expense, homebuyers can take out bigger mortgages, which create upward pressure on home prices. Just like everything else, be it health care, college, or housing, when the government starts subsidizing it, it gets more expensive.

As a consequence, eliminating the MID probably won’t reduce homeownership rates, but it could reduce home prices. This is particularly true in upscale neighborhoods, as the MID is most beneficial for those in the highest income tax brackets. (A taxpayer in a 39% tax bracket will get a 39¢ benefit for every dollar deducted, while one in a 20% bracket will get only 20¢.) With millions underwater on their mortgages and home prices still nearly 30% off their peak, a hit to home prices should not be taken lightly.

It is unlikely that Congress would completely do away with the MID. Most proposals would curtail it, not end it. Reforms being discussed would eliminate the deductibility of interest on home equity loans and second homes, or reduce the size of eligible mortgage debt from $1 million to $500,000. Other proposals would convert the subsidy from a deduction to a credit, which would help more lower- and middle-income taxpayers who do not itemize. A less costly option I have suggested is to replace the MID with a credit for people who pay down their principal, encouraging them to build equity.

Alternatively, Congress might decide to place an overall cap on the use of tax breaks, as Mitt Romney suggested during the presidential campaign. Here, homeowners could keep their MID up to the cap, but in doing so might have to forgo other deductions, such as those for state and local taxes.

If Washington decides to curb the MID, it will probably include some grandfathering of current homeowners, according to Sen. Johnny Isakson (R-Ga.), who spent 33 years in Atlanta’s real estate industry. That seems only fair, since so many families have budgeted for their mortgage payments based on MID savings. But it also means that if you are thinking about becoming a homeowner, now may be the time to buy, before Congress acts.

So here’s my prediction: Congress will move ahead with tax reform, taking some kind of overall “cap” approach to tax expenditures. It will use part of the resulting revenue to lower everyone’s marginal rates, with the remainder applied to deficit reduction. In the process we’ll get a healthier economy, one where decisions are made based on what people really want instead of chasing tax subsidies. This assumes, of course, that tax reform will actually happen, a big assumption, since gun control and immigration appear to be higher presidential priorities.

Hey, I can dream, can’t I?

Fortune contributor Sheila Bair is a former chair of the FDIC and the author of New York Times Best Seller Bull by the Horns: Fighting to Save Main Street From Wall Street and Wall Street From Itself.

This story is from the March 18, 2013 issue of Fortune.

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