The impact of proposed federal tax reforms on U.S. financial markets

Business Economics, Jan, 1996 by Albert E. DePrince, Jr., William F. Ford

In sum, insurance companies and depository institutions must consider the development of new products, should current products that shield investment income from taxes loose their appeal in a world of no taxes on interest and dividend income, or in a world in which tax rates in general are much lower than they are today.

Home mortgages, home ownership and home prices: The housing sector will also feel the effects of the changes proposed by Armey as a result of the elimination of the deductibility of mortgage interest. The deductibility of mortgage interest has become a powerful tax shield for homeowners. Its effect has been to lower the cost of capital for homeowners, much the same as the deductibility of interest has lowered the cost of capital for corporations. Elimination of that personal tax shield will raise the cost of capital for homeowners. Most economists predict that, as a result, home prices will be adversely affected. Without a phase-in period, some estimate that the elimination of mortgage interest deductibility could lead to a sharp price drop for higher priced homes.

A phase-in that grandfathers existing mortgages until they are fully paid off or refinanced would lessen the impact, but there would still be an adverse effect. Admittedly, if rates should fall overall as a result of the elimination of taxes on personal interest income, home prices could be buoyed. However, it is hard to say if the effect of lower interest rates would overcome the loss of the mortgage interest expense tax shield. Moreover, there is some doubt that rates will fall significantly via the elimination of personal taxes on interest income. As a result, some decline in home prices may be initially experienced under Armey's tax proposal.

A change in the mix between owner-occupied and rental units may also be an unplanned outcome of the Armey plan. Loss of the mortgage deduction will change the desirability of home ownership vs. renting. As such, there could be a fall in the proportion of homes that are owner occupied and an increase in the relative importance of multifamily homes.

The General Level of Interest Rates

All of the major tax reform plans provide for lower personal tax rates in exchange for a broadened tax base. Because of that, many analysts have speculated that lowering personal tax rates on interest income ought to lower the general level of interest rates. This assumes that tax rates enter into the calculation of the general level of rates. Indeed, this is the approach taken in most money and banking textbooks as well as texts on financial markets. However, that is more of an assumption than a statement of fact. Some practitioners maintain that tax rates do not enter into the determination of the general level of rates. Reasons for this conclusion vary. Some point to the fact that many major institutional investors are already exempted from taxes on interest income, or pay little in the way of taxes on such income. Of particular importance are life insurance companies, pension funds, and more recently, annuities issuers.