Sending the wrong signals

The critics of my article on house prices and wage inflation have focused mainly on the policy implications. One premise in my argument was that wages would perform their allocative function more efficiently and with less inflation if lower relative house prices and higher average vacancy rates for rented and owner-occupied accommodation could be induced in areas of high labour demand. The other premise was that lower average house prices would slow wage inflation and curb the consumer boom.

I am surprised that not one correspondent has mentioned the first of my two alternative suggestions for the tax reform of owner occupation: the introduction of a tax on imputed rent. More on that later. My critics concentrate their concern on the second reform possibility, the 'phasing' out of mortgage interest tax relief. Their most important criticism is that this could have the opposite of the intended effect on regional house price differentials, since the £30,000 limit on mortgage interest tax relief represents a smaller proportion of the price of a house in London and the south east than in the cheaper regions.

However, it is plausible that it is the absolute not the proportional effect that matters. I still believe that house prices in London and the south east would fall by larger absolute amounts and probably by bigger proportions. My reasons are as follows: the speculative bubble has been most inflated in London and the south east and pricking it should therefore lead to the biggest falls there; the proportion of the stock of mortgages below £30,000 is much higher in the cheaper regions; higher rate taxpayers lose disproportionately, and these are more likely to be found living in expensive houses and regions.

There are policies which focus more sharply on regional differentials. Giles Keating is surely correct to observe that the elimination of mortgage interest tax relief for higher rate taxpayers with a compensating reduction in higher tax rates would be wholly unambiguous in narrowing regional house price differentials.

It is possible that even such a mild reform would be sufficient to burst the house price bubble in London and the south east and allow at least a small deflation to a more sensible structure of prices. He is surely also right to argue that recent first time buyer would do better under this proposal than under a blanket phasing out even if done very gradually, of all mortgage interest tax relief.

However, in the longer term I do not think the Keating reform goes far enough. In addition to the inflation and other macroeconomic problems associated with the house price boom which tax reform would do much to correct, there are serious micro-economic inefficiencies caused by the current tax code as it affects owner occupation. It almost certainly leads to an inefficient use of the current housing stock with endemic under-occupation. This problem is particularly acute among older couples and those whose children have departed but who do not move to more appropriate accommodation because the real economic return on staying is so high - and do not rent out any of their space because of the current tenancy legislation.

The distorting effect on other economic decisions is surely important too. At the margin, a small entrepreneur deciding whether to plough £100,000 back into the business or to move upmarket to a more expensive house compares the prospective capital gains or profit tax on his business gains with the lack of such tax on housing. The less generous depreciation allowances now prevailing also tend to make the plough-back option less favourable.

That is why serious attention should be focused on the first of my reform proposals: to introduce a tax on the imputed rent on houses while maintaining some system of mortgage interest tax relief. It is quite unambiguous in its effect on regional house price differentials. It would provide a permanent corrective against the tendency of house prices to destroy the incentive to relocate that wage changes can provide.

It is also less distortionary, as John Kay and Mervyn King argue, in that houses would then be treated more like other assets. But this would be accomplished without losing a good feature of the current system, which is that the effective rates of interest on borrowing (dominated by mortgage borrowing) and on lending are similar. This similarity avoids distorting savings and investment decisions.

The tax I have in mind can be made relatively simple administratively, and avoids many of the objections to the current system of local authority rates as well as to the old "Schedule A" tax on imputed rent abolished in 1963. Indeed, it would offer the opportunity to reform at the same time the present system of local authority finance. I propose that imputed rent be proportional to the current market value of the house (or houses) owned. Imputed rent would simply be added to earned incomes as part of total taxable income. Overall tax rates would, of course, be reduced in compensation.

One important objection to the existing local authority rates arises because of the different rate per pound charged by different authorities. This it is widely believed, has perverse consequences for economic location decisions and contributes to the cumulative decline of regions and localities. Another objection to rates and to the old "Schedule A" is that rateable values involve too large an arbitrary element, in part, because properties are valued.

To get away from these defects, it would be better to base house valuations on historical purchase prices, repriced using the Department of the Environment's mix-adjusted regional house price indices, available back to 1968. For the now small proportion of properties that could not be valued in this way and to advise on valuation appeals, the Inland Revenue would consult existing district valuers.

There are other policies that would help to loosen the restrictions which our ill-functioning housing market is now imposing on the labour market and the rest of the economy. One is the (to me unthinkable) proposal to abandon the British system of green belts and planning controls. Among the milder policies on offer is to increase subsidies to housing associations to provide sheltered accommodation for old people. This would release family accommodation that could house many economically active people.

Finally, I must make it clear that I am not denying that regional house price differentials have a positive role in creating an incentive for employers to locate in less prosperous localities. But so long as experience supports the current expectation that house price differentials will widen further, it is very hard to persuade staff to relocate in this direction.

The expectation of some narrowing of regional house price differentials should have a strongly beneficial effect on regional location. A less distorted tax system would allow both housing and labour markets to fulfil their allocative functions more efficiently.
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