Tax Reform's Third Rail: Mortgage Interest

Policy Backgrounders | Taxes

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

Tax Rates, Interest Rates and Housing Prices

Figure I - Real Median New Home Prices and Average Marginal Tax Rate

If the deduction increases the value of housing and eliminating it would reduce that value, these effects should have appeared in the past whenever tax rate changes increased or decreased the value of the deduction.

"Historically, declining tax rates have been good for homeowners."

Of course the value of the mortgage interest deduction falls when tax rates fall. A $10,000 interest deduction that saves a taxpayer $3,000 per year if he or she is in the 30 percent tax bracket saves only $2,000 if the tax rate falls to 20 percent. Yet historically, declining tax rates have been good for homeowners.

Tax rates and housing prices. During the 1970s, the inflation that pushed taxpayers into higher tax brackets increased the value of the mortgage interest deduction to homeowners. Thus it should have caused housing prices to rise. By the same logic, the sharp reduction in tax rates during the 1980s should have caused housing prices to fall.3

In both cases, the reverse happened.

Figure I looks at the inflation-adjusted median price for new homes and the average marginal tax rate. It shows that rising marginal tax rates did not raise the real price of new homes. The real median new home price was actually less in 1982 than it was in 1973. By contrast, housing prices shot up when the Reagan tax cut became fully effective in 1983 and continued to rise even after the 1986 tax reform dropped tax rates further.

Interest rates and housing prices. One can argue that housing prices were flat in the 1970s and rose in the 1980s despite the tax changes because changes in interest rates overwhelmed the tax effects. The home mortgage interest rate rose from an average of 7.96 percent in 1973 to 15.14 percent in 1982. Rates fell thereafter, bottomed in 1986 at 6.39 percent and rose to 8.8 percent by 1989. Thus much of the rise in home prices in the 1980s took place while interest rates were rising.

Nevertheless, the interest rate is an important factor in setting prices. The lower the interest rate, the more house one can afford on the same income. However, market interest rates are to a large extent set by tax rates. The higher the tax rate, the higher the interest rate must be for lenders to get the same aftertax return.

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