Would the housing market crash if we eliminated the deductibility of home mortgage interest on personal income tax returns?
Real estate agents and mortgage-related businesses argue it would. Basic economic theory says there would be at least some decline in home values. But economic historian and Bloomberg News columnist Amity Shlaes argues that these objections are overblown, and that there is no time like the present to eliminate this tax expenditure.
Who is right?
Such lowering rates and broadening the base certainly would simplify tax returns and might improve the overall efficiency of the economy. But moving from an income tax regime that has been in place for decades to one with no credits, exclusions or deductions definitely would impose adjustment costs.
This is the sort of knotty problem that arises when implementing a long-term solution causes serious short-term problems.
Shlaes argues that the mortgage-interest tax credit has induced demand for homes, thereby artificially driving up prices. Reducing demand would mean prices and values would attain a natural, market-driven, lower level.
The problem is that tens of millions of people purchased homes after making calculations about how much they could afford to spend on principal and interest. For many, that included consideration of how much their income taxes would be lowered because mortgage interest can be deducted from taxable income.
With current marginal tax rates, these people as a group would pay about $100 billion more per year if mortgage interest suddenly was not deductible. Removal of that implicit subsidy would affect future willingness to pay for houses.
Most economists would agree that house prices would drop. The argument is that an increase in effective after-tax interest rates lowers the value of a capital asset.
That is the basic theory. It also predicts that with rational home owners and buyers having good foresight, the effect of eliminating mortgage interest deductibility would be a one-time hit to housing values that would resemble a one-time tax on housing values.
Not everyone would be a net loser, however. People with taxable income would pay less because of the lowered rates that would accompany loss of the interest exclusion.
But those with low taxable incomes relative to housing values think senior citizens and young, lower-income working people who own a house would take a hit.
Just how big the housing price drop would be is an unanswered empirical question. Real estate and mortgage industry associations claim the economic sky would fall. Shlaes dismisses their wails.
Her argument seems to be that there is no better time than the present to introduce such a change because house prices already have taken a hit.
One might also note that in an era of historically low mortgage interest rates, the value of the tax break is substantially less than it was five years or more ago.
Note also that the cuts in marginal rates proposed at one time or another by candidates Mitt Romney and Paul Ryan would, in themselves, reduce the value of the mortgage exclusion. Dropping the top rate from 35 percent to 25 percent would reduce the tax-reduction of a dollar of mortgage interest by 10 cents.
There is a related issue if tax reform includes abolishing the exclusion of interest on municipal bonds from taxation. Contrary to popular opinion, this is not a special perk for rich investors. Because it is excluded from taxation, interest paid on municipal bonds is substantially lower than that on corporate and other taxable bonds. Over the long run, this special tax treatment is largely a federal subsidy to state and local government.
Abolish it, and the cost of borrowing by such governments would go up. Unless there was a loophole for interest from bonds already issued, existing bondholders would have to pay tax on interest they had planned on being tax free. And there would be no escape by selling the bonds, since prices of existing municipal bonds would drop. Again, much of the effect would be like a one-time tax on owners of an asset.
Grandfather in interest on existing bonds and you avoid that capital levy, but you also prolong the existing $50 billion per year cost to the Treasury.
Broadening the base strikes many as a fine idea in the abstract. But the details make it complicated in the real world.
Ed Lotterman teaches and writes in St. Paul, Minn. Write him at email@example.com.