Ken Gibb's 'Brick by Brick'

Housing, academia, the economy, culture and public policy

Category: Economics

Exploring the Scottish Economy

My last official act with Policy Scotland is to participate today in a launch for our edited book ‘The Scottish Economy: A Living Book’. I edited this new overview with Duncan Maclennan, Des McNulty and Michael Comerford. We are immensely grateful to all of those who contributed to the book’s 19 substantial chapters. We think it is a genuinely useful and serious contribution to an empirical understanding of both the state of key sectors and the economic challenges the country faces.

Of course, Scotland is a place for different kinds of economic debates – those that mirror wider conceptual and empirical debates elsewhere about macroeconomic policy, government intervention, national strategies and what works. But is also, rightly or wrongly, where so much of the constitutional debate about Scotland turns. Just in the last week, both aspects of these debates have surfaced as a result of the Scottish Government’s publication of the new GERS data on Scotland’s public finances and in the anticipated economic strategy content of the new Programme for Government to be launched next week.

This book has a unique history. Sir Alec Cairncross established the Department of Social and Economic Research at the University of Glasgow after the 2nd world war as an empirical research–intensive group of social scientists. In the mid 1950s, he edited a book entitled ‘The Scottish Economy’, featuring an empirical account of all the major Scottish sectors, which involved wrestling with often quite primitive data, but as was characteristic of the diagnostic investigative approach, often featuring remarkable forensic analysis of what was available. Of course, post war Scotland is in some respects now barely recognizable but many root issues and characteristics like inequality, spatial variation, the problems confronting Glasgow and the debates over strategy, productivity and growth still to the fore.

The Department of Social and Economic Research begat the Department of Urban Studies in the 1990s and now Urban Studies is a successful subject area in the School of Social and Political Sciences. The ESRC Centre for Housing Research, led by Duncan Maclennan, was located within S&ER, where, for a couple of years, Sir Alec’s daughter, Liz, was a researcher with us. We thought that as a commemoration of that excellent path breaking empirical study, we should seek to re-create its essence 60 years on. Although the subject material has changed (we don’t, for instance, have a chapter on the church in Scotland), we have, we hope, produced a significant substantial volume that should add value for academics, students, political and commentariat classes across many domains in Scotland. Retaining the link to the history of the book, we were delighted that Frances Cairncross could offer a foreword and Laurie Hunter, long term head of the department of Social and Economic Research, could add an afterword, too.

The book has a series of five chapters at the beginning of the book that are broad-based about the history of the Scottish economy since the 1950s, including one on the development of economic policy, alongside chapters on fiscal matters, the contemporary landscape and the Scottish population. We then move on to a series of sector or more topic-specific chapters concerned with issues as diverse as: oil and gas, infrastructure, rural Scotland, education, health, housing, the environment and renewables, the financial sector, urban Scotland, women in the labour force, local government finance, inequality and poverty, and government’s place in economic strategy. Chapters combine careful analysis of descriptive material with reflection on current and future challenges.

The main strength of the book is that we have assembled many of the key writers academic and non-academic who can write with authority on these matters (and they have done so). Second, a distinctive feature is the ‘living book’ element, by which we mean the updatable accompanying website which visualises much of the data contained in these chapters. The empirical focus is a drect legacy of the original Cairncross volume and we hope readers will find it useful. We also intend to use the website to provide periodic additional content, perhaps through blogs and author/editor notes.

In this way, and short of further editions (which we hope there will be an appetite for in time), we hope to overcome the classic problems such volumes face (subsequent events overtake the book). Our main such example, which only features in the introduction, is Brexit. Several of our authors (and indeed one editor) are thoroughly versed in the economic debates around leaving the European Union but our timescales precluded adding a further chapter late in the day. I hope the website will be able to host a series of contributions on that pivotal topic.

It is a nice way to sign off from Policy Scotland and I would like to thank my editorial colleagues, all the 33 contributors, the publisher and Policy Scotland staff and interns and for doing such a great job throughout the project. I wish the new director Chris Chapman well and Policy Scotland continued success. The new housing evidence centre, CacHE, will be working directly with Policy Scotland and we will have many continuing overlapping strands.

 

 

 

 

 

 

 

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Accountable? Transparent? Budgets and Public Finance in Scotland

 

‘Exceptionally complex and opaque’ and ‘without precedent internationally’. Fraser of Allander Institute on the Fiscal Framework, quoted by the Finance Committee, Scottish Parliament in their 2017-18 draft budget report

I found myself reading the Scottish Parliament Finance Committee’s draft budget report  the other day in part to prepare for teaching on public finances in Scotland. I was struck just how non-transparent the fiscal framework is and how difficult it is to communicate the consequences of the rules of the game in terms of Scottish policy intentions and budgetary implications. It is as if the designers in Holyrood and Westminster were seeking to be rewarded for fiendish inventiveness rather than designing a set of financial rules that were clear, transparent and fostered accountability. In that respect, the Finance Committee’s report is remarkably helpful (along with the recent SPICe briefing on the budget).

I will get into the main points that struck me shortly but it also raised a second related question. In the year of the council elections in Scotland, there is a near equivalent lack of transparency regarding the local government settlement and the consequences for local decisions on tax and spend. This has, if anything, been exacerbated by both the implementation of the recent council tax reforms and the controversy over what the draft budget means for local spending by councils. We need more transparency here too and perhaps a local fiscal framework (something being pursued by the Scottish Greens) that makes explicable and straightforward how local tax and spend works, how it is impacted by Scottish ministers and what decisions mean for tax bills and spending choices.

What is it that makes the new national fiscal framework so difficult and why is it so significant? The devolution of new tax powers reduces the size of the Block grant. Critical to how this will operate is,  how the Block Grant adjusts, which comes down to a series of decisions, firstly, about the baseline reduction that is determined by revenue in the year prior to the devolution of the tax in question. Thereafter, the second critical question is how accurately tax revenues for the now devolved tax are forecast in terms of playing into public spending planning and control decisions and the risks of over-estimation. Third, there is the contentious question of how to uprate the block grant adjustment for the devolved taxes in subsequent years. This concerns the extent to which Scottish tax revenues grow relative to UK tax revenue growth and  (and this is where the controversy exists between the two governments) then how adjusting for relative population growth between Scotland and rUK operates.

These Byzantine and head-hurting rules are incredibly important. If Scotland can grow its tax revenue quicker than rUK, the block grant and the size of the fiscal cake expand. This fundamentally depends on relative tax policy changes, which currently benefit Scotland because we are not raising the threshold for the higher rate of income tax by as much as HM Treasury – and other things equal we should grow tax revenue per head more than rUK. But it is also driven by relative population change, relative economic and productivity growth (and these presently all look less favourable from a Scottish perspective). As the Finance Committee stress, the Scottish Government have taken on considerably more responsibility and the technical requirements for forecasting future tax, economic growth and in specific sectors too (e.g. land and buildings transactions tax depend on housing and commercial property markets) – and they have done so in a period of remarkable uncertainty, austerity and Brexit.

The Scottish Government is presently consulting over the Scotland Performs National Performance Framework. In the light of the above maybe they need to change the absolute or top line purpose of Government to maximising relative tax revenue growth?

One might conceivably say ‘well, these risks are what happens with more responsibility and that is what real devolution is all about’. My view however is that what we might be seeing is actually the outcome of bargaining over an inherently complex system and one that consequently is difficult to predict, manage and base fiscal plans on. I am sure the Scottish Government will step up to the plate – they have to get this right and must invest the necessary resources and capacity in doing so. Specific forecasting expertise by the Scottish Fiscal Commission will also become much more important in the future. Moreover, the plan is that in less than 5 years the whole basis of the fiscal framework will be reviewed and the indexing methods and other fundamentals may well be substantially revised. Let’s hope for less haste and that a simpler and more durable set of negotiated outcomes is the result.

Then there is the controversy over the local government settlement. There are several accounts of what is happening to local government spending, depending on what you compare it against (draft or final budget in 2016-17), how wide you draw local government activity, and, if you do include other elements, that you know what these extras are worth. SPICe estimates that local government spend in 2017-18 may either fall (compared to 2016-17) by 1.6% to 3.2% in real terms, or if you just look at the core grant (including non-domestic rates), it may fall by between 4.5% to 5.8%. However, speaking to the local government committee of the Scottish Parliament, the Cabinet Secretary argued (para 273, Finance Committee Report on the 2017-18 Draft Budget) that ‘when wider spend on local services, including funding for health and social care integration and from council tax reform is considered, there is an increase in expenditure on local services by local authorities of £240 million or 2.3 per cent.

Clear as mud. And then there is the interaction between grant, non domestic rates and council tax – we (i.e. tax paying voting citizens of Scotland) surely need to clearly understand how all this works together so that we can make sense of the financial and service outcome implications of different political platforms? Can we not do better?

 

What do we know about the demand for private renting?

Regular readers will know that I have previously argued that we know surprisingly little about the UK rental market, despite the magnitude of growth in the sector in recent years. Evidence is hard to come by because of the disparate diffuse nature of the sector, which is really a series of well-defined demand segments. But this does not stop many people writing about the sector as if it was homogenous, simple to understand, monitor, evidence and, consequently, intervene in to moderate excesses.

Unfortunately, this over-generalisation has extended to the former Chancellor of the Exchequer who introduced tax changes that will reduce returns and increase borrowing and transactions costs (but without any proper analysis of the impact of these changes). But the sector is not simply an investor question – it is also about who lives in the sector and their aspirations and experiences; and it is all the more important because at the margin it is the sector where the action is because of credit constraints on entering owner occupation and, for others, because of the insufficient level of affordable housing supply of social housing.

It is against this backdrop that a couple of weeks ago the Bank of England’s blog site Bank Underground issued an interesting paper on the drivers of the demand for private renting by Mariana Gimpeliewicz and Tom Stratton. In what follows I will summarise their paper and its findings and then reflect a little on what they say.

Noting the observed growth in the share of total dwellings privately rented since 2002 and the growth since 2008 of buy to let mortgages (BTL) rising at more than 6% per annum (a subset of all private renting), the authors argued that it made sense to try to understand the growth in PRS demand, what its main components are and then divide the analysis between pre-crisis and post-crisis and also make some projections about future demand levels in the sector. The authors note that BTL loans explained about 70% of PRS expansion before the crisis but that tighter underwriting may explain why BTL only supported about a third of the growth after the crisis (most of which came from ‘cash purchasers’).

The main drivers of demand for the PRS are (1) demographic sub-groups i.e. students, in-migrants and younger people, who all have a higher propensity to rent privately; (2) where the provision of social housing falls, households will be funneled to the rental market; and, (3) potential first time buyers who are credit-constrained or face affordability shortcomings will be obliged to either rent or live with parents. In this study, the lack of affordability data means the focus instead under (3) is on credit conditions.

The authors found that pre-crisis, net inward migration was the largest contributor of PRS demand ie about a quarter of all sector growth (2002-07). Additional students helped explain another 12.5% of growth, with slightly less growth due to the reduction in social housing available. Their analysis explained about half of the growth in the sector n this period. Between 2008-13 (the credit crunch period), migration remained an important factor, with a declining role for social housing and student growth. Much more important was tighter credit conditions for first time buyers ie the withdrawal of high LTV loans – they found that this accounted for two thirds of the growth in the private rented sector in this period. Overall, their drivers account for 82% of the growth in the sector and all of the BTL segment’s growth. The authors recognise that affordability may be driving the unexplained growth – in other words that by driving up house prices new BTL supply may be making owning less affordable and hence more are directed towards the rental market (but this is supposition).

Looking ahead, the authors expect demand to grow to 2019 but much less slowly than in recent years. This amounts to as much as a million additional properties in the PRS in this period. The key to how this turns out will turn on the extent to which frustrated home-owners actually manage to purchase their first home. Buy to let growth is forecast to slow.

This paper is on the one hand an interesting thought experiment that allows us to see how the different segments are growing at varying rates and have done in the recent past. It shows also that buy to let is far from all of the story. One just has to look around our University cities, for instance, to see the growth in bespoke purpose-built student accommodation. The split between pre and post crisis is also intrinsically sensible and a useful exercise.

However, despite the value of the disaggregation of the sector, the use of different data and its creative manipulation, it is worth noting that there is not much underlying economics in the construction of these different numbers. So, relative rents and housing costs and income play no direct role in coming up with these numbers. Instead, a series of generally reasonable assumptions, extrapolations and extraneous propensities are adopted. This is reasonable in the absence of the economic data of the right kind but we should be cautious.

We need more work more on these sub-sectors – what are the economic drivers in different segments; how is individual tenure choice governed by things like relative prices, credit availability, income, down-payment constraints and household variables? These models may well fluctuate over the credit and wider business cycle but do they also vary across space in different regional labour markets? What about the industrial economics or theory of the firm of different kinds of landlords – what are their motivations and how responsive are decision makers to changes in financial and economic variables (this latter question is vital to understanding the impact of policy interventions?

 

Brexit and Public Policy Capacity

The post was written with Des McNulty and is also avaialble on the Policy Scotland website.

In the shock and uncertainty following Thursday’s vote, the focus has primarily been on the constitutional, social and economic questions that flow from disengaging with the EU and on the political fallout. Important as these questions undoubtedly are, there is an underlying problem with policy capacity, not just because of immediate political vacuums in Westminster or the lack of a plan amongst those calling for Brexit about what that might mean beyond a few slogans. 

The challenge for both the UK and devolved governments is to carry on their normal work (and do so competently across their range of responsibilities), while urgently building up capacity so they can understand EU disengagement and thereby negotiate effectively. And at the same time they are having to manage and ride out downside economic risks (which will inevitably impact on their ability to balance these tasks). 

The scale of the challenge ahead is unprecedented. Following the 2016 Scotland Act, the Scottish Government is presently faced with implementing tax powers and the delivery of elements of social security. These are the biggest technical, policy infrastructure, scrutiny and personnel challenges since devolution was enacted in 1999. But they are as nothing compared to the requirements for expert analysis, negotiation and co-ordination across the thousands of often inter-related substantive areas affected by EU withdrawal. This is not just a challenge for Whitehall – there are huge implications for the devolved governments also. 

At this point, no-one really knows how big or complex a job this will be – we don’t know what objectives of any of the negotiating parties are likely to be, what the processes are or who will be at the table. This may be one reason why the UK Government wish to slow down the Article 50 decision (even if at the expense of the negative consequences of short run economic uncertainty). We do know that a co-ordinating body is being hurriedly established across all Whitehall departments to start this work. But one consequence of deficit reduction policies since 2010 has been the winnowing out of analytical expertise in Government departments (in Scotland and Wales as well as at UK level). 

The Scottish Government faces complex and in some respects contradictory pressures. First, they need to deliver competent government across their portfolios, at a time when local government and many public agencies are dealing with severe real terms reductions in their running costs budgets, which are likely to continue for years to come. Second, they have difficult choices to make about how to use their new fiscal and welfare powers, given expectations and the resources required to build the infrastructure needed to implement e.g. new social security arrangements. Third, they need to shift personnel and undoubtedly bring in people from outside to advise and assist on options in future EU/UK/Scotland negotiations. Fourth, alongside all of that, if the SNP administration wishes to put forward a new independence referendum proposal, they will want to provide a credible blue print that addresses the issues on which the Yes campaign was weakest, most notably the currency question.

Perhaps one of the lessons of the last few days is the danger of assuming that ‘other things do remain equal’. The leadership of the ‘leave’ side were wrongfooted by the prime minister’s resignation. They didn’t expect to win or to have to lead the implementing of Brexit, at least not the immediate stages hence the lack of a plan. In advance of the vote, economists identified turbulence caused by short run uncertainty, including inflationary devaluation and stock market reversals as risks. They also pointed to the longer term insidious effects of investment postponed or displaced, jobs moved abroad and longer lasting uncertainty associated with the trade deals that we may eventually secure (e.g. what kind of market relations including labour movement can be secured with the EU). In the EU referendum there was a wholesale rejection of expertise and evidence per se (when it does not suit) with decisions ultimately resting on attachment and perception (arguably something similar happened in the Scottish Independence referendum). But governments can’t work in that way – there is surely now a belated realisation of the need to strengthen government capability by reversing the hollowing out of analytical capacity.

The probability of a Brexit-induced recession or economic reversal is a significant constraint on capacity building for negotiation and analysis of EU disengagement, something that we see as vital if government, the civil service and other sources of expertise such as the universities are to rise to the complex multi level challenge that UK and devolved governments now face. At present the markets are discounting our ability to reduce the public deficit and at the same time expecting lower economic growth. Other forward indicators like bank and property sector shares are also uniformly negative. 

The fiscal stance of the UK Government in terms of deficit reduction may have to be relaxed in order to mitigate the consequences of economic slow down. But further austerity can also be anticipated, given the impact on government revenues. The pattern over the last few years has been to prune back civil service numbers and analytical capacity has taken a particularly heavy hit. But given the scale of the changes and pressures on government there is an urgent and continuing need for expertise if we are to properly understand the options that new circumstances confront us with and provide the information necessary to make properly informed choices. 

The EU referendum outcome is not one that most of the experts, whether in academia or government, would have preferred. Surely any implementation and other adjustments arising from the referendum must however be informed by available evidence and draw on relevant expertise, some of which is in short supply inside government itself. It is now up to the public policy community to mobilise and engage in a way it has not done before and to government to open out so that the challenges we all face are not met because we fail to provide or apply knowledge which would be helpful and relevant.

Three (tax) strikes and you are out 

A relatively little-mentioned aspect of this week’s budget was the continuation of the fiscal assault on buy to let landlords. As we know, the rate of capital gains tax has been cut but the private landlord has been exempted from this effective tax subsidy. The rate of CGT remains at the old higher rate for them. While this is only a relative disadvantage compared to other forms of assets, it is a continuation of a process whereby the Treasury has accumulated fiscal penalties on the sector over the last year or so (reducing tax relief to the basic rate for interest on borrowing and also the 3% hike on all rates of stamp duty quickly replicated in Scotland).

The rationale from the UK Government is two-fold: they want to pursue a tenure-based housing policy that promotes the growth in home ownership and are of course pursuing a range of more or less credible policy proposals to do just that. Second, however, they are justifying this approach insofar as it means reducing the incentives to invest in private renting (or stay in the sector), because the Bank of England published its view that BTL investment may be pricing out home owners and creating bubble like inflation in the housing market (that needs to be moderated).

The logic of this argument is I think pretty ropey. It is one thing to say that rental investors are bidding up the properties they purchase (they obviously are very active and taking a large chunk of new lending and yes may be pushing prices up a bit); but it does not follow that by choking off the return to such investment via blunt fiscal interventions will (a) deflate any such bubble (whether or not it is a real issue consistently or largely outside of the Metropole) or (b) that this will in the short to medium run actually make things better in terms of the supply of housing. Let’s unpack the argument a bit.

