Tax Reform's Third Rail: Mortgage Interest

Policy Backgrounders | Taxes

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

The Impact of a Flat Tax

In the unlikely event that the institution of a flat tax caused housing prices to decline, the decline must be viewed in context. First, the drop would not be permanent. If home prices were to fall by, say, 15 percent, home construction would decline as well. This reduction in the supply of housing would cause home prices to rise again within a short time.

"The lower prices on homes people sell would be exactly offset by lower prices on those they buy."

Second, any loss of wealth would affect only those who had planned to sell their homes and realize the gain. But the vast majority of homeowners sell in order to buy another home. Since the loss of deductibility would affect all houses, the lower prices on homes people sell would be exactly offset by lower prices on those they buy.

Any decline in housing prices would greatly benefit first-time home buyers, many of whom rent and receive no benefit from the current deductibility of mortgage interest. Home buyers also would benefit from the increase in aftertax income that would enable them to save for a down payment, once taxation of interest and the double taxation of dividends and capital gains are eliminated. Many studies have identified the lack of a sufficient down payment as a greater barrier to first-time home buying than housing prices or interest rates.

Third, the flat tax would benefit homeowners by eliminating the capital gains tax. Currently, homeowners must buy a new home of equal or greater value within two years or pay capital gains tax on all accumulated gains, including gains on earlier home sales. This causes some people to overbuy housing and incur a large debt, since they can only tap into their home equity by borrowing against it. It also puts an enormous burden on those who must realize their gains because of a lost job, unforeseen medical or other expenses or divorce - and those who cannot roll over the gain from their home sales into higher-priced homes.4

Fourth, enactment of a flat tax would increase growth and increase the value of stocks, bonds and other investments. Professor Dale Jorgenson of Harvard estimates that national wealth would immediately rise by $1 trillion if a flat-rate consumption tax were implemented.5

And much of the increase in growth would come from eliminating the current tax bias in favor of housing over other investments. A 1987 study by Professor Edwin Mills of Princeton estimated that equalizing the aftertax rate of return between housing and other capital would increase the stock of non-housing capital by 12 percent and increase real growth by 10 percent.6

A long line of tax reformers has criticized the mortgage interest deduction as unfair because its benefit rises with one's marginal tax rate and thus one's income. According to the Joint Committee on Taxation, 89 percent of all the mortgage interest deductions are claimed by taxpayers with incomes over $50,000. And because only 21.2 percent of taxpayers claim the mortgage interest deduction, it is of no value to 78.8 percent of taxpayers.7

The deduction also would be unfair under a flat tax plan, since all taxpayers - including renters - would have to pay a higher rate to make up for the lost revenue. The tax revenue lost because of the deduction is estimated by the Joint Committee on Taxation to be $58 billion.

The DRI study makes some valid points about the possible effects of a flat tax on the housing market. But the $70,000 study, financed by Realtors, addressed only the tax's impact on housing. It ignored the effects of a flat tax on economic growth, saving and other portions of the financial landscape.

"Despite the attack by their association, individual Realtors support a flat tax with no mortage deduction."

The prospect of losing the mortgage interest deduction does not appear to be hurting the flat tax drive. A 1995 poll by Mitchell Research found that 56 percent of people support a flat tax without the mortgage interest deduction, but only 41 percent with the deduction. A recent survey commissioned by Citizens for a Sound Economy showed that many individual Realtors also support a flat tax without the mortgage deduction. By a 2-to-1 margin, the Realtors surveyed would give up their own deduction if it meant a lower tax burden. Only 11 percent rated the mortgage interest deduction as the most important reason people buy a home.

Many Americans understand that allowing one deduction would bring back others, and soon we would have a new tax system as complex and unfair as the old.

NOTE: Nothing written here should be construed as necessarily reflecting the views of the National Center for Policy Analysis or as an attempt to aid or hinder the passage of any bill before Congress.

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