Local Taxes and the Housing Market: Learning from the Past
by Ken Gibb
My first research study was about the extent to which shifting from the system of domestic rates to the community charge (or poll tax) would lead to housing market effects, namely rising house prices. In the late 1980s and for a little while after, several econometric studies confirmed significant non-zero price effects.
I was in a meeting of Scottish Property Tax Reform the other day where we realised that it was important to rehearse these arguments again in the light of the Commission on Local Tax Reform’s examination of alternative local taxes and the possibility of moving Scotland away from local taxes on property to a local income tax, supported in the recent past by both the SNP and the Lib Dems.
The conceptual argument is about property tax capitalization and runs as follows. Introducing a recurring annual tax on property values will reduce house prices because people bidding to buy a house will know that there will be annual cost in the form of property taxes and reduce their bids accordingly. The recurring tax is literally capitalised into lower house prices. This is widely recognised in the literature . Economists have also looked at how differentials in both taxes and the perceived value of local services lead to constant quality house price variations across council boundaries because these net differences are capitalized into property values .
Now imagine that a recurring property tax like domestic rates or indeed the council tax is abolished and replaced with a tax on people or on incomes. The argument is that removing a tax on a specific commodity (i.e. housing) and replacing it with a general tax will reduce the relative cost of housing compared to everything else, and increase the demand for housing. Because housing supply is very unresponsive or inelastic, this will of itself generate higher house prices.
Normally, such studies assume that the tax change is revenue neutral i.e. the aggregate effect on incomes in unchanged as a result of the tax change. As a result, one can focus on the substitution effect as housing costs fall. In reality of course, when we disaggregate there will be winners and losers from the tax change by tenure, income, demography and location. The aggregate (even council-wide) analysis of house prices tend to gloss over this disaggregated effects.
If we accept the fundamental idea, it then becomes an empirical question as to how much prices rise. We can look at four studies of these house price effects following on from rates abolition in the late 1980s. What do they say?
- The Department of the Environment provided an annex on house prices in the Green Paper that introduced the world to the poll tax in 1986. The DoE accepted the capitalization argument and concluded that in national (UK) terms house prices would rise by 15% in the short run and 5% in the long run.
- Gordon Hughes at the University of Edinburgh estimated (1987) the medium term price effects at standard regional spatial scales. He argued that house prices would rise by between 11.6% (South East excluding Greater London) to 23.1% in Scotland (the high figure presumably in part the result of the 1985 Scottish rates revaluation) with a national average of 14.4%.
- In 1988, Peter Spencer wrote a report for Credit Suisse First Boston Bank arguing that we should distinguish between cash-constrained and unconstrained households and estimated that in the short run house prices would rise by 13% and in the long term by 7% for those who were cash-constrained (and presumably would have limited access to mortgages), whereas the unconstrained households would see house prices rise by 85% in the short run and by 30% in the long run.
- Finally, a later study by Leslie Rosenthal in Fiscal Studies in 1999 found that house prices would rise by between 10% and 17% as a result of rates abolition.
Now, there are quite a few technical questions to consider. One is how house prices and the so-called user cost of capital or something similar, are calculated in each case. Another is the thorny question of just how unresponsive or inelastic housing supply is and whether or not it is formally modeled in each of these studies and across different spatial levels. At the time I certainly found Spencer’s work particularly convincing but clearly all four studies predicted non-trivial long run price effects as a result of rates abolition.
Why is this important in the context of the council tax or local property taxes more generally in 2015 in Scotland? First, there is the tax base argument i.e. diversifying the tax base away from income to a less productive tax base – property – is better as a way of reducing revenue risk and lowering incentives problems associated with higher tax rates on income. However, the main housing market points, second, are surely about affordability and wealth inequality.
Higher house prices clearly make it yet harder for people to access home ownership or move upmarket when they need to. It makes properties more expensive to build and invest in. Higher house prices translate into higher rents as well. This may all sound good to NIMBY home-owners and buy to let landlords but acts to merely reinforce the gap between property insiders and outsiders. This cannot seriously be considered to be a sensible direction of travel when government espouses widely shared policy goals to reduce inequality and make housing work better.
I am not saying that abolishing the council tax in favour of a non-property solution would lead to the same house price effects as suggested in the late 1980s scenario, only that the logic of the capitalization process remains and we should expect higher house prices to an extent as a result. And that should be factored into future discussions about the future of local taxes in Scotland.
- Topham, N (1983) Local Government Economics, in Milward, R (ed) Public Sector Economics. Longmans: London.
- WE Oates (1972) Fiscal Federalism. Harcourt Brace Jovanovich: New York.