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A simple one

August 5th, 2003

Among the questions raised on the Monday message board is one where the answer is, in the words of Ronald Reagan, simple but not easy. The correct way to deal with stamp duty on house purchases is to scrap and replace revenue by scrapping the land-tax exemption for owner-occupied housing.

The current system discriminates in favor of existing home-owners against homebuyers. But since the interests of existing home-owners represent the most sacred of Australian sacred cows, I can’t see this changing.

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  1. August 5th, 2003 at 10:40 | #1

    Pr Q advocates the simple but not easy:

    scrapping the land-tax exemption Owner-Occupied Housing [O-OH]

    Surely Pr Q means scrapping the Capital Gains Tax exemption on O-OH?
    And if the CGT exemption is scrapped, wouldn’t you have to introduce Interest Rate Tax-deductability on O-OH mortgages?
    That would be a big cost to revenue, perhaps exceeding the gain in CGT.
    OTOH, by scrapping CGT liability/introducing IRT deductibility would treat the residential home as a financial security rather than a personal utility, the state would introduce transparency & accountability into the investment system. This would be the final stage in the complete rationalisation of everyday life.
    In general, Australains over-invest in property and under-invest in equity, which is why people like visiting and living in Aust homes more than investing in Aust firms.
    (empirirical evidence please?)

  2. August 5th, 2003 at 13:01 | #2

    Supposing that JQ meant what he said and not what Jack Strocchi thinks he might have, I’d raise two of the standard objections I often raise when confronted with fanatical single (land) taxers:-

    - What transitional measures would you have to mitigate the inequity for someone caught under both systems? That is, if someone pays large stamp duty to get a property on day -1 and then on day +1 has to start paying unanticipated land tax, this is effective double dipping. (Conversely, with aggregate revenue remaining unchanged, there must be some winners who end up with no tax incidence.)

    - While typical business owner/operators have an associated revenue stream, mere owner occupiers might be forced to refinance to pay an unanticipated land tax. That is, apart from those still in the work force, there are often retired people who would be forced into new financing measures. Apart from the inequity of this, what about the transaction costs? Wouldn’t those both add to the effective incidence on this group, and possibly even reduce the revenue to the extent that some might be forced out and unable to pay anyway (blood/stone, etc.)?

    I do know that at least in theory there are workarounds, I was just wondering which ones JQ had in mind and what hidden costs those might impose.

  3. John Quiggin
    August 5th, 2003 at 15:54 | #3

    It would be reasonable to give recent purchasers who had paid stamp duty a once-off holiday of, say, five years from land tax.

    As regards retired people, the best option would be a reverse mortgage, that is, a debt that would be collected only when the house was sold or bequeathed. If this was not politically possible, the next best is a concession similar to those that often apply to rates.

    CGT reform is necessary, but neither simple nor easy. I’ll say more about this soon, I hope.

  4. August 5th, 2003 at 16:49 | #4

    That reverse mortgage approach is precisely the one that I looked into before, that presents all sorts of hidden costs to those that have to call on that option. Interest rates are often uplifted, and there are fees to pay as well. This also applies to the rates concession approach, as the roling over effective interest rate is also set high (to prevent taxpayers ripping the government off!).

    The nearest I could ever find to a workable approach was a variant of grandfathering, and even to me it seems clumsy. The idea would be that every property would attract not stamp duty on subsequent sales/transfers but an enduring and continuing charge, valued equivalently to the former lump sum payable on the transfer. Then properties would over time accumulate additional charges on each transfer, gradually less each time in real terms from the depressing effect of existing encumbrances. Refinancing problems get folded into those of transfer, and that’s a problem area that people have already adjusted to (the “an old tax is a good tax” principle).

    But this merely moves the problems around; imagine how convoluted the pattern of encumbrances would become, particularly on changes to parcels of land. At least it makes the problem areas clearer, more explicit, where the JQ suggestions hide them a bit.

  5. James Farrell
    August 5th, 2003 at 17:08 | #5

    “The current system discriminates in favor of existing home-owners against homebuyers.”

    How so, John? If the incidence of stamp duty falls mostly on the seller, which surely it must (at least in the case of free-standing established houses), it would be the reverse, surely. What am I overlooking here?

  6. James Guest
    August 5th, 2003 at 19:06 | #6

    Last point first. James Farrell has missed what JQ said, viz. that it was home-owners who were favoured – not “home sellers”. Most people are not willing sellers or sellers at all. So buyers in need of somewhere to live must bid up prices until sellers are willing. It is an empirical question in the end but it seems likely that buyers bear most of the incidence of stamp duties because most owners are not under any pressure to sell.