A THOUGHT EXPERIMENT

Clearly, private renting and owner-occupied segments of the housing market are interdependent – they are a more or less functioning system where change in one affects the other. In recent years, largely though not wholly as a result of the non-affordability of home ownership and linked  long term supply shortages, demand has grown and supply has responded on the rental market to accommodate unfulfilled home ownership demand and, to an extent, meet new demands independent of this frustrated non-owning segment. Intervening through fiscal levers to make the rental sector less attractive may well reduce new investment and stimulate disinvestment – slowing the growth and even reducing the sector’s actual size. But there are least three problems that arise in this system where I think the Treasury is not thinking it all through.

First, it will take a long time for any downward pressures on prices caused by a landlord or investor exit to impact on house prices to the extent that they make a material difference to potential first time buyers (and it is questionable if this would ever be the case in some parts of the U.K.)..

Second, the PRS is not the only force acting on house prices – there remains the chronic weakness of new supply to deliver and the myriad host of new announcements and policies supposed to unlock housing supply, as well as of course other demand side policies like Help to Buy.  Where is the evidence that this strategy adds up or that BTL is the critical driver of prices?

Third, in the (potentially lengthy) intervening period while we wait optimistically for this supply renaissance to deliver large numbers annually of a range of owner-occupied supply to locations where there is demand and a good proportion of it is accessible to potential purchasers – just where are the growing number of households going to be accommodated? Will a shrinking rental market simply not reduce the options for people to rent and bid up market rents?  Surely, this continuing long term problem in the home ownership sector is precisely why we need a well-functioning, better regulated (e.g. longer length of tenancy) and well policed rental market? Actively trying to make it less competitive and less attractive to investors is simply wrong-headed.

Thinking about local housing market volatility

A recent paper in Bank Underground (the Bank of England’s new blog site) by Arzu Uluc uses an interesting local-level data set (325 local authorities in England covering 1997-2009) with which to examine local housing booms and busts. The underlying model draws on data including real house prices, real gross disposable household income per capita, dwelling stock per capita and various mortgage market variables like loan to income, loan to value and the share of interest-only mortgages.

The author concludes that the local research allows us to infer (and reasonably so) that volatile housing markets can ‘threaten financial and macroeconomic stability’. Credit conditions in terms of the key ratios and types of mortgage products play an important role through the ‘1997-2009 housing cycle’.

Uluc presents his empirical work by generating six stylized facts. These are:

  1. Real house prices rose on average by 150% between 1997 and 2007 and then fell 12% by the end of 2009.
  2. Changes to the proportion of high loan to income mortgages were positively correlated with local housing booms and busts.
  3. There is a negative relationship between the changes to the proportion of high loan to value mortgages and the size of local booms and busts.
  4. Changes in the share of interest only mortgages were pro-cyclical (similar to 1. above).
  5. Housing booms and busts were also associated with real drivers like real income and dwelling stock growth.
  6. The bigger the local boom, the larger the subsequent bust.

A few caveats are in order – it is not clear why local authority data is particularly appropriate rather than broader more functional geographies; nor does it appear from the blog that there is spatial dependency accounted for in the analysis. I also wondered if the London effect needed to be explicitly modelled (or indeed some sense of North and South)? On the other hand, the author is clearly concerned about attribution and possible reverse causality or confounding factors in the models deployed. These are all things that can no doubt be explored in a longer paper.

What about the bigger messages?  The model is best summarised by a quote from the post: ‘the econometric analysis…suggests that booms and busts ere associated with both real factors and credit loosening. Higher real income growth [was] associated with larger booms in [the] 1997-2004 period, and in 2007-09 areas with higher growth in the dwelling stock per capita tended to see larger price falls”.

Thus, and despite the fall in endowment mortgage volume shares after 1997, changes in the share of interest only mortgages were associated with local house price booms. Similarly, higher loan to income ratio shares of new mortgages were associated with local booms. The interesting negative relationship between high loan to value mortgages as a share of the total and local house price growth – may be explained by the growth of the share of home movers as opposed to first time buyers among total transactions and the increased financial support utilised by remaining successful first time buyers from family and other savings (which also drove down LTV ratios).

As Uluc stresses, there are reverse causality explanations and possibly confounding omitted variables that may instead better explain what is going on – but the associations found are striking. It is a reminder of how difficult it can be to disentangle the relationship between the real housing market and monetary transmission through credit variables – something well known in the wider housing and economy literature but just as striking here.

