Effects of Flat Taxes and Other Proposals
on Housing: An Overview

Jane G. Gravelle
Senior Specialist in Economic Policy

June 17, 1996

96-552

SUMMARY

Several proposals for major revision of the Federal income tax system have been discussed in the 104th Congress. Perhaps the most prominent proposal is the flat tax. Most of these new taxes would convert the tax base from income to consumption, most would eliminate deductions for mortgage interest and property taxes, and most would flatten the rate structure--in some cases by adopting a single tax rate. Under current law, owner-occupied housing is favorably treated relative to other investments. Studies have estimated that some of these revisions would cause a decline in demand for houses and significant reduction in house prices--perhaps in excess of 15 percent. These studies, however, presumed a fixed supply of housing; even a limited supply response would greatly decrease predicted asset price effects. Supply response is likely to be large in the long run and not insignificant in the short run. Effects on housing demand might also be mitigated by increases in savings rates and lower interest rates. Thus, effects of the flat tax on housing prices are likely to be limited in the short run and very small in the long run. Rental housing demand, on the other hand, would be encouraged with a shift to a consumption tax base.

A BRIEF DESCRIPTION OF THE PROPOSALS

Several major Federal tax reform proposals, including proposals to replace the current income tax with a new type of tax, have been discussed in the 104th Congress.[1] Perhaps the most widely discussed proposal is the flat tax introduced by Representative Armey and Senator Shelby.

Most proposals would convert the tax base from an income to a consumption base and most would flatten the rate structure--in some cases by adopting a single tax rate. These proposals would generally eliminate deductions and credits, including those for mortgage interest and property taxes, a treatment consistent with the treatment of business interest, which is neither deducted nor taxed under these consumption tax proposals.

The current proposals fall into five categories: the retail sales tax, the value-added tax (VAT), the flat tax, the USA tax, and income tax reforms. The first four proposals have a consumption base, and the first three are levied at a flat rate, although the flat tax proposal, by taxing wages at the individual rather than the firm level, allows an exemption. The USA tax includes both a VAT and a direct consumption tax on individuals with graduated rates. The USA tax and the Gephardt income tax reform retain deductions for mortgage interest (but not property taxes).

PREVIOUS STUDIES OF EFFECTS ON HOUSING

Some studies have suggested a significant reduction in the price of owner-occupied houses would occur if these proposals were adopted.

The issue of housing prices was highlighted by a study by DRI/McGraw-Hill (hereafter the DRI study). The DRI study estimated that eliminating mortgage interest and property tax deductions would be equivalent to losing 15 percent of current housing asset value. The study also estimated an overall fall in housing prices with the enactment of a flat tax in the neighborhood of 15 percent, most of which would occur immediately.[2] These results are dependent on interest rate changes; without a fall in interest rates, the price reductions are estimated at 34 percent. A subsequent study by the same organization indicted that the drop in house prices would triple mortgage losses and double foreclosure rates.[3] In addition, a preliminary paper by Green, Hendershott, and Capozza that examines the effects of various tax revisions estimates that there would be: (1) substantial effects of the flat tax on housing prices in metropolitan areas; (2) more modest, but still significant, effects from a disallowance of mortgage interest and property tax deductions; and (3) virtually no effects from another proposal, the USA tax.[4] These effects vary from one locale to another, but are very large in magnitude.

EFFECTS OF THE FLAT TAX ON HOUSE PRICES

There are two different types of effects on assets of switching to a consumption tax base. The first arises because a consumption tax allows a deduction for purchases of assets, but imposes a tax on the sale of assets. For this reason, a consumption tax is characterized as a tax on wages plus a lump-sum tax on old capital. Firms pay taxes on the sale of assets directly, and in the case of incorporated businesses this lump-sum tax on old assets is reflected in stock market prices, which fall. Owner-occupied housing is exempt from this tax on old assets under the flat tax--indeed it is the only asset that is exempt. From this viewpoint, owner-occupied housing seems the asset that merits less concern with respect to price. Indeed, current owners could actually gain under some types of tax revision.

