Housing - Finance ; Income tax ; Flat-rate income tax

Randall J. Pozdena

English

Research Papers in Economics

FRBSF
January 25, 1985 WEEKLY LETTER
The Flat Tax And Housing
The United States Treasury recently presented sug-
gestions for reforming the Federal individual and
corporate incometax systems. Its proposal, identi-
fied as a "modified flat tax," was the latest in a
numberofproposals genericallyrefered toas "flat
tax" systems. Manyofthese flat tax systems alter
thetaxtreatmentofhousingsignificantly. The pur-
pose ofthis Letter is to discuss briefly the rationale
behind a flattax system and the implications of
such a system forthe housing market.
In its mostgeneral sense, aflattaxsystem is simply
one that imposes a tax on income, profits, wages
or some other base at a rate that is independentof
that base. Thus, mostofthe sales, property and
excise taxes levied in the United States today are
flattaxes. A sales tax, forexample, applies a
flat rate to the volume ofretail sales. The present
flat tax reform movementapplies the flat rate
principleto the Federal income tax system in
which individual incometax rates rise progres-
sively with income.
Rationale
The rationale for replacing a progressive tax sys-
tem with a flattax system lies in the effects of
taxation in distortingeconomic behavior. Taxa-
tion ofwage income, forexample, is believed to
reduce labor supply and, hence, to depress na-
tional income. Undera progressive rate scheme,
the highest marginal tax rates - and, hence, the
greatest disincentives to additional work - are
imposedon thosewhoearn thehighestwage, who
usually are considered the most productive work-
ers. Thus, although a progressive tax rate system
may have desirable consequences forequity,
namely, by placing most ofthe tax burden on
those best able to pay, itmay have a more than
offsetting deleterious effect on the performance of
the economy.
The economist Edgar Browning, for example, has
demonstrated that when the tax burden is shifted
from the lowest incometaxpayers to the highest
incometaxpayers byprogressivetaxation, the loss
totheeconomyas awholefar exceeds thebenefits
to the low incometaxpayers. Converting a pro-
gressive rate system toaflatrate system generating
equivalenttax revenue, therefore, could be ex-
pected to increase national income. Economist
Jerry Hausman estimates thatconvertingour pres-
ent income tax system to a 20 percent flat tax
system would result in an 8 percent increase in
income because itwould encourage individuals
to work harder.
In a similarway, the progressive taxation of in-
come earned from invested savings is believed to
result in lower aggregate saving and, hence, less
rapid accumulation ofproductive capital in the
economy. Households in the top 1percentof t.~e
income distribution are responsible for approxi-
mately 25 percentofall saving thatoccurs in the
U.S. economy. Although ithas proved difficultto
documentempiricallytheeffectofeconomiccon-
ditionson saving behavior, aflat rate tax system
can be expected to reduce the tendency to substi-
tute consumption for saving. Economists Auer-
bach, Kotlikoff, and Skinner estimate thata flat
rate income tax generating the same total revenue
would increase national wealth 6 percentmore
than a progressive system.
Marginal vs. average rates
Critics believe that the present Federal income
tax system is flawed notonly because ofthe
progressivityofthe current rate structurebutalso
because ofthe level oftax rates. In an attemptto
correct the disincentive effects ofhigh marginal
tax rates on productive economic activity, a tre-
mendously complex system ofdeductions and
exemptions has been employed. The result is a
system with a very high marginal tax rate (esti-
mated by economist Robert Barro to average
about33 percent) and awasteful useofresources
to avoid paying taxes.
Because ofsuch considerations, most current
"flattax" proposals call notonly for "flattening"
the rate schedule but also for reducing the aver-
age marginal tax rate applied to taxable income.
However, for the reform to generate the same
amountof revenues in total, allowable deduc-
tions and exemptions must be reduced orelim-
inated. Although the various tax reform pro-
posals differ significantly in theirdetaiIs, there
are four major changes in deductionsorexemp-FRBSF
tions that conceivably mighthave an effecton
the housing market.
Mortgageinterestdeduction
First, virtuallyall ofthe major"flattax" proposals
impose some limitationson the deductibilityof
mortgage interest. TheTreasuryplan,forexample,
disallows deductions ofmortgage interest on sec-
ond homes. The Bradley-Gebhardt "FAIR" plan
implicitly reduces mortgage interestdeductibility
as taxpayer income rises. And the DeConcini
"FLAT" plan eliminates mortgage interest deduc-
tibility altogether. All of the major tax reform
proposals continueto allow mortgage interest on
rental property to be deductible. By itself, limiting
the deductibility of mortgage interest on owner-
occupied residences would encourage the use of
equity financing (also known as "self-financing")
in home purchases and renting rather than home-
ownership. The overall effectwould be to reduce
the demand for housing capital and to depress the
priceofhousing. It is notclear howbigthe effect
on housingprices wouldbe, however. Manywest-
ern economies, includingAustralia and Canada,
limitordisallowthe deduction ofmortgage inter-
est, yetthe relationship between their housing
costs and income is similarto thatobserved in the
United States.
Propertytaxes
A second feature ofmany "flattax" reform pro-
posals thatwould influence the housing market is
theeliminationorrestriction ofthedeductibilityof
propertytaxes against income. The property tax is
a componentofthe costofconsuming housing
services. Limiting the deductibility of property
taxes, therefore, will increasethe implicitafter-tax
costofobtaining housing services. This, too,
wouIdtendtodepressthedemandforand, hence,
the priceofhousing.
This price effectwill be smaller in states such as
California that rely moreon tax revenues from
incomeor retail sales rather than property to
support public services. Ifthe deductibilityof
propertytaxes wereeliminated by law, onecouId
expect a further shiftingofthe tax burden for
financing public services awayfrom property to
other bases. This shiftwould, in turn, ameliorate
the depressing effectofthis aspect oftax reform
on housing prices.
Decelerateddepreciation
A third, specific, feature ofmanyflattax reform
proposals relevantforhousing istheeliminationof
accelerated deductionsfor depreciation ofcapital
assets. The Treasury proposal, for example, re-
commends lengtheningthe depreciable lifeof
capital assets such as rental housing. Fortheexist-
ing stock ofhousingto be heldvoluntarilyby
investors after such achange, the priceofhousing
must fall. In addition, the change would give rise
to agreater desire for owner-occupancy.
Marginal tax ratesand capital gainstreatment
Finally, the changes in marginal tax rates could
themselves disturb housing markets. Finance
theory provides a guide to the potential effects. It
stresses thatthe demand forcapital - suchas
housing-depends upon the "usercost" ofthat
capital. The user cost ofhousing capital can be
approximately represented bythe foregone inter-
est earnings on equity in the house (that is, fore-
gone from an alternative investmentofthe same
funds) plus the costofdebtservice minus any
anticipated capital gains - all on an after-tax
basis. Even when mortgage interestremains
deductible, the reduction in marginal tax rates
increases the after-tax return on non-housing in-
vestments and thereby the opportunity costof
equity in housing. It also increases the after-tax
cost ofdebtservice, everything else beingequal.
In addition, mostofthe tax reform proposals
reduce oreliminate the current preferential treat-
mentofcapital gains. The consequent red!Jction
in after-tax capital gains also increases the user
costofhousingcapital as definedabove. Thus, the
reduction in marginal tax rates and the changes in
the preferential treatmentofcapital gains tend to
increase the user cost ofcapital and thereby re-
ducethe demand for housing capital.
The current Treasury proposal adds some other
considerations to this analysis. By indexingboth
interest income and capital gains receipts to the
inflation rate, itwould tax onlythe real (and not
nominal) incomefrom these two sources. More-
over, itretains a $125,000capital gainsexclusion
on private residences that, in effect, continues
the current, favored capital gains treatment of
owner-occupied housing. Nevertheless, in an
environmentoflow inflation, the Treasury's pro-posed change in capital gains treatmentwould
still increase the user costofcapital to investors
on the margin.
Overall effects
It should be apparentfrom this discussion that a
careful inventoryofthe myriad features oftax
reform proposals is needed to determine theiref-
fect on housing. Eliminatingthe mortgage deduc-
tion, forexample, would introduce a bias toward
rental housing, buteliminatingaccelerated depre-
ciation would encourage owner-occupancy.
Similarly, although a.1I ofthe reform features
discussed above would, bythemselves have a
tendencytodepress housing prices, the compara-
tive treatmentofhousingversus otherassets could
have an offsetting effect. The Treasury has stated,
for example, that its reform proposal represents a
shiftofthe Federal tax burden awayfrom house-
holdstocorporations. Ifthiswere indeed thecase,
the proposal may make owning housing more
attractive than owning corporate equity. This
wouId tend to offset, at least partially, the down-
ward pressure on housing prices exerted bythe
features discussed above.
In addition, one mustdistinguish between the
short-term and long-term effects ofsuch reform
proposals. Ifthe economy is, in fact, responsive to
reductions in marginal tax rates in the directions
assumed bythe architects ofthese plans, interest
rates would fall and national income would rise.
Both ofthese effects would tend to increase the
demand for housing and further offsetthe effects
caused by less favorable tax treatmentofhousing
alone.
It is also importantto pointoutthat none ofthe
majortax reform proposals eliminates a majortax
feature that favors housing in general(and owner-
occupancy in particular) overothercapital-the
failure ofthe tax system to tax "imputed income"
enjoyed byowner-occupantsofhousing. An own-
erofa homeenjoys a continuous flowofservices,
such as shelter, security, and various aesthetic
amenities. These services have value in the mar-
ketplace and thus represent income to the house-
hold. However, becausethis income is received in
the form ofservices that are consumed directly by
the household, it escapes taxation as income.
Regardless oftheuItimate direction oftax reform,
therefore, housingwill retain mostofits favored
treatment in oureconomy.
RandallJ.Pozdena
Opinionsexpressed in this newsletterdo not necessarily reflect theviews ofthe managementofthe Federal Reserve Bank of San
Francisco, orofthe BoardofGovernorsofthe Federal Reserve System.
Editorialcommentsmaybe addressedtotheeditor(GregoryTong) ortotheauthor....FreecopiesofFederal Reservepublications
can beobtainedfrom the Public Information Department, Federal Reserve Bankof San Francisco, P.O. Box 7702, San Francisco
94120. Phone(415) 974-2246.BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
'J!!!!::> 'o:>sPU!!J:I U!!S
l:SL 'ONIIWlHd
mVd :l9VISOd's'n
llVWssvnISBI:I
OUBOS:lBd
SelectedAssets and Liabilities
Large Commercial Banks
Amount
Outstanding
01/09/85
Change
from
01/02/85
uo~6U!Ljsom Ljo~n u06l:lJO 0POAl:lU
oLjoPI !!omoH O!UJoJUO) ouozPtJ 0l1soltJ
O)SI)UOJ:::I UOS
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Change from 01/11/84
Dollar Percent!
Loans, Leases and Investments1 2 188,371 -1,186 13,449 7.7
Loans and Leases1 6 170,043 -1,178 15,743 10.2
Commercial and Industrial 52,364 - 724 6,189 13.4
Real estate 61,841 - 133 2,599 4.4
Loans to Individuals 32,363 104 5,649 21.1
Leases 5,282 69 227 4.5
U.S. Treasury and Agency Securities2 11,183 - 10 - 1,331 - 10.6
Other Securities2 7,145 3 - 961 - 11.8
Total Deposits 195,073 -5,372 8,192 4.4
Demand Deposits 45,141 -5,871 - 27 - 0.1
Demand Deposits Adjuste<j3 30,925 -2,252 - 465 - 1.5
OtherTransaction Balances4 13,275 - 41 853 6.9
Total Non-Transaction Balances6 136,657 541 7,367 5.7
Money Market Deposit
Accounts-Total 45,593 542 2,825 6.6
Time Deposits in Amounts of
$100,000or more 40,487 134 2,153 5.6
Other Liabilities for Borrowed MoneyS 21,090 - 504 2,600 14.1
Two WeekAverages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Netfree reserves (+)/Net borrowed(-)
Period ended
12/31/84
75
30
45
Period ended
12/17/84
40
44
3
1 Includes loss reserves, unearned income,excludes interbank loans
2 Excludes trading account securities
3 Excludes U.S. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
5 Includes borrowingvia FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percent change

The flat tax and housing

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The flat tax and housing

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