Safety in Property Tax

House price inflation is back. As often before, it also imperils economic stability. The answer is radical property tax reform. This change would be particularly important if the UK adopted the euro.

The UK economy is more vulnerable to house price movements than other members of the European union: it has low transactions costs on housing; it has a high level of owner-occupation and a small private rented sector; and its financial institutions offer the highest ratios of loans to prices. Consequently, rises in house prices increase wealth and loan collateral, and fuel spending to a greater extent than elsewhere.

For this reason, the housing market poses one of the biggest risks to membership of the eurozone. Today, interest rates are almost down to eurozone levels. But the differences between the UK and most of the eurozone in the strength of consumer spending and the housing market are striking. A national property tax based on market value would therefore be a powerful stabiliser. Such a tax would siphon off the additional spending power automatically. It would also damp the portfolio motive for purchasing houses.

What is happening today underlines the dangers. House prices rose 16.2 per cent in the year to May of this year, according to the Halifax. Many of the forces driving the market are comparable to those of the 1980s. These include: high income growth; easy loan conditions for owner occupiers and now also for buy-to-let investors; still lower interest rates; and continued population growth. At the same time, increases in supply are modest. With mortgage borrowers able to borrow so much, spectacular rates of return have been achieved.

While price rises almost certainly have weaker inflationary consequences than in the 1970s and 1980s, the time lags are long and the effects unlikely to be negligible. The government may, for example, be unable to resist the pressure for higher pay from its employees, given its commitment to improving public services.

Against this background, the current property tax is remarkably inefficient and inequitable. It imposes the lightest tax rates on houses greediest for space, in the most expensive locations and belonging to those with more than one home. The announcement that the 50 per cent discount on second homes will, in future, be at the discretion of local authorities is merely an overdue step in the right direction. Tax rates are highest in Liverpool and lowest in Kensington and Chelsea. Moreover, within any local authority, small homes are most highly taxed despite the trend towards smaller family sizes.

Council tax should be made heavier and progressive. It is not difficult to deal with the most politically powerful objection - that a more progressive tax would impose a heavy burden on cash-poor, house-rich pensioners. Pensioners could be allowed to defer council tax until the property is sold or out of the estate. Regional inequalities in rates should also be eliminated. If politically necessary, the top rate of income tax could be cut to compensate those whose council tax bills would rise.

Alas, the government seems unwilling to consider ways of making such a reform politically acceptable. Yet the UK is the only country with an openly regressive property tax. It might be preferable, therefore, to abolish council tax. Local authorities could then be granted a local income tax, while taxation of property became national. This would be the simplest way to equalise rates across the country.

Two options might be envisaged. The first would be a tax similar to the old Schedule A, in which imputed rent for owner occupiers is treated as another form of income within the income tax. The other - and probably simpler - approach would be a national property tax based on market values, with revaluations every two years. The database and technology for mass valuations has improved greatly in recent years, making this more feasible.

Currently, council tax revenues are only 0.3 per cent of the value of UK owner-occupied housing. It is also far too weakly related to current market values. A rise to 0.5 per cent would still leave it lower than in most countries. It would also leave the mass of the electorate better off, since today's regressive element would be eliminated. The better off could also be compensated, if necessary, by a small reduction in the top income tax rate.

If introduced overnight, on a revenue neutral basis, such a reform could more than halve the current annual rise in house prices. Alternatively, the time scale of reform could stretch to three or more years. This would serve to damp expectations in the meanwhile. Either way, a reformed and more equitable property tax would increase economic efficiency and stabilise the house price cycle and the economy. This change is now overdue.
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