Under a pure flat tax, all deductions, including the mortgage interest deduction, would be abolished. Some have claimed that the deduction increases the value of housing and have estimated that eliminating it would reduce the value by 15 percent. Yet historically, declining tax rates have been good for homeowners. Thus during the 1970s, the inflation that pushed taxpayers into higher tax brackets increased the value of the mortgage interest deduction, but the real median new home price was actually less in 1982 than in 1973. By contrast, housing prices shot up when the Reagan tax cut became fully effective in 1983 and continued to rise after the 1986 tax reform dropped tax rates further.

Interest rates are also an important factor in setting housing prices. A flat tax would eliminate taxes on interest received, causing all interest rates to fall by approximately the spread between tax-free municipal bonds and comparable taxable securities, including mortgages. Mortgage rates should fall about 1.35 percentage points, from approximately 7.6 percent today to 6.25 percent (a drop of about 18 percent), as soon as the flat tax takes effect. Homeowners could refinance their mortgages and still come out ahead.

Even without a decline in tax rates and interest rates, international data suggest that the loss of mortgage interest deductibility would not devastate housing.

• Israel and Australia have home ownership rates significantly higher than the United States and no mortgage interest deductibility.

• Rates in Canada and Japan are about the same as in the U.S., also without deductibility.

• By contrast, France and the Netherlands have much lower home ownership rates despite mortgage interest deductibility and higher tax rates.

And in the U.S., three of the five states with the highest home ownership rates - West Virginia (73.3 percent home ownership), Michigan (72.3 percent) and Pennsylvania (72 percent) - do not allow mortgage interest deductions from the state income tax.

Any flat tax passed by Congress likely would allow homeowners to deduct interest for the life of their existing mortgages, losing deductibility only with a sale or refinancing. The flat tax also would benefit homeowners by eliminating the capital gains tax.

According to the Joint Committee on Taxation, the mortgage interest deduction costs $58 billion in lost revenue, but 89 percent of the deductions are claimed by taxpayers with incomes over $50,000. And because only 21.2 percent of taxpayers claim the deduction, it is of no value to 78.8 percent of taxpayers.

Source: Bruce Bartlett, "Tax Reform's 'Third Rail': Mortgage Interest," NCPA Policy Backgrounder No. 139, February 16, 1996, National Center for Policy Analysis, 12770 Coit Rd., Suite 800, Dallas, TX 75251, (972) 386-6272.

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