Maybe there is a way to spur consumption at a cost to the Federal purse  well below the price tag on President Obama’s new jobs program now placed at $450 billion.  Bear with me.

The 1986 tax reform act was a real watershed for US income tax.  The number of rates was reduced.  The actual rates were revised.  The Alternate Minimum Tax was expanded.  And more. 

But there was one change made that was not gnerally understood and certainly not remembered by those under 50 years old.  Until then you could deduct interest payments on consumer loans.  Yes, the interest on credit card debt, auto loans, and such could be deducted from your taxable income.  The 1986 act eliminated this deduction.  However, while it eliminated most deductions of interest rates, the 1986 act left one intact, in fact somewhat enhanced, deduction of interest paid on loans used to buy your home, i.e. mortgages. 

The reaction to closing one loophole while leaving one open was rapid.  Consumers turned to using loans based on the equity they had in their homes since this allowed them to continue deducting interest paid on “consumer” loans.  Enter the “home equity” loan as the favored way to extend credit to consumers. 

Of course this made real estate even more attractive.. While before home ownership was encouraged by allowing deduction of interest paid on the mortgage used to buy your home, now you could use the same home to deduct interest on your consumer borrowing.   A real shot in the arm for the real estate market.

Funny, at the same time the 1986 act destroyed the most active part of the real estate market.  It severely restricted the use of losses on “passive income” to lower taxable income.  The hot market then was selling participation in group purchases of  high value commercial real estate that allowed deduction of a share of the real estate’s losses according to your participation in the group.  The exact instrument was the Real Estate Investment Trust or REIT.  A classic tax shelter.  The 1986 act effectively put paid to this shelter which in turn hit the commercial real estate market like a tsunami. 

The effect of the change on deducting losses from ”passive income” did not just kill the commercial real estate market, it also led to the “Great  Savings and Loan Bank Collapse.”  You see, most of the loans used for REITs came from S&Ls who were investing heavily in these highly rated investments.  The 1986 act killed the market, ruined values, thus the underlying mortgages, and left the S&Ls holding the bag.  Not too different from our current burst “housing bubble.”

But back to my proposal.  I urge restoraton of the deduction of interest paid on consumer debt from taxable income.  This has two effects.  First, it would sharply reduce recourse to using your home for consumer credit.  Second, and far more important, it would encourage consumption by making interest on consumer borrowing tax deductible.  For example, as real estate vendors have been doing with home sales since 1986, auto dealers would be able to promote sales by saying how much you will save on your taxes by buying a new car. 

Now how much would this cost the Feds?  Looking at the cost of allowing deduction of interest paid on new car sales alone, using average new car sales for the last few years, the average price paid, average auto loan interest payments , and average income taxes paid with an assumption that all would deduct interest paid on auto loans, I come up with a loss to tax revenue of under $1.8 billion, a far cry from the President’s new jobs program that will cost $450 billion.   But if it resulted in a 10% rise in car purchases that would mean a gain of $ 15 billion in new car sales.  Not a bad cost/benefit ratio.

I can only imagine what making consumer debt interest tax deductible for all purchases would do.  But consumer purchases account for 70% or more of our economy which this year means about $10.5 trillion, yes trillion, not billion.  If making debt interest tax deductible would push consumption up by say 3% that would mean an increase in sales of $450 billion.  Using the ratio I found in matching tax loss due to allowing deduction of interest paid on new car loans to increased sales we would find that the $450 billion in additional sales would incur a loss to tax revenues of about $55 billion.   In other words we could get the President’s $450 billion in stimulus to the economy for only $55 billion in government funds instead of costing $450 billion to the government and in turn the tax payer.

I say go for it.