Mortgage Interest Deductibility and Housing Prices

Article excerpt

Over the past few years, there have been several proposals for replacing the income tax system with a system based on taxing consumption. Many of the proposed reforms include eliminating the deductibility of home-mortgage interest, but this provision raises a question: Since the deduction subsidizes home ownership, will eliminating it substantially reduce the value of owneroccupied housing?(1)

If Congress planned to end the home-mortgage interest deduction, leaving the rest of the tax code untouched, this concern would be well founded. To see why, consider that the decision to buy a house is based on the monthly cost of ownership. Individuals calculate an implicit rental equivalence that combines after-tax mortgage payments, property taxes, insurance, maintenance, and the opportunity cost of their down payment.(2) For a given mortgage interest rate, eliminating the tax deductibility of the payments increases the after-tax cost, leading to a decline in demand for owner-occupied housing and ultimately reducing housing prices. In other words, the simple experiment of removing the mortgage interest deduction, without changing anything else, has the result people seem to think it will. Moreover, the effect on housing prices differs across income levels. As we discuss below, most of the benefits of the home-mortgage interest deduction accrue to higher-income households, mainly because lower-income households do not itemize their tax returns.

The proposed tax changes, however, are not this simple. Most are modeled on the Hall-Rabushka proposal for taxing consumption at a flat rate.(3) One claim made by the authors of these proposals is that the tax code changes will increase aggregate saving. As the subsidy for purchased housing ends, the demand for other investments (like more productive business capital) will rise, increasing investment and saving. With such a major overhaul of the tax system, it is difficult to predict how much housing prices would change, or to anticipate the direction of interest rate changes, let alone their magnitude.

In this Economic Commentary, we analyze how implementing a flat tax on income and ending the deductibility of mortgage interest payments would affect housing prices. We argue that, to the extent that housing prices decline, more of the impact will be borne by those at higher income levels. However, since these households put a smaller fraction of their wealth in housing than do lower-income families, changes in the value of their other assets may mitigate the decline in the price of their homes.

Flat Taxes, Interest Rates, and Housing Prices

In its extreme form, the flat tax acts as a pure consumption tax, and, in nearly all of the proposed plans, replaces the current system with one that has a single standard deduction. Each individual's wage income, less that deduction, is taxed at a flat rate. In addition, firms pay a tax at the same rate on fringe benefits and other nonwage compensation. There are several ways to implement such a consumption tax, but the bottom line is that under a flat tax system, businesses are taxed on their profits and net interest paid, while individuals pay a flat wage tax.

The tax deduction for home-mortgage interest subsidizes home ownership, but some tax reform proposals include provisions for eliminating it. Will ending the deductibility of home-mortgage interest diminish the well-being of homeowners? However much housing prices may decline, families at higher income levels will bear most of the impact; but since they put a smaller share of their wealth into housing than do lower-income families, increases in the value of their other assets may offset any decrease in housing value.

In comparison, a value-added tax (VAT) taxes businesses on their profits, net interest paid, and wages. In the end, the two systems end up taxing exactly the same thing--consumption. This is most easily seen by considering the VAT. …