    Generally… As a state politician and earlier, for decades, I was struck by the unsatisfactory nature and incidence of state taxes. Land tax has inappropriate exemptions and progessive steps – and it far too high at the top. That dates back presumably to Georgist and other populist prejudices, but also to the big lag of valuations behind rapidly rising land prices in inflationary decades. A low flat rate land tax with no exemptions or concessions (or minimal maybe confined to very low value properties and farms), added to the rates notice, would serve to pay for every property owner’s special interest in the making and administration of planning law and the provision of state property services. Some additional land tax might be justified to balance the capital gains tax exemption. Or it could be incorporated into a low rate wealth tax accompanied by reduction of income tax.

    There seems to be nothing to be said for the stamp duty on purchase except for the difficulty of phasing it out and its *very* rough equivalence to a GST on the consumption which consists of housing oneself. The extraordinary arbitrariness of its incidence on people who move (not counting those who do it as a way of making money) as against those who don’t makes it a very ill designed substitute for more rational and regular taxes.

    The imposition of capital gains tax in relation to the private residence has difficulties alluded to by others, including the problem for people of raising cash to pay it when they are merely moving house and, again, the fact that some people will be able to avoid incurring the tax simply because they (and their heirs) have no need to move whereas others will need to sell and move frequently. Other reasons for sticking to rates and land tax include 1. the logic of allowing interest on home mortgages if CGT on disposition of private residences is allowed; 2. the logic of adjusting the interest allowance by half to correspond to the CGT discount (see more below), and 3. the arbitrariness of determining the rate of CGT according to the marginal income tax rate of the (presumably) principal breadwinner in a particular year.

    The question of negative gearing deserves a quick look here because, as noted above, full tax deductibility is hard to square logically with a big concession on CGT rates (albeit offset to some modest extent by inflation. Here is a serious cause for you JQ. Let’s solve the negative gearing problem, at least so far as it applies to real estate, by allowing full – as opposed to 50 per cent – tax-deductibility only to those whose trading or general business activity means that their gains from real estate wil be classed as ordinary income taxable at their full marginal rate.

    James Guest

  7. August 6th, 2003 at 17:47 | #7

    Pr Q has a chance to refute a fallacy that pervades economic thinking – that tax/outgoings cost-push is behind the rise in property prices rather than credit/income demand-pull.

    In fact, there is no real cost-floor to the supply of assets, hence fire sale prices to high replacement cost asset are possible.
    But there is a price-ceiling that the market imposes in the long run, which is set by the income earning (profitability) or welfare generating (utility) power of the asset.
    However, in the short-run, the market can overestimate the value of assets due to the elasticity of supply of funds and the difficulty of asessing utility/profitability of assets.

    In a competitive and well informed market, such as Aust Eastern seaboard metropolitan real estate,
    the price is set by how much buyers are willing to pay, since a seller can always be found if the price is right.
    Buyers reservation prices are set by their earning power, which includes emptors wages and the imputed value/realised rental income of the property.
    Increases in government charges/taxes reduce the vendor’s capital gains ie they change the distribution, not the aggregation, of the producer/sellers surplus.
    A reduction in government charges will therefore increase vendors tax free capital gains without reducing emptors prices.
    This is standard Marshallian demand/supply theory.
    A good test of this hypothesis would be to observe the price action of property markets that did not suffer Aust stamp duty etc but that were enjoying similar capital gains tax exemptions and low interest rates.
    A cursory glance at overheated oceanic metropolititan property markets in other OECD states confirms Marshall’s theory.
    Also standard financial economic theory suggests that when a major class of assets receive a priveleged tax treatment (CGT cuts for RIP and CGT exemption for O-OH) these assets will experience overcapitalisation of investment funds and extra-ordinary price rises.
    Thus a 30% rise in after-tax profitability caused by the 50% cut in CGT will generate, ceteris paribus, a 50% price rise in RIP’s.
    This is precisely what has happened with the boom in inner city apartment building and correspondent rise in prices of same.
    Come on Pr Q, stick up for economic theory.
    It is your bread and butter.

  8. derrida derider
    August 6th, 2003 at 20:12 | #8

    Land tax has inappropriate exemptions and progessive steps – and it [is] far too high at the top. That dates back presumably to Georgist and other populist prejudices.

    Uh, no, its not Georgist prejudice but rather simple public choice, which pushes pollies to make taxes heavy on a narrow base rather than light on a broad base as economists would prefer. Its a matter of number of losers versus revenue gained when you introduce the tax.

    If you doubt this look how payroll tax has the same problem. By any economic measure it would be both more efficient and more equitable to make the payroll tax rate independent of firm size, but that’s not the political calculus.

  9. John
    August 6th, 2003 at 20:42 | #9

    DD, I think you’re right, but note that this is the opposite of the usual public choice theory on, say, tariffs, where a tax is spread thinly across many consumers to benefit a small group of producers.

    This ‘concentrated gainers, dispersed losers’ theory has a very poor predictive record – in general, industry concentration is negatively correlated with protection.

  10. Observa
    August 7th, 2003 at 01:46 | #10

    I should point out that the price boom in housing has also been accompanied by a paralell boom in the Commercial/Industrial sector as well.(well at least in Adelaide which I am familiar with) I came across this when I placed an ad to rent part of my factory in Wingfield(the major industrial area North of Adelaide) recently. I was immediately inundated by calls from Commercial real estate agents wanting to know if I was interested in selling as they had plenty of eager investors on their books.

    The story from the agents was the same. Prices have risen dramatically recently. Instead of investors wanting properties at 10-12% returns, they were now willing to purchase industrial property on 7-8% returns. The agents explained that this was largely due to the impact of the FHO grant(coupled with low interest rates) having driven up the price of cheaper housing that had previously been sought by the rental investor. The returns in this sector(even with prevailing low interest rates) just didn’t stack up anymore. Hence the switch in investor attention, particularly among the mums and dads investors. Indeed on this point, one agent described an auction sale he had attended this week, of a gilt edged KFC site with long lease, being sold for a 5% return on finance at 6%. Hence the dramatic lift in prices.

    Now while a large price gain is attractive, CGT coupled with my wife and I facing high marginal tax rates, would preclude us from taking advantage of such a rise(well at least until retirement and a low taxable income year). As well, there is nowhere else to place the proceeds to achieve a commensurate return. The result for business is higher rents, with little respite by buying a property(or developing on vacant land), since prices have been driven skywards. Still business is generally booming and allows the higher market rents to be extracted without too much pain.

  11. Observa
    August 7th, 2003 at 04:51 | #11

    For the uninitiated the current capital asset price boom in real estate can largely be explained by Classical economic theory. This is the notion that ‘capital’ asset prices (CAP) should trend toward some long-term real rate of return(LRRR).

    Now the discussion to date has shown how external price shocks like CGT,FHO grants, negative gearing and stamp duty can have an impact on this mythical beast(ie the LRRR). Discounting these for the moment(as economics is want to do for simplification’s sake), then it was probably inevitable that a sustained fall in interest rates would produce the sustained rise in CAPs.

    For example, in a stable perfect world, with negligible inflation, if we all observed that real estate rose in real terms by say 2% per annum, due to a slow ongoing scarcity factor, then we may all reasonably come to view this as the LRRR. Consequently a gradual and smooth fall in interest rates say from 10% to 5% over a 5yr period, should double the price of real estate over the same period.(essentially the similar argument with price movements for a perpetual bond issue with a set coupon rate) Now the immediate problem with this smooth transition(to the LRRR) is one of rising expectations. After 2 or 3 years of rising CAPs well above the LRRR, the market anticipates this will continue(assuming it is confident interest rates are heading down)and the ‘bandwagon effect’ has begun, as more and more investors recognise easy pickings. Simply hop in to the bank with your surplus deposit(plus the benefit of negative gearing)and borrow on the expectation that the rise in price will overcome any stamp duty penalty, or relatively stagnant rental return. The only small problem is you don’t realise your profit until you’ve sold, which becomes a big problem if prices turn south and we all want to sell together. The bandwagon in reverse.

    Now the perversity of a sustained fall in interest rates(supposedly the Holy Grail for business investing in income earning capital equipment) becomes apparent. It is clearly feasible that the market overshoots the LRRR, say by trebling real estate prices over a 6 year period, before the bust. This perversity of outcomes, could be exacerbated for those paying more than our hypothetical doubling of prices, as they fall back below the LRRR in the reverse banwagon effect. Recovery back up to the LRRR may take another 2 or 3 years.

    Where the upper and lower limits to wild oscillations in CAPs are, is something Classical economics has little to say about. Like meteoroligists, economists watch the storm clouds brewing, but are powerless to predict the strength or timing of a Cyclone Tracy. The question is- do they have any similar historical examples of sustained falls in interest rates, on which to hang some reasonable predictions? The other issue is-with globalisation and perhaps unprecedented access to international capital at low prices, is it possible for Australians to drive CAPs to historically unprecedented levels?

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