Thursday, 3 March 2016

Could Abolishing the Stamp Duty Solve the UK Housing Affordability Crisis?

Posted by Christian Hilber (LSE Geography & Environment and SERC) and Teemu Lyytikäinen (VATT Institute for Economic Research)

First published in Disclaimer Magazine

In a recent article, the Economist argued that the current policy debate relating to the UK housing affordability crisis may focus too much on housebuilding. It may overlook a bigger potential source of supply: existing homes. The argument goes as follows: overcrowding has gotten worse over the last 20 years, but more than one-third of households have two or more spare bedrooms. The solution: abolish the Stamp Duty Land Tax (SDLT). This would boost housing transactions and lead to a more efficient allocation of housing. It would also encourage elderly couples to downsize after their children fly the nest. The Economist estimates that there are 16 million or so spare rooms. Allocating housing more efficiently would free up some of these.

Other Economists have branded the SDLT: it creates a mismatch in the housing market and can have adverse consequences on the labour market. The SDLT creates a disincentive for people to move house, in turn implying that the unemployed may be less flexible in their search for new employment. The consequence may be longer unemployment spells and higher unemployment rates.

There is convincing evidence for the UK, the US or Canada, that land transfer taxes - such as the SDLT - do reduce household mobility very substantially. But to date little is known about whether land transfer taxes mainly distort housing-related or job-related moves.

Some simple considerations suggest that the adverse effects of land transfer taxes may be confined more strongly to the housing market. To see why consider potential movers who compare the cost of a move with the corresponding benefit. The cost of the move - in the form of the transfer tax - will be independent of the nature of the move. However, the benefit associated with a move will likely vary widely depending on the type of move. Job-related moves and long-distance moves are typically more momentous and associated with larger benefits, typically happening regardless of the transfer tax. Housing-related moves and short distance moves, however, are often more incremental changes that are associated with smaller benefits that often do not outweigh the additional tax cost.

In a recent SERC Discussion Paper we test this prediction. Exploiting a discontinuity in the SDLT schedule (where the tax rate jumps from 1 to 3 percent), we isolate the impact of the tax from other determinants of mobility. What we find is intriguing. A higher SDLT has a strong negative impact on housing-related and short distance moves but does not adversely affect job-induced or long distance mobility. In other words: the distortions associated with the SDLT appear to be mainly confined to the housing market - not the labour market.

The estimated distortions in the housing market are not only significant in a statistical sense; they are also economically very meaningful. Back-of-the-envelope calculations imply that the welfare loss associated with the rate increase from 1 to 3 percent is between 36 and 47 percent of the additional revenue generated by the tax increase. The SDLT is a staggeringly inefficient tax because it creates very substantial mismatch in the housing market. There is a strong case for replacing it by another less harmful tax - ideally an annual local Land Value Tax or property tax. For the reasoning see here

Abolishing - or replacing - the SDLT would allow many more young families with children to live in more adequate housing space and elderly people to spend the monetary equivalent of a bed room or two on other things. And it could bring about a tremendous welfare improvement by means of a more efficient use of housing space.

But can abolishing the SDLT resolve the British housing affordability crisis? Probably not. Abolishing (or replacing) the SDLT will likely result in a more efficient allocation of space, with fewer underused or unused rooms. But it may not generate any (or much) new supply in the form of new housing units. Consider a stylized world with 50 small flats and 50 big houses and 50 empty nesters and 50 households with children. Initially the match is bad so that half of the units are misallocated. Now relocation costs are reduced significantly - not to zero because there are other moving costs apart from the SDLT - and the match becomes nearly perfect: the empty nesters move to the flats and the young families relocate to the larger houses. The existing housing space (rooms) will be used more intensively, but the reform would not create any new housing units, ‘just’ a better match.

In reality we have of course immigration and new households form each year, so more and more people need to be housed and, as a consequence, demand pressure increases over time. Moreover, housing is to some extent ‘malleable’. Even the existing British planning system allows some sub-division of housing units. In our stylized example, some of the large houses may be subdivided into flats and this would permit Adam Smith’s ‘invisible hand’ to house some newcomers (migrants or newly formed households) into the housing market. In such a setting, indeed abolishing the stamp duty could help - to some limited extent - alleviate the severity of the housing affordability crisis. But it could certainly not solve it.

Does the policy debate in the UK focus too much on housebuilding? The Economist argued that even if the government succeeds in spurring on house builders, prices may continue to gallop upwards because (1) “Britain is bad at putting houses where they are most needed” and (2) even if new developments are added in overheating parts of the country, “this may fail to tame prices” because according to a recent LSE London report new development may actually increase the value of housing in their immediate surrounding areas.

Britain is currently bad at putting houses where they are most needed. This is because the British planning (and tax) system is seriously flawed. It gives very few incentives to local authorities to permit any development at all, thus ultimately causing the housing affordability crisis. This is reinforced by NIMBYs trying to prevent any new development in their backyard, because it could adversely affect their views, lead to congestion or threaten their asset values. NIMBY pressures will be greatest in the most desirable - high demand - places. The only local authorities that have some real incentives to permit development are those with high unemployment rates. Commercial development may generate jobs and even residential development will temporarily create local construction jobs. So, construction takes place in economically disadvantaged - low demand - areas where new housing is least needed. The right conclusion however should not be not to focus on housebuilding. The right conclusion ought to be to fix the planning and tax systems, so they can provide the right incentives to local authorities to build housing where it is most needed.

The second argument put forward by the Economist - that new development locally may increase prices locally - is not necessarily incorrect but very misleading. If a new development brings in new infrastructure and boosts the local economy through extra spending on shops and services, this may indeed cause house prices to increase locally (this is what the LSE London report suggested). But the Economist muddles up two effects. The first effect, the supply effect, all else equal unambiguously lowers house prices. The second effect, more amenities and better infrastructure, all else equal will unambiguously increase local demand for housing and thereby increase house prices locally. It is well possible that the latter effect in some instances outweighs the former because additional amenities and better infrastructure draw in demand from elsewhere. But to conclude from that that more supply increases prices is wrong - or at least very misleading in the sense that it muddles the two effects. Moreover, and importantly, what this very “partial equilibrium” argument ignores is the fact that new supply locally - while increasing demand locally - will reduce the demand pressures elsewhere in the region. So a local development will marginally reduce prices, not necessarily in the location itself, but in the wider surrounding areas. Such an effect on wider surrounding areas triggered by one local development will likely be very small, possibly too small to measure empirically. However, thousands of local developments in overheating areas will likely reduce demand pressures in these overheating areas very substantially, helping to reduce house prices notably, and arguably even more importantly house thousands of households in desirable places. The Economist reached the wrong conclusion (that too much focus is on housebuilding) because it ignored this “general equilibrium” argument and neglects the fact that new houses in high demand places would bring huge benefits even if their impact on prices were limited.

The SDLT is a very inefficient way of collecting revenue. Abolishing or replacing the tax could improve the match of people and dwellings noticeably, but it would be unlikely to create many additional housing units - by means of subdivision - and it would be unlikely to affect prices much. The uncomfortable truth is that, to solve the housing affordability crisis, policy makers won’t get around fixing the broken British planning system. This is a big and complex political endeavour but one with huge returns for generations to come.