A fall in owner-occupied house prices arises from a different effect. For new business investments, the deduction of cost when sold effectively eliminates the tax on the return to new investment, even though earnings from the investment, including its sales proceeds, are taxed when consumed. The elimination of taxes on the return to new investment causes investment to flow out of the currently tax favored owner-occupied housing sector (where returns are already effectively tax-exempt, because the implicit rent from owning a house is not taxed) into the business sector; this shift in demand can cause owner occupied housing prices to fall. It is this effect on owner-occupied housing prices, which may be largely transitory, that is the focus of the recent studies on asset prices.

The increase in return on competing investment, and not the restriction in itemized deductions, is the main source of shifting asset preferences from housing to business investment. Actually, by eliminating the distortion in choice due to the tax system, economic efficiency and welfare should be improved. Economists would normally regard this reallocation of resources as a long-run benefit rather than a cost of tax reform; the cost is in any undesirable distributional effects that cannot be offset with other policies.

The dampening of investment in owner-occupied housing may be offset by a fall in pre-tax returns, and interest rates. Some fall in interest rates would be expected even in the absence of savings increases, because of the current tax subsidy for debt finance at the firm level. Additional reductions in rate of return will occur if savings increases, an outcome that is generally predicted by economic theory but whose magnitude is difficult to estimate. Several other factors could also moderate the effects on the cost, or on the shift in demand due to the change in cost. The increased cost of mortgages to cash-constrained first-time home-buyers should be largely offset by the automatic decline in the interest rate that would occur even without an increase in savings.

Ignoring these factors, and assuming no increase in savings, the price of housing is estimated to fall by 22 percent as a result of the flat tax if the supply of housing were fixed.[5] A third of the effect is due to the loss of itemized deductions for mortgage interest and property taxes; the remainder is due to higher returns available elsewhere on equity that would be invested in the home. The reduction could be considerably less if savings increases--a one percentage point decline in rate of return would reduce the effect by more than fifty percent. In general, these effects are smaller than those estimated by DRI for a given savings rate assumption. Larger properties would have larger price declines than smaller ones, in part because the current tax benefits are larger for the higher income individuals who purchase these properties.

These price changes are the upper limit of expected effects (given the estimates of increased costs) because they assume a fixed supply. Even a limited amount of response in supply could strongly affect the price change. In the long run there are reasons to believe that supply response is such that there would be virtually no price change--the price of housing largely reflects its cost of construction. Nor are prices in urban areas likely to be affected much in the long run since urban land prices are influenced by the availability of substitutes outside the cities, and because urban land has alternative uses.

While there is more possibility of asset prices being affected in the short run, there are reasons, even in this case, to expect many factors to smooth and constrain the adjustment process. New construction could be altered, and individuals may defer selling plans until the market adjusts. Even a modest supply response (e.g. a one-half percent decline in supply on the market for a one percent decline in price) would cut any price reduction in half.

Historical evidence does not support the expectation of large price changes. Figure 1 juxtaposes historical changes in housing prices from 1971 to 1989 with the estimated price reductions from fixed supply assumptions for both DRI and CRS estimates with and without interest rate reductions due to savings response (an A suffix indicates no savings response; otherwise, returns are assumed to fall by one percentage point). The historical period spans a period in the early 1980s when there was a significant reduction in the favorable treatment of housing and an increase in interest rates, factors that should have depressed housing demand.[6]

Figure 1: Percentage Change in Housing Price:
Historical vs. Effects of Flat Tax Calculated with a Fixed Supply Curve

Figure 1: Percentage Change in Housing Price:
Historical vs. Effects of Flat Tax Calculated with a Fixed Supply Curve

While short run impacts on housing are less predictable than long run effects, both theory and empirical evidence support some supply response. There are other factors as well, including the possibility of increased savings rates, that could mitigate any contraction in demand, and moderate the effects on house prices.

Rental housing should become more attractive under the flat tax, although the effects appear to be modest. Current owners of rental housing would, however, have to pay a tax on sale, even though they can deduct acquisitions; hence, rental housing is subject to the lump-sum tax on old capital.

OTHER TAX PROPOSALS

In the case of a VAT or retail sales tax, the effects will depend on how housing in treated. New owner-occupied housing can be included in the base (the normal presumption); it can be excluded from the base; or both new and existing housing can be included. Assuming that only new houses will be included in the tax base, the effects would be similar to the flat tax, with one caveat. Since VAT and sales taxes are likely to require a price accommodation, current home-owners may actually receive a windfall from the lump-sum tax on old assets, since the increased construction cost will cause their prices of housing to rise, while the value of outstanding debt will be fixed. This permanent effect will cause their equity values to rise by more that the tax rate. If however, new housing is excluded, this price effect will not occur and owners of homes will experience an effective burden on their equity asset because other consumption goods will rise in cost. Owner-occupied housing will, however, retain its preferred status and there will be a much more limited effect on asset prices due to the shift of investment out of housing and into business use. Finally, both new and existing housing could be included. In this case, there is both a lump-sum tax on housing (although housing prices will rise, the increased price will be needed to pay the tax and the sales proceeds will still purchase fewer consumer goods) and a depressed demand for owner-occupied housing.

The effects on rental housing demand would be similar to the effects of the flat tax (assuming new housing sold to owner-occupants is taxed), except that the price accommodation will mitigate the burden of the lump-sum tax on owners of rental housing. As a result, owners of rental housing would be better off under these taxes, other things equal.

The USA tax has effects similar in many ways to the flat tax, although the ability to deduct mortgage interest will modify any effects by retaining part of the preferential treatment of owner-occupied housing. Most income tax reforms would be likely to have much more modest effects on owner-occupied housing.

CONCLUSION

The likely outcome of these tax changes would be to contract the amount spent on housing, and cause some individuals to make different tenancy choices. Economists would typically view this shift as a benefit of tax reform, because the current tax system encourages an inefficient overinvestment of funds in housing and consequent underinvestment in business assets. Such a shift would, however, constitute a change of tax policy which has long favored home-ownership. In the process of making this shift, there would be a contraction of demand for housing which could depress asset prices. This effect on asset prices is largely transitory and there are reasons, both from theory and the historical record, to expect that such effects would be small.

[Return]¹ See Flat Tax Proposals: An Overview. Congressional Research Service Issue Brief IB95060, by James M. Bickley for more detail on the features of these tax proposals.

[Return]² DRI/McGraw-Hill, Residential Real Estate Impacts of Flat Tax Legislation. Summary Prepared for the National Association of Realtors, May 1995. Principal Investigators: Roger E. Brinner, David Wyss, and Mark Lasky.

[Return]³ DRI/McGraw-Hill. The Impact of the Flat Tax on Mortgage Foreclosures and Losses. Summary Prepared for the National Association of Realtors, January 1996. Principal Investigators: David Wyss and Cynthia Latta.

[Return]⁴ Richard K. Green, Patric H. Hendershott, and Dennis R. Capozza, Taxes, Mortgage Borrowing, and House Prices, Preliminary Draft prepared for Brookings Conference on the Economic Effects of Fundamental Tax Reform, January 18, 1996.

[Return]⁵ The estimates reported in this paper are taken from Jane G. Gravelle, The Flat Tax and Other Proposals: Effects on Housing, April 29, 1996. CRS Report 96-379 E, April 29, 1996, which analyzes this issue in much greater detail.

[Return]⁶ This series is taken from James M. Poterba, Taxation and Housing Markets: Preliminary Evidence. In Do Taxes Matter? Ed. Joel Slemrod, Cambridge, MA, MIT Press, 1990.