President George W. Bush's tax advisory panel released its final report last week. The panel recommended sweeping changes in the tax treatment of mortgage interest.

Would these changes lead to a collapse in housing prices, as some have speculated?

Let's take a look. Under current law, housing enjoys a uniquely preferred tax status. For tax purposes, filers are able to deduct from their income the interest paid on mortgages as high as $1.1 million for first and second homes. Homeowners also can deduct interest on home equity loans up to $100,000.

Unfortunately, much of America doesn't enjoy the generous subsidies these provisions offer. According to the report, more than 70 percent of filers didn't benefit from the mortgage deduction in 2002.

This is largely because it can be claimed only by itemizers, who constitute just 35 percent of the nation's taxpayers. Of those who do use the deduction, high-income households receive disproportionately large benefits.

Poor Rationale

Economists agree that this tax preference distorts the allocation of capital toward housing in a way that hurts the economy. In addition, the evidence suggests that the mortgage interest deduction does little to increase home ownership, because those wealthy enough to take the deduction are going to own a home anyway. The deduction does, however, encourage the wealthy to have larger homes.

Given the poor rationale for this tax break, it's not surprising the panel decided to undo it. Under both of the proposals submitted, mortgage interest wouldn't be a deduction at all.

Instead, the panel recommended, filers with mortgage interest would receive a 15 percent tax credit on their mortgage debt, subject to a limit based on the average home price in their area. Interest on mortgages for second homes and home equity loans wouldn't be eligible for the credit.

These changes would significantly reduce the cost of housing for the majority of Americans, since most taxpayers don't receive any mortgage deduction benefits. Some of those already benefiting from the deduction would see no change in their housing costs.

Influencing Decisions

For others, the proposal probably would increase the cost of housing, either by lowering the mortgage limit, or by reducing the benefit by the difference between a person's tax rate and the 15 percent credit rate.

How would these changes affect housing prices? There is ample evidence that taxes and interest rates influence home- buying decisions. Accordingly, one can say with confidence that a large segment of the population would seek to buy a first or larger home, while a smaller but richer segment would be willing to spend a smaller share of its income on housing.

At the low end of the market, the net impact would be to increase demand and prices. This higher demand should stimulate construction, especially for starter homers.

At the high end, there would be two effects. First, the increase in the cost of buying a new home would drive down demand and depress prices.

Ripple Effect

This effect could, in principle, be very large indeed. Economic studies suggest that the tax benefit of the mortgage interest deduction is partly capitalized into the value of home. My own estimates suggest that wholesale repeal of the deduction could reduce home prices by as much as 16 percent.

The adoption of the panel's recommendations would reduce prices by less than that for most properties. For a typical high-end home that has its tax benefit cut in half, my calculations suggest the price might decline about 8 percent.

A second ``ripple'' effect would work to offset this, however. When lower-income individuals buy a new home for the first time, they will often displace a slightly higher-income individual looking to trade up. That person in turn will use the extra profits from the sale of his starter home to buy a nicer house. The next person in the chain will sell the house, and may well trade up also.

This ripple effect has been found to be significant. A path-breaking paper written in 1988 by economists N. Gregory Mankiw of Harvard University and David N. Weil of Brown University found that a major reason for the rise in housing prices in the 1970s was the influx of first-time buyers as the baby boomers matured.

Net Effect

This paper clearly had a big impact on how the panel devised the housing tax changes. (I chuckled when I saw that the authors thanked James Poterba, now a member of the panel, for helpful comments.)

It's unlikely that the ripple effect will fully offset the impact on the price of high-end homes. However, the structure chosen by the panel ingeniously reduces the tax code's distortion in favor of housing investments in a way that avoids exposing the market to a calamitous price decline.

These proposed changes would increase the price of less expensive homes, and reduce the price of expensive ones, at least slightly. The net effect on the average home could be positive or negative, but should be small.

When would we see these effects? If market participants start to expect these tax changes, prices might begin moving immediately.

Kevin A. Hassett is a resident scholar and director of economic policy studies at AEI.