If the flat tax is to gain the support of the public, its advocates will have to confront defenders of existing deductions head on. The most important deduction for most itemizing individuals is the mortgage-interest deduction. Many observers defend this deduction as encouraging home ownership; some argue that it is necessary for tax neutrality. Under the Armey flat tax, the deduction disappears.
Many groups believe they would be injured by the elimination of the mortgage-interest deduction. They argue, for example, that the loss of the deduction would raise the cost of home ownership, reduce the value of existing homes, and generally cripple the home building industry. In combination, the realtors, the home-builders, the mortgage lenders, and the construction-workers unions make a very powerful lobby, particularly when millions of homeowners are added to the mix.
The concerns of the mortgage-interest deduction lobby are generally misplaced. As noted above in the discussion on interest rates, the tax a saver must pay on interest income is recovered by demanding a higher interest rate. Since a flat tax does not tax individual interest income, pretax market interest rates will fall significantly, just as tax-exempt bonds now pay interest more than 2 percentage points below the rate paid to taxable bonds. Mortgage lenders, seeing their cost of funds fall, will be driven by competition to pass these savings along to mortgage borrowers in the form of lower mortgage rates.
In after-tax terms, the elimination of the home-mortgage deduction will neither raise nor lower the interest cost of home-mortgage borrowing. Therefore, that reform should have no affect on the demand for homes or on property values.
The benefit of lower mortgage rates does not extend to current mortgage holders unless they refinance their mortgages. Thus a legitimate problem is the treatment of mortgages underwritten prior to the enactment of a flat tax. Most of these borrowers assumed they would be able to deduct mortgage interest paid, thereby producing a lower after-tax interest rate and a lower tax burden. Since an estimated 27.4 million taxpayers will claim this deduction in 1995 to the tune of about $238 billion, a potentially huge bloc of voters stand ready to join the ranks of flat-tax opponents. While many or most may be able-to refinance, refinancing may be impractical for many current mortgage holders if, for example, they expect to sell the property in the following year or two.
A fair (and politically sensible) solution to the old mortgages problem might be to allow homeowners to deduct the interest on mortgages taken before the flat tax is enacted. While fairness demands grandfathering pre-existing mortgages, the consequence would be a slightly more complicated tax system and a short and medium-term erosion of the tax base, which would have to be offset with initially higher tax rates.
A loss in the battle over the mortgage interest deduction would not derail the essential effort to develop a flatter, simpler, more saver-friendly tax system. It would, however, require a much higher tax rate initially, and it would make it harder to repeal other popular deductions, like that for charitable contributions.