Would the housing market crash if we eliminated the home mortgage interest tax credit?
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 — the reduction of demand that Shlaes sees as benign.
And it is what most economists would say. The argument draws directly on work that British economist David Ricardo, the father of both finance and trade theory, did 190 years ago — 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, nearly all the adjustment would be immediate. The effect of eliminating mortgage interest deductibility would be a one-time hit to housing values. Anyone owning a home at the time of the change, whether or not they have a mortgage and whether or not they pay income tax, would suddenly have less net worth in their house. The effect 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. Those with higher taxable incomes relative to the value of their homes might be better off.
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. Moreover, the economy would be more efficient if we did not have this tax subsidy distorting how people spend their money.
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. Since rates are currently low, and state and local governments are refinancing as much debt as they can, one might echo Shlaes argument that there is no time like the present.
However, unless there was a loophole for interest from bonds already issued, existing bondholders would get hammered. They 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, some of the effect would be like a one-time tax on owners of an asset.
Grandfather in existing bond interest and you avoid that capital levy, but you also prolong the existing $50 billion per year cost to the Treasury many years into the future.
“Broadening the base” strikes many as a fine idea in the abstract. But implementing the details make it very complicated in the real world.