Tax Reform's Third Rail: Mortgage Interest

Policy Backgrounders | Taxes

No. 139
Friday, February 16, 1996
by Bruce Bartlett


In mid-1995, the politically powerful National Association of Realtors launched an attack against the flat tax. Its in-house newsletter even declared, "It's War!"1 The association is battling to save the mortgage interest deduction, a feature of the tax code that has been in place since the inception of the income tax in 1913 and one that would be abolished along with all other deductions by a pure flat tax.

The deduction has long been considered the untouchable third rail of tax reform. However, a close look at a flat-rate tax suggests that, on balance, homeowners would gain more from it than they would lose.

The Realtors entered the fray armed with a traditional Washington weapon: a study. Their study was done by DRI/McGraw-Hill, a private economic consulting firm. It concluded that enacting a flat-rate income tax such as that proposed by Congressman Dick Armey and others would cause home prices to fall by 15 percent, wiping out $1.7 trillion of homeowners' equity.2 DRI claimed that a flat income tax would cause housing prices to collapse, primarily because it would eliminate the mortgage interest deduction and increase the aftertax price of housing.

"Realtors have declared 'war' against the flat tax."

Underlying that claim is the theory that being able to deduct mortgage interest increases the value of a home relative to the other goods bought on time, such as a car, and that this tax saving is reflected in the price of a house. If this were true, withdrawing the mortgage interest deduction would reduce housing values.

Of course, how much the deduction reduces anyone's aftertax cost of housing depends on the homeowner's income. Someone paying taxes at a 15 percent effective rate saves approximately $1,200 in taxes per year on a $100,000 mortgage at current mortgage interest rates. Another paying taxes at a 28 percent effective rate saves approximately $2,200 on a similar mortgage.

The DRI analysis largely ignores the other effects of a flat tax on the aftertax income of homeowners:

  • The tax rates under the Armey plan would be 17 percent for all taxpayers, and a typical family of four would pay taxes only on income above the personal allowance of $31,400.
  • Although taxpayers could not deduct their mortgage interest, they would pay no tax on the interest they earned from savings.
  • The double taxation of corporations' earnings would also end, so that shareholders would not pay taxes again on dividends from corporate profits.

An objective study of the impact of a flat tax on homeowners would have taken these factors into account.

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