Stylised facts are useful, but as the author points out, they are the starting point that we then develop models and theories from and look at fresh data to test the ideas that originally flow from these facts. It would therefore be interesting to extend this data forward beyond 2009 and also to aggregate a sub-sample of the local authorities into clusters that approximate for sub-regional housing market areas. If we did so, would we also be able to detect the influence of the changing regulation and practice of mortgage lenders in more recent years?

Local Taxes and the Housing Market: Learning from the Past

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 [1]. 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 [2].

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.

  1. Topham, N (1983) Local Government Economics, in Milward, R (ed) Public Sector Economics. Longmans: London.
  2. WE Oates (1972) Fiscal Federalism. Harcourt Brace Jovanovich: New York.

Local Tax Reform: God and the Devil in the Details

The media covered Reform Scotland‘s contribution to the local tax debate yesterday. This was a welcome contribution to the aims of tax reform situated much more squarely in thinking about the wider role of local government in modern Scotland. Central to their case is the localisation of financial powers – increasing the autonomy of local government in Scotland by ending the council tax freeze, returning local control of non domestic rates to councils and, most radically, offering local government the right to decide on their own type of local taxes.

In a sense Reform Scotland have correctly identified the fundamental questions of the relative autonomy and the funding balance between Holyrood and town hall as the irreducible decision for the future – and that local tax choices could be essentially a local or a Scottish level decision. They could have gone further in terms of aims to consider the appropriate distribution of powers and functions between local and central government and, indeed, further still to  address the geography of local government  itself and the optimal number of councils.

Reform Scotland want decentralisation and devolution to councils and what they say chimes with Strengthening Local Democracy. However, for the Commission on Local tax Reform   there is a sense that they may feel Reform Scotland is looking at this with the wrong end of the telescope. The remit of the Commission is clear – it is about domestic local taxes only (including the freeze) and implicitly the balance of funding and non domestic rates are ‘on hold’. We may support the overarching aim but it has to be translated into this narrower focus on the local tax question for the time being. It is therefore critical that any subsequent reform proposals, if enacted, do not impede further goals regarding the other parts of this agenda – but these may not come to pass for quite a while after local taxes change (and with good reason, there is a lot to think about, see below).

Let’s talk more about their specific proposals – which admittedly are a little light on detail. Some might argue that what Reform Scotland offer is an aim or set of goals for local government reform but the design implications of what they propose for thinking about tax reform have many consequences, and I do not think that they are all thought through.

The main proposals are:

  • Give tax setting powers back to local government (end the freeze).
  • Return non domestic rates to local government (not part of the Commission remit).
  • Propose giving local authorities powers to establish the local taxes that work for them and of course that this should be accountable to local electorates and tax paying citizens. Reform Scotland say that this might include land value taxes or indeed sales taxes.

Ending the freeze would be welcome and would of course allow councils to set their own rates of council tax allowing them to spend more or indeed to cut taxes. Almost inevitably this would not be a complete freedom and one would imagine some form of incentives and penalties for excessive annual increases. One question is whether or not this is sufficient for visible transparent local democratic functioning or whether it is necessary to give the power to change the basis of the tax too, as Reform Scotland would argue?

I was struck in the recent review of international evidence we did just how many countries have multiple local taxes (usually a combination of property and income taxes) and also that many of our major cities, outside of the UK, have many local taxes (one study of big OECD global cities averaged five local taxes). Except in the UK where we only have the council tax. So, my reflections here are couched in terms of seeing the case for multiple local taxes raising broadly the same revenue as at present with perhaps a supplementary local income tax augmenting a better form of property tax (Burt thought this unworkable but I am not so convinced).

I am not convinced about the localising of the form of local taxation for two principal reasons. The first is that a range of local tax systems operating across Scotland will play merry hell with the grant system which will have to compensate local authorities on a different basis depending on the system in operation.  This may act to make the system much less transparent as well as increasing the transactions costs of setting up and running the system. Taxpayers making decisions across the cost of service between authorities or even mobility decisions will need to understand the differences n respective local tax systems.

Second, we would need to have a range of supports for low income households that vary by local tax system e.g. you might need a rebate system for a property tax or reformed council tax  but not for a local income tax. The experience in England of localising council tax benefit has been to create a patchwork of local means-testing systems. Do we really want that in Scotland?  Isn’t tax rate variation powers at the local level with a good defensible local tax solution for all of Scotland sufficient? I also doubt that many councils have the resources, staff and confidence to go their own way – tax systems are important pooled resources across a country for a reason. Economies of scale and scope are important.

I am an in-principle supporter of land value taxation but recognise it would have some challenges to be introduced and transitional phasing in and compensation will probably be necessary until it is established. I also think there is a case for thinking of it as a national tax for all Scotland – but that is another story. I do think, however, that Reform Scotland’s other potential proposal – a sales tax – does need to be seriously questioned. We have extensive VAT in the UK set at a high standard rate. Indirect taxes on consumption are notoriously regressive and impact hardest on low income groups. Local sales taxes cause all manner of border hopping and cross border shopping investments which are inefficient and cause wasteful displacement of economic activity.  The EU would almost certainly preclude new sales taxes – so it is probably not a starter even if it did not have these detrimental effects.

