Slaughter a sacred cow to aid homeowners' interest

0 Comments | Insight on the News, Feb 17, 1997 | by Patrick Chisholm

Proposals for a flat tax have faded from the headlines, but they are likely to come alive early in the 105th Congress. The biggest champion of a pure flat tax is House Majority Leader Dick Armey of Texas, but even some Democrats, including House Minority Leader Dick Gephardt of Missouri, favor a flat tax as long as certain sacred retained -- foremost among them the mortgage-interest deduction. Even many Republicans are afraid to support a flat tax that eliminates it. They're under the erroneous impression that it actually helps the middle class.

Dead wrong. Early last year realtor and mortgage-banker lobbies launched a scare campaign warning of a plunge in home values should the mortgage-interest deduction be revoked, apparently believing that this would make interest payments less affordable, creating a wave of defaults.

This intimidated enough politicians into either retaining the mortgage-interest deduction under a flat tax (or flatter tax, as the case may be) or rejecting the flat tax outright.

The fears are patently unfounded. If the deduction were eliminated, people would continue to , pay their mortgages, just as they did in the early eighties, when mortgage payments shot up because of skyrocketing interest rates.

Home prices still went up. The mortgage-interest deduction popular with the public because of the perception that it lowers their housing costs. But most homeowners should not be applauding the deduction because it causes higher interest rates, which cancel the tax benefit.

Interest rates are higher because the tax loophole creates an artificially higher demand for mortgage loans. Higher demand for something makes its price rise. And a mortgage-interest rate basically is the price of a mortgage loan. Revoking the deduction would make rates drop. This is exactly what happened after the attractiveness of utilizing the mortgage-interest deduction was significantly reduced by the 1986 Tax Reform Act. Predictably, mortgage-interest rates came down after 1986. Housing prices, on the other hand, did not fall, but steadily have increased since then.

Interest rates would fall anywhere from 1 to 2 percentage points if the mortgage-interest deduction were eliminated under a flat tax, according to several analysts, and it is likely they would fall that much if the mortgage deduction were eliminated while keeping the current tax system.

Even a study sponsored by the National Association of Realtors (a pro-mortgage-interest-deduction lobby) concedes that mortgage-interest rates could fall by that amount. That would mean a drop in a 30-year fixed mortgage rate from the current 8 percent to 6 or 7 percent.

Opponents of doing away with the mortgage-interest deduction often say this action would hurt the middle class. This is dead wrong; the opposite is true.

Fifty percent of the financial benefits associated with the mortgage-interest deduction goes to households earning more than $100,000 per year, yet they only are 6 percent of the population. Much of the deduction is used to subsidize expensive vacation homes, even yachts used as second homes.

Meanwhile, mortgage-interest rates are artificially high for the 75 percent of American taxpayers who don't take the mortgage-interest deduction -- they take the standard deduction. Eliminating the mortgage-interest deduction would be a boon to these homeowners because of the resulting lower interest rates. Lower rates also would prompt a lot of renters to become buyers.

Assuming the mortgage-interest deduction were abolished while retaining the current tax system, I calculate that a homeowner making the median household income of $35,000, paying 8 percent interest on a $70,000 loan (and taking the standard deduction) would enjoy about $1,000 in lower annual interest payments, assuming interest rates dropped from 8 percent to 6.5 percent.

Even a homeowner making $100,000 per year with a $150,000 loan still would come out about $750 ahead, since the lower interest payments would offset the loss of the mortgage-interest deduction (using married-filing-jointly tax rate schedules). With an annual income of $500,000 and a $1 million loan, however, a homeowner would undergo a net loss of about $14,000.

But not even the very wealthy should complain -- a lower overall tax rate could compensate high earners for much of the loss. The mortgage interest deduction costs the government about $55 billion in lost revenue. If the loophole were closed and revenues went up by that amount, the general level of taxation could be lowered. In fact, this would result in about $1,200 in lower annual tax payments for each of the nation's 45 million households on average.

Of course, it would not result in exactly $1,200 for each household. If the money were distributed according to how much each income level currently pays in taxes, the wealthy would enjoy the bulk of the tax savings since they pay the bulk of the nation's taxes. (The richest 1 percent of Americans pay 28 percent of the taxes. The richest 10 percent pay 57 percent.)