Tax Reform's Third Rail: Mortgage Interest

Policy Backgrounders | Taxes

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

Tax Rates and Interest Rates

"Housing prices shot up with the Reagan tax cut and continued to rise after the 1986 tax reform dropped tax rates further."

The impact of tax rates on interest rates can be measured precisely because yields on municipal bonds are tax free. In recent weeks the difference in the interest rate between municipal bonds and high-grade taxable bonds has been 1.35 percentage points. In theory, this spread should roughly equal the average marginal tax rate.

Therefore, eliminating taxes on interest received should cause 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. This is because a tax-free yield of 6.25 percent to mortgage lenders is approximately the same as a taxable 7.6 percent yield.

"Mortgage rates should fall by about 18 percent as soon as the flat tax takes effect."

The median marginal tax rate is well below the average (mean) marginal tax rate, so mortgage rates should fall by more than the aftertax interest cost would rise on existing mortgages. (The average is higher than the median because more income is earned by people in higher tax brackets.) Since most taxpayers are in the 15 percent bracket, they would in effect pay 15 percent more on their existing mortgages without deductibility. But if market interest rates fall by more than 15 percent, they could refinance their mortgages and still come out ahead - even without the interest deduction.

The decline in interest rates does not depend at all on any increase in the saving rate. It simply involves an equalization of taxable and tax-exempt yields. However, eliminating all taxes on interest and ending the double taxation of dividends and capital gains will increase saving to some extent. All other things being equal, interest rates should fall even more as saving rises, which will further cushion homeowners from the loss of mortgage interest deductibility.

The DRI study assumed a fall in interest rates but understated the amount by comparing municipal bond rates to 10-year Treasury bond rates. However, municipal bonds are much riskier than Treasury bonds (as holders of Orange County, Calif., bonds recently discovered) and Treasury bonds are also free of state taxes. Thus the spread is much less than between municipals and, for example, high-grade corporate bonds.

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