What about returning non domestic rates (NDR) to local councils? There are several issues here (which is probably part of the reason why it did not feature in the Commission’s remit). First, the current system imposes a national tax rate which generates NDR income that goes to Holyrood. This is then distributed back to councils on a per capita basis. The original reasoning during the development of the poll tax system was both to placate the business lobby but also to enhance the population driven nature of the grant system envisaged (although there is also a significant needs-based redistributive element). It is important to stress that we still operate this poll tax simplified grant system. Actually returning the NDR to local level implies two decisions: first, giving the income raised locally back to local government (the urban argument made by for example Glasgow and Edinburgh who are big losers under the current system), which is distinct from, second, allowing councils to set the NDR tax rate.

In principle, I also favour returning income and tax raising powers over NDR to local government (again with reasonable controls over excessive tax rates) but we need to recognise that if it was just about giving the income raised back to local governments there would be big losers as well as winners. We need to know what that pattern would be and whether we intend to compensate for it, perhaps by reintroducing resources element to grants so that those councils with smaller tax bases receive extra central funding. But to be clear that would drive a coach and horses through the current funding system and would require a fundamental remaking of the system and a redistribution of grant overall. This is equally true of reinstating local tax rate powers over NDR. It may be a worthwhile goal (I think it is) but it will not be an easy fix.

The aims set out by Reform Scotland are worthwhile and supportable but the devil is in the details and cannot be lightly dismissed as such. There is sense in doing local government finance reform one step at a time, if only because doing it all together can be disastrous  (as we saw in 1989-90) and there may be too many spinning plates to manage if we wish to compensate losers and transition to a new more rational and fair system.

Housing and the Productivity Puzzle

Last week IPPR published a new report on the productivity gap or puzzle (Tony Dolphin and Izzy Hatfield are the authors of ‘The Missing Pieces: Solving Britain’s Productivity Puzzle’). This is a thought provoking report on one of the critical economic policy questions of our time. It also inevitably spills over into wider questions of interests such as the nature of work, wages, in-work benefits and indeed the long term effects of housing and housing tax policies.

What is their diagnosis and what do they propose to improve the situation? First of all, UK productivity performance is significantly poorer than European competitors such as Germany, the Netherlands, Belgium and France. At the same time over time the UK’s current productivity performance has notably worsened compared to its long term average up to the watershed year of 2007. Dolphin and Hatfield use a number of techniques to try to understand what is going on to create these worrying stylized facts.

Their analysis suggests that:

  • Poor performance against European competitors can be explained by lower productivity within UK industries not due to the overall composition of industry output being biased toward low productivity sectors.
  • Lost output growth per worker since 2008 within the UK has been due to broad performance weakening: the decline of oil & gas and financial sectors are a small part to this trend but actually the poor performance occurred across all sectors.
  • Poor productivity during the UK recession is related to labour hoarding and the fall in wages shifting the capital-labour ratio. But the recovery phase is characterized by a jobs growth that was disproportionately in low productivity low pay sectors.

The IPPR study therefore suggests that new job growth needs to be increasingly shifting into higher productivity sectors like manufacturing and finance. Firms should also be encouraged to increase training in their workforces (including increasing productivity in lower value-added sectors where so many work). They also argue that the Government’s catapult centre initiatives are focused on the high end of productivity enhancing sectors but this misses the importance to the economy of the domestic services: wholesale, distribution, caring services, food and retail. How are we to increase productivity here? The authors argue that the living wage proposal may be a positive step, if unemployment remains low, but cuts to capital spending, infrastructure, further education and science budgets are not conducive to this key engine of improving the economy (and reducing the budget deficit).

Housing matters to increased productivity and should be part of this debate. First, housing costs are an important part of the financial triangle facing people at the margins of work: what wages and working hours can they command; what in-work benefits and tax credits do they have access to that can augment their disposable income and, what are their housing costs and what housing options are there if a move rather than commuting is required for work? We know that the welcome higher levels of statutory minimum wage will often be offset by cuts to things like tax credits. Moreover, unpublished qualitative research I have been recently nvolved with suggests that labour market choices are significantly influenced by the cost and insecurity of private renting versus the perceived security of social renting (even if it is therefore traded off against work further afield).

Second, sufficient supplies of accessible and affordable housing and alongside it opportunities for subsequent trading up are essential to well functioning labour markets supporting careers but also longer distance mobility. This is about housing planning and the economics of the supply side but it is also about wider planning questions and the interdependence of the different parts of the housing system as a whole, for instance, concerning how housing investment across different segments and tenures complements business investment in the allocation of new land development opportunities. More than a decade ago I was in a project team led by Geoff Meen that suggested, at a regional level, that housing investment in new homes led business investment (jobs followed people). These are big complicated questions but they need to be part of the debate.

Third, writers like Duncan Maclennan have a longstanding interest in the notion that the housing sector impedes wider economic productivity because of the inflexibility of the housing system more broadly conceived – this is as much about insufficient investment as it is about misallocation of resources because affordable housing and land are often in the wrong place and not where housing and labour demand is high. Housing is also key infrastructure for the future and while not as obvious as the case made for high speed broadband or fancy transport or water industry investment – it is a necessary condition of sustainable growth. While it is not always clearly evidenced there are a range of arguments indicating that better housing and communities lends itself to improved education, employment and health outcomes (though it is often hard to decisively sort out causality).

Finally, and to return to a hobby horse, a tax system that encourages undiversified saving in less productive assets like second hand housing, promotes excessive borrowing and acts to encourage market speculation cannot be a positive productivity driver.

 

Payback

Policy Scotland has been co-hosting a two day workshop with the University’s Behaviour, Structures and Interventions Research Network. The event was entitled: ‘Marginalisation, Stigma and Choice? We heard papers on poverty and aspiration failures, international studies of early years interventions, human trafficking, a panel on What Works Scotland, among others. It was diverse, multidisciplinary and provocative.

There is much one could talk about after listening to these papers. I am going to focus on just one paper, that of Stephen Machin (UCL/LSE) who did an excellent keynote presentation on ‘Changes in Labour Market Inequality’. Effectively, this was an overview of recent trends in the GB labour market, real wages and inequality. I was taking handwritten notes (an increasingly lost art) in the session so excuse my lack of precision with some of the points discussed below. The main stylised facts that emerged, for me, were as follows.

First, for median real wages, the cumulative fall since 2008 has been 10%.

Second, this fall comes after a long period of annualised growth in real median wages of 2%. The downturn in real wages came well before the financial crisis of 2008. 

Third, the most recent evidence suggests that median real wages may now finally be rising but Machin cautions this may be more the effect of very low inflation that actual change in the labour market.

Fourth, if we break down the 10% fall we find that the median real wage for men fell by 12%, for women by 7% but for the 18-24 age group the reduction was fully 16%. Interestingly, the fall for those in the lowest decile was 10% almost the same (11%) for the top decile.

Fifth, Machin noted that many have argued that the fall in productivity is even worse. In fact, as he pointed out, the productivity drop is measured against the long term trend since 2008 and adds up to a 16% reduction. If you look at median real wages relative to the aforementioned annualised 2% growth trend, the overall drop relative to trend is more like 20%.

Sixth, looking across the OECD since 2008, the UK’s wage performance in real terms was 23rd out of 26 – i.e. the fourth worst.

Seventh, the pay inequality ratio (comparing the 90:10 percentiles for full time weekly earnings) grew in the long term from 2.7 in 1980 to 3.7 in 2012. Comparable respective figures were 3.6 and 5.3 in the USA, 2.0 growing to 2.4 in Sweden but going in the opposite direction (and outlier), France went from 3.4 to 3.2.

Eighth, these median wage figures refer to individuals. IFS figures for the same period (since 2008) suggested that household income fell by 4.5% over the same period but this could be disaggregated to -8% for working age households and strikingly a 4% increase for pensioner households.

Ninth, there has been a significant divergence between total compensation trends racing ahead of average wages at the same time that average wages have moved well ahead of median real wages.

What is going on? First it is increasingly clear that unemployment is no longer a good indicator of labour slack. In the recent period we have seen the rise of low income self-employment, a sharp increase in underemployment (.e. working less hours than desired) and increasing employment of older, hitherto retired, people.

Second, jobs are of course being created but productivity is not rising. Machin thinks real wages are being squeezed because of weakened trade union power, the impact of the unemployment elasticity on real wages and, albeit without a lot of evidence, the sense that benefit conditionality is driving the unemployed to take on low wage employment that help to bid down wages. Machin worries that this may be a trend and that the new normal will be flat median real wages and secular stagnation, rather than some cyclical adjustment that will pass.

All of this takes place in a context where further working age benefit cuts are being planned. Most of the emphasis when criticising these policies has stressed social justice, poverty and inequality arguments. Machin adds to this litany the idea that it may also contribute to low or flat real wage growth – a macroeconomic low growth concern.  

Scary stuff – even if these median wage patterns are not long terms trends it will take a long time to get back to trend levels of real wages. For example, looking at those in the under 25 age group their real wages are now back at 1997 levels. A further slightly depressing thought was that the productivity problem, amongst other things, will undoubtedly make it harder for employers to act on demands for introducing the living wage.