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John Quiggin

Tax reform the way to go

John Quiggin Australian Financial Review

19 July 2007

With an election only months away, it’s not surprising that house prices are a hot political topic. It’s also not surprising to hear plenty of hypocrisy, on the topic.

The crucial problem is that, while it’s politically obligatory to favour affordable housing, the majority of the voting population already own (or are paying off) their houses, and stand to gain if prices rise. As John Howard reportedly said in 2004 ‘"I haven't met anybody yet who's stopped me in the street and shaken their fist and said: 'Howard, I'm angry with you, my house has got more valuable'

In 2004, house prices had been rising strongly for years, and interest rates were at historically low levels. If it had been possible to slow down the increase in prices of the preceding few years, no one, except perhaps some overgeared investors, would have actually been worse off. Existing home owners would have foregone some unrealised capital gains, but would still be well ahead, and new buyers would have benefitted from lower prices.

The conflict is more acute this time around. In some areas, particularly in parts of Sydney prices have declined in real terms at the same time as interest rates of risen. The result, for those who entered the market at high prices is not pretty. Interest payments are consuming as much as 30 per cent of household income, yet the payoff of large capital gains, seemingly guaranteed by all historical experience, looks to be a long way off.

Moreover, given the spread of aggressive lending practices in this period, many buyers started with low levels of equity, often below 20 per cent of the purchase price, and have made only marginal progress in paying off the debt. It would take only a modest further decline in prices to push many into negative equity.

Yet prices are still unaffordably high for many would-be homebuyers. At this point, the best policy advice would seem to be that of the Irish farmer, when asked for directions who said “Well first off, I wouldn’t start from here’.

Suppose though, that governments really wanted to make housing more affordable. What policy measures could they take.

The speculative boom in prices was ignited by the government’s decision, back in 1999, to halve the rate of capital gains tax. On grounds of tax neutrality alone, it would be desirable to reverse this change. However, assets bought under the current rules would have to be grandfathered, and expectations of capital gains are now fairly moderate, so it is unlikely that this would have much immediate effect.

The Treasurer has argued that the big problem is the failure of state governments to release more land on urban fringes. But shortages of new land are not the main problem.

Urban housing prices follow a gradient, reflecting the value of time and convenience. Houses and land close to the city are more valuable than similar houses further out. Go far enough out, and the price is determined by the cost of converting land from farming or other uses into house blocks.

If house prices were being driven by a shortage of new land on the outskirts, the price gradient should be getting flatter. In fact, as the Productivity Commission has shown, the gradient became steeper between 1994 and 2002, and it has become even steeper since then. The outer suburbs, were the last to boom, and the first to slump, most notably in Sydney.

A much more plausible candidate for reform is the way residential land and housing services taxed. On standard tax principles, the flow of services from land should be taxed on an annual basis, just like other income. Indeed, land taxes are generally considered the most efficient available to government. On the other hand, transactions taxes like stamp duties are highly inefficient.

If stamp duties were abolished, along with the current exemption from land tax enjoyed by owner-occupies, the price of houses would not change much, since the present value of their services would remain the same. But the cash costs faced by new home buyers would decline drastically. On the other hand, existing home owners would face a new annual charge.

The experience of the NSW government, which tried to cap the land tax exemption at $1 million shows that such a shift in the tax burden would be politically suicidal. We may like our leaders to talk about making housing more affordable for young families, but, as a community, we have been unwilling to do anything serious about it.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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