The president’s budget takes on what has long been considered a sacred cow by trying to reduce the mortgage-interest tax deduction for top earners.

The president’s budget seeks to raise $318 billion over the next decade by lowering the value of itemized tax deductions for the wealthy — including interest paid on home mortgages. Households that currently pay income taxes at the 33% and 35% rates would only be able to claim deductions at the 28% rate. That means that for every $1,000 in deductions, a household in the top tax bracket would realize a tax savings of $280, down from the current $350. The proposal wouldn’t take effect until 2011.

The mortgage-interest deduction for owner-occupied homes is estimated to cost the government $100 billion this year, making it the largest government subsidy for housing and one of the most expensive tax deductions.

The real-estate industry, which has long squelched efforts to tamper with the mortgage-interest deduction, warned Thursday that any rollback could undermine an already decimated housing market. “It’s an awful policy to recommend at this time,” said Lawrence Yun, chief economist for the National Association of Realtors. “The source of economic problems is falling home prices, and this proposal raises additional uncertainty” about where and when prices would set a floor, he said.

But many economists have long argued that the deduction doesn’t actually have a significant impact on home ownership, and instead mainly subsidizes the cost of buying a home for the richest Americans, who would buy homes even without it. Some have blamed the mortgage-interest deduction, in part, for spurring borrowers to take out larger mortgages in order to maximize their subsidy.

“One of the costs of the deduction has become painfully obvious to the extent that we have encouraged borrowers to bet so heavily on housing. That now looks foolish,” said Edward L. Glaeser, a Harvard economist.

Nearly 80% of the benefits from mortgage-interest and property-tax deductions go to the top 20% of taxpayers in terms of income, according to Urban-Brookings Tax Policy Center, while only 3.5% of the benefits go to people in the bottom 60% of income earners. Most lower- and middle-income homeowners don’t qualify for the deductions because they don’t itemize deductions on their tax returns. During the presidential campaign, Mr. Obama proposed a 10% mortgage-interest tax credit for homeowners who don’t itemize.

In 2007, households with adjusted gross incomes of at least $200,000 accounted for 30% of all mortgage-interest deductions, by dollar value.

The proposal to cap the deduction could have an outsized effect on higher cost-of-living housing markets such as California, New York and Florida, which have a higher share of affluent homeowners. Already, some of those states have borne the brunt of home-price declines, and government efforts to improve mortgage financing and stem foreclosures have bypassed borrowers in high-cost markets with loans that are too big for government backing.

But economists have also faulted the mortgage-interest deduction for inflating prices in supply-constrained markets such as Manhattan and coastal California. “If supply is fixed, a demand subsidy will just push up prices, making housing less affordable for ordinary Americans,” says Mr. Glaeser.

The proposal, which would also curb deductions on charitable giving, could face an uphill battle in Congress and among powerful lobbies. The real-estate industry strongly opposed a 2005 proposal from a White House tax-overhaul panel to convert the deduction to a 15% tax credit. That proposal also called for lowering the $1 million mortgage ceiling on the deduction to the size of an average mortgage for each housing market.

Some of President Obama’s top economic advisers have called for a refundable tax credit that would replace the current mortgage-interest deduction. If Mr. Obama’s budget proposal were to pass, tax experts say that could establish a beachhead for a more expansive overhaul later. “This is probably the easiest way politically to start down that track — to limit it for high-income people,” says Gerald Prante, an economist at the Tax Foundation, a nonpartisan Washington research group.

WSJ