Rating the Housing Boom

Once again the UK is suffering unbalanced growth, led by consumer spending, asset price rises, and an apparent return to speculative frenzy in the higher-priced parts of the housing markets.

Price increases at the top end of the London market and other parts of the South-east, of the order of 20 per cent in the past 12 months and 7.5 per cent in the past three months alone, have recently been reported. These have been driven by a mix of rises in City salaries, rises in share prices and increased foreign demand, for example from Hong Kong. These rises are showing signs of spreading mid-market, as those priced out of, say, Hampstead, buy in less fashionable districts.

Expect soon to see evidence of the well established ripple effect from London and the South-east spreading to other regions. Our research (*) on booms and busts in the UK housing market indicates that once expectations of capital gains exceed the friction from transaction costs - the UK's are among the lowest in the world - speculation is likely to spread and be hard to stop.

As the housing market gets stronger, sterling has returned to the overvalued levels preceding our exit from the ERM in 1992, principally because of the UK's relatively high interest rates. This threatens investment and employment as well as worsening the trade deficit.

The 1980s taught us the inflationary consequence of house price booms. Through increased mortgage costs, which affect the Retail Prices Index, and through the increased wealth of owners fuelling consumer demand, they feed into the cost of living, and so into wage demands, and they distort regional labour markets(**).

The trick will be to avoid repeating these mistakes and to reduce the danger of missing the Government's inflation target. The measures proposed here would do much to dampen housing speculation, as well as deflating interest rates and currency expectations.

The main ingredients are:

• a modest rise in interest rates, signalling firmness of purpose;
• an increase in stamp duty on house purchases, say from 1 per cent to 2 per cent;
• the phasing-out of mortgage interest tax relief;
• reform of Council Tax.

The modest fiscal tightening of such package will help fill the hole in public finances. Moreover, the package will improve the economy's automatic stabilisers and resource allocation, as well as being seen as fair and equitable.

The rise in stamp duty would increase revenue by around £500 million. At current low interest rates, tax relief costs the Treasury around £2.5 billion. Phasing out tax relief will be perceived as a continuation of Conservative policy of recent years. However, given the current upswing in the housing market, it will now be correctly timed to dampen the business cycle. The most serious politico-economic argument against phasing out tax relief is that it hurts most those with mortgages closest to the tax relief ceiling of £30,000 - including those in regions with the cheapest housing, where prices have risen least. This is one reason why council tax reform is crucial.

A second is to avoid the further rises in interest rates that would otherwise be needed. Such rises would be particularly damaging for the many households still in mortgage arrears stemming from the house price boom of the late 1980s.

The council tax is in most respects highly regressive. There are eight valuation bands, ranging from A (under £40,000) to H (over £320,000), using 1991 valuations. Taking as reference two adults living in an £80,000 house (Band D), those in a £30,000 house (Band A) will pay two-thirds as much tax, while those living in a £320,000 house, or indeed, a £5m mansion (Band H), pay only twice as much.

The tax is also regressive across local authorities. For instance, the City of Westminster, with many of the most expensive dwellings, has the lowest council tax rates in England. Moreover, many current market valuations have since diverged from the notional 1991 valuations. There are now probably three times as many dwellings over the £320,000 threshold as in 1991.

It is a stark fact that if domestic rates had continued, and were still a similar proportion of income, they would now be raising £30bn in revenue. By contrast, the council tax collected only £9.8bn in 1996. While this might be regarded as making its regression less intolerable, the tax shortfall has been disproportionately borne by lower income groups through compensating VAT rises. There is scope for raising more from a reformed council tax.

Changes should be made immediately, even if they entail supplementary bills

But the council tax cannot be changed overnight. A phased reform would have four main elements.

• A minimum rate of tax. In 1996-7, six authorities out of 358 charged below £500 for a two-adult Band D residence. Imposing a £550 minimum for 1997-8 would iron out some of the worst of the regional discrepancies, and target those areas with the most affluent residents, where house prices have risen most.
• A supplement in 1997-8 on people in Bands G and H, making council tax less regressive. Doubling the tax on those in Band H (around 110,000 properties), and raising by 50 per cent the tax on those in Band G (around 700,000 properties), would raise around £800m in extra tax. These two measures should be implemented immediately, even if they entail councils sending out supplementary bills. An adjustment of revenