Pain Now, Gain Later
The case for dumping the popular home-mortgage tax-deduction.
By Amity Shlaes

(FORTUNE Magazine) – THESE DAYS AMERICANS seem to love their mortgage-interest tax deduction as much as the house that comes with it. So, let's get something straight right now: President Bush's tax panel probably won't get far with its new proposal to reduce the homeowners' beloved break. Voters would howl. Real estate brokers would howl louder. Congress, especially the Westchester County, N.Y., delegation, would just chicken out.

But that would be a shame. Because if you take a close look at the panel's reform proposals, which were buried earlier this month in most of the nation's newspapers, an intriguing picture emerges. Taken as a whole, the reforms--which include reducing the top tax rate to 30%, repealing the alternative minimum tax, and making health insurance deductible--would invigorate growth and provide more than enough breaks to offset a house deduction. And if you don't believe the members of the tax panel (or me, for that matter), consider what happened in one country that actually got rid of its real estate dole: Britain.

In the 1980s Britain had its own version of the mortgage deduction, known as MIRAS, or "mortgage interest relief at source." With the top income-tax rate at 60 percent (25 percentage points above ours today), the MIRAS break mattered a lot. Then in 1988 Nigel Lawson, Margaret Thatcher's Chancellor of the Exchequer, changed the rules. He pulled the top tax rate down to 40 percent and cut back on MIRAS. Property values dropped as much as 20 percent--for a while. The fact that interest rates were heading up at the time made the pain even worse. Yet Lawson's successors persevered, hacking away at what remained of the mortgage break throughout the next decade. And in 1999 Gordon Brown, the current Chancellor of the Exchequer, did away with MIRAS altogether.

By then this last outrage was scarcely noticed. Partly that's because there was little left of the relief, but it was also because housing prices were rising smartly. And they have continued to rise. The numbers from Nationwide, a building-trade group in Britain, show that home prices have tripled since the MIRAS experiment was launched in the late 1980s. The very day that Bush's tax panel suggested reducing the mortgage-interest deduction in the States, British papers carried the news that an unrenovated bungalow on Sandbanks, a holiday peninsula in Dorset, had sold for a record £2.75 million--about 100 times what such real estate fetched in the 1960s.

There are a slew of lessons for tax-break-loving Yanks in all this. First, some moments are better than others for doing away with deductions. The interest-rate hikes in Britain--some of which had more to do with the exchange rate than anything--probably made mortgage-break withdrawal more painful. Second, if you make changes gradually, they hurt everyone less. Finally, and this is the most im- portant lesson to consider, the entirety of the tax plan is what really matters. Britain's income-tax rate cuts were good for the economy. They helped rationalize an irrational system and convert Britain from an economic embarrassment to a relatively competitive country. That in turn fueled growth. Foreign nationals, many fleeing France's higher levies, have driven British house prices up, at least those in London. No wonder Philip Booth at the Institute for Economic Affairs in London argues that "there is little direct connection" between mortgage-tax breaks and house prices.

Now, it would be wrong to get rid of the mortgage-interest deduction--or transform it to a credit, as Bush's tax panel suggests--in a vacuum. And it makes a lot of sense to fear that Washington will never implement other tax reforms, even if it promises to do so. But if Washington really does lower other tax rates significantly and simplify the tax code, then trimming the house deduction will be no tragedy. Sorry, realtors.

■ AMITY SHLAES is author of a forthcoming history of the Great Depression and New Deal for HarperCollins. Her 1999 book, The Greedy Hand: Why Taxes Drive Americans Crazy, was a national bestseller.