The federal mortgage interest deduction acts as an incentive for homebuyers to take on bigger mortgages than they might need, making it harder to safeguard the financial system against systemic risk, the president of the Federal Reserve Bank of Minneapolis told bankers meeting in Montana this week.

Lowering the fraction of mortgage interest households are allowed to deduct from their taxable income would help protect the financial system in the event of another housing boom and bust, Minneapolis Fed President Narayana Kocherlakota said.

If policymakers want to encourage homeownership, he said, they could replace the mortgage interest deduction altogether with a tax credit that offsets part of a buyer’s down payment on a home.

Kocherlakota said tax deductions for corporate borrowing should also be scaled back, because they serve as a "debt tax shield" that encourages financial institutions to take on debt instead of attracting deposits.

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