A Tax Code Fix That's in Our Interest

John H. Makin is director of fiscal-policy studies at the American Enterprise Institute in Washington.

During testimony before the main tax-writing committee of Congress, I asked a committee member if an American family with above-average income and a $100,000 mortgage would be willing to pay up to $20 a month more on that mortgage in exchange for a $60-billion cut in our annual budget deficit, a higher national saving rate and a lower trade deficit?

The answer was "no." If that congressman was right, and the pathetic charade being played out this year on budget negotiations suggests that most of his congressional colleagues agree with him, then Americans had better be prepared to stop complaining about budget deficits and heavy borrowing from foreigners.

I think that the congressman was wrong. He made the typical mistake of believing that a correction of our tax code's distorted treatment of interest income and expenses--so that saving is not discouraged and overborrowing is not encouraged--would discourage home ownership. It would not.

A proposal to correct the tax treatment of interest is nothing new. The Treasury's tax reform plan of November, 1984, included such a plan.

But it was unnecessarily complex. A much simpler approach, call it "half-interest," would be to tax only half of interest income and allow deduction of only half of all interest expenses. Half-interest would help to correct the overborrowing/undersaving bias in the tax code. The correction is simple to apply, requiring only the insertion of "one-half" into a few lines of the tax code.

Half-interest would raise the private saving rate, especially the currently low personal saving done by individuals. Individuals would get to keep more of the interest earned on every dollar of saving and so would save more. This incentive is superior to the individual retirement account plan that induced more savers simply to move already accumulated savings into IRAs. They saved on taxes but didn't increase overall saving. Half-interest would reward every addition to saving with more interest after taxes.

It would also discourage overborrowing. At current rates, borrowing for everything from leveraged buyouts to the speculative purchase of real estate would be discouraged if only half of the interest- expense deduction could be taken. The $2- billion-plus annual interest bill on the approximately $20 billion of junk bond financing for the NJR Nabisco leveraged buyout currently is reduced by about $680 million a year, thanks to full interest deductibility and a 34% corporate tax rate. Under half-interest, it would be reduced by $340 million while taxes paid to the Treasury would rise by $340 million.

For average borrowers, the after-tax cost of borrowing would be little affected by half-interest because more saving and less borrowing would mean lower interest rates. With savers and borrowers agreed on an after-tax real interest rate of 2%, a 12% pretax market rate under current tax law would drop to 9.6%. Pretax, monthly interest expense on a $100,000 mortgage would fall by $177 while after-tax mortgage interest, with half instead of all mortgage expense deductible, would rise by $20.

America's trade deficit and foreign borrowing requirement would be cut by the half-interest proposal. About two-thirds of the $135 billion in foreign borrowing in 1988 resulted from an abnormally low personal saving rate and about one-third resulted from our budget deficit, which was about $45 billion above its usual level of 2% of gross national product. If the personal saving rate were raised from its current level of just above 4% to 6.5%, the external borrowing requirement of the United States would fall by $90 billion. We would be on the road away from our current "global debtor" status.

Half-interest would cut the budget deficit in two ways, thereby reducing even further our need to borrow from abroad. The revenue loss from not taxing half of interest income would be less than the revenue gained from eliminating half of interest deductions. This follows from the fact that much of interest earning now accrues to pension funds that are already tax-exempt while, as any follower of leveraged buyouts or high-priced real estate knows, the interest expense deduction is heavily used. Capping the interest deduction at just half its current level would gain billions more in revenue than would be lost by taxing only half of interest income.

The second revenue gain would come from the lower interest rates that the proposal would induce and the resulting interest saving on the national debt. The Congressional Budget Office estimates that a drop in interest rates by two percentage points would produce a saving on interest outlays of $150 billion over five years. This saving, coupled with the net revenue gain from half-interest, could produce $60 billion in annual deficit reduction.

Policy-makers and taxpayers who say they want a higher national saving rate and a lower budget deficit should give serious consideration to the half-interest proposal. Alternatively, if they want more federal spending, higher interest rates and less affordable housing for average Americans, they should recommend raising taxes. Congress will be happy to oblige.

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