The Flat Tax and Property Values

Sanjay Paul
February 1996

A version of this article appeared as in February 1996, Business Forum, Green Bay Press-Gazette.

The smell of taxes is in the air. The 1040's have arrived, and so have the W-2's and the 1099's and all the rest. It is time for that annual ritual - the filing of the tax return.

The entries have been made, the calculations done, the deductions taken. Many hours have been spent, but finally it's all over. You turn to your husband with a pleased smile and say, "Dear, we are getting a refund this year. Let's go out for dinner tonight." To which your husband, whose culinary offerings these past few days have tested your taste-buds sorely, promptly agrees.

This scene - or something like it - is repeated in millions of households every year. The ending is not always so pleasant - an unanticipated payment to the IRS instead of a tax refund can be a trifle annoying - but the completion of the filing itself is a source of great relief. And if Steve Forbes has his way, the job of filing one's return in the future should become easier. Much, much easier.

Mr. Forbes, the one-issue wonder, has amazed one and all by his spectacular ascent in the polls. A virtual unknown just a few months ago, Mr. Forbes has catapulted past Phil Gramm to become Bob Dole's leading rival in the race for the Republican nomination for President. He has managed to accomplish this on the basis of one simple idea: The 17 percent flat tax.

The idea of a flat tax has been around for some time. But it was not until Mr. Forbes started brandishing it like a weapon against all the ills plaguing the American economy that the public took notice. (And, oh yes, spending a few of his millions on television commercials to spread his message didn't hurt.)

People were struck by its remarkable simplicity - at one stroke, a flat tax would render obsolete the current tax code with all its complexity. Gone would be the numerous provisions, as would the loopholes for the well-heeled. The flat tax would also put paid to the myriad deductions, including the one cherished most by the middle class - the mortgage interest deduction. And it is this deduction that poses a great challenge to Forbes' flat tax plan. (Another is the issue of fairness - is it fair to tax the rich and middle class alike? - but that's another story.)

The proposed abolition of the mortgage interest deduction gives rise to a couple of questions. First, will it cause a middle-class family's taxes to rise? Second, will it cause the prices of homes to fall?

Whether a family will end up paying more, or less, in taxes depends to a large extent on the income level at which the tax goes into effect. The greater the tax-free amount, the smaller will be the tax bill. For example, if the first $30,000 of one's income is tax-free, an annual income of $50,000 will imply a federal tax bill of $3,400 for the year (assuming a flat tax of 17% on income in excess of $30,000.)

About the effect on home prices. Almost certainly, abolishing the interest deduction will lower home prices and decrease household wealth (a home is, after all, an important asset). Without the deduction, the cost of owning a home increases. This will dissuade some people from buying a home; the resulting drop in the demand for homes will cause their prices to decline. Little wonder, then, that the real-estate industry is vehemently opposed to the flat tax plan.

And what does Mr. Forbes have to say about this? Not surprisingly, he disagrees with the contention that his proposal will lead to an erosion in home prices. Mr. Forbes argues that his plan will cause interest rates to decline thereby reducing the cost of home ownership. Accordingly, home prices will not fall; in fact, they may even go up.

There are two parts to Mr. Forbes' argument. First, he expects interest rates to decline. Interest rates, especially long-term interest rates (which is what matters most for mortgage rates), are likely to fall if the government budget deficit is reduced. (Smaller deficits imply that the government is borrowing less; this decline in demand for loans will cause interest rates to fall.) The budget deficit will come down if the government reduces spending (details of which are still sketchy) or if tax revenues climb. With the introduction of a flat tax of 17 percent, what is likely is that tax revenues will fall, although Mr. Forbes claims, with a supply-side flourish, that the proposed tax cut will lead to greater economic growth, higher household incomes and, consequently, increased tax revenues.

Mr. Forbes is also quite optimistic about the extent of the interest-rate decline. At around 6 percent, long-term interest rates are already very low; it is unlikely they will fall significantly enough to offset the effects of the abolition of the interest deduction.

Thus, home-owners cannot expect much by way of interest-rate declines if the flat tax goes into effect. But there is a ray of hope for the beleaguered middle class. Tax cuts do promote faster economic growth, which results in higher incomes. That, plus the prospect of simpler filing, should provide some consolation for the drop in property values. Also, by then, your husband may have learnt some new dishes.

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