Free Liberal

Coordinating towards higher values

Tax Reform Panel Says: Cut Mortgage Tax Deduction

by Fred Foldvary

The Presidentís Advisory Panel on Tax Reform, which I wrote of previously, has issued its recommendations to reform federal personal income tax. The full report is scheduled to be delivered to the U.S. Treasury Department by November 1.

The Panel proposes to reduce the mortgage interest deduction to the loan limit of the Federal Housing Administration, which in high-priced states such as California would be $312,895. The reduction of the deduction would be offset by a 15 percent tax credit on mortgage interest payments up to the FHA loan limit.

The real estate lobby is already screaming. Representatives from California and other real-estate bubble states are voicing opposition, saying that their states would bear most of the shifted burden. Brokers and others in the real estate industry say this would hurt their business.

What those in the real estate pressure group are not saying is that the tax breaks for real estate, such as the deduction for mortgage interest and property taxes, is what drove real estate prices up in the first place. To the extent they are beneficial, governmentís goods and services such as highways, streets, parks, schooling, security, welfare aid, and farm subsidies, all drive up rentals and the price of land, since these are paid for mostly from taxes on wages.

The big landowners are now screaming because government will reduce their subsidy. To be fair, there is a bit of a problem when someone has recently bought a house for $1 million, expecting her $912,895 mortgage to be tax deductible. Suppose her mortgage rate was six percent. On the $600,000 mortgage that now would not be tax deductible, the mortgage payment is $36,000 per year. If half her extra income were taxed by federal and state taxes, the deduction reduces her taxes by $18,000.

To see the effect on land value of this $18,000 subsidy, relative to other taxpayers, we need to get the real interest rate. Suppose inflation is two percent. The real, after-inflation, interest rate is then four percent. Now divide $18,000 by .04; we get $450,000. A tax-free bond that paid $18,000 per year would have a market value of $450,000. The same applies to land!

We can see how the mortgage deduction is in effect a much lower mortgage payment, which relative to other assets makes real estate much more profitable. So buyers will bid up the price of real estate until its return is similar to that of bonds and stocks.

Now letís see how the extra tax burden would be offset. At six percent, the mortgage payment on $312,895 is $18,774, and the 15 percent tax credit is $2816. At a 50% tax rate, that is like a deduction of double that, or $5632. So overall, she would pay higher taxes.

Also, the panelís proposal would eliminate the deduction for state taxes. Suppose she pays a state income tax of 10% of her income of $200,000 and she is in a 35% federal tax bracket. Not being able to deduct the $20,000 state tax would increase her federal tax by $7,000. Ouch!

In my judgment, the tax deduction for state income taxes should be kept, while the deduction for real estate taxes and mortgages should be eliminated. The elimination of deductions for real estate would reduce the distortion of prices that has fueled the real estate bubble, while the deduction for state taxes includes taxes on wages, and the effect of higher taxes on wages is to distort the labor market. The difference is that civic services get capitalized into higher land prices but not higher wages.

Overall, the proposed reform is revenue-neutral. So whatís the point of this tax reform? The purpose is simplify the income tax and also to base future economic decisions more on real economic prices and less on distorted, skewed, twisted after-tax phony prices. And why is the real estate lobby screaming? Because folks that buy high-priced real estate would pay higher taxes, and that would reduce real estate prices, which reduces the commissions obtained by real estate brokers. But people should not be paying so much for real estate in the first place. They are only doing so because of the tax breaks and expected price appreciation!

The panelís proposals would also greatly simplify the tax code by abolishing the Alternative Minimum Tax (AMT), a second method of calculating taxes which eliminates a lot of the tax deductions of the primary tax code. It was intended to more highly tax the rich, but since the numbers are not indexed for inflation, ever more middle-income taxpayers are hit by it, which not only increases their income tax, but makes the tax calculation much more complicated. The AMT should indeed be abolished.

The panelsí proposals would move the current US personal income tax closer to a flat-rate tax, with fewer brackets and fewer tax deductions. The best policy would be to eliminate the income tax on all income other than land rent. Alternatively, the US government could scrap all federal taxes and instead require each state to pay a proportional share of the federal budget. But, given the political realities, the tax panels are an improvement, and should be adopted. If the real estate lobby is screaming, it is because their overpriced commissions would be reduced. Poor babies! When the real estate lobby screams, this tells us that the proposal is a good one!

This article first appeared in the Progress Report, Reprinted with permission.

Dr. Fred Foldvary teaches economics at Santa Clara University and is the author of several books: The Soul of Liberty, Public Goods and Private Communities, and the Dictionary of Free-Market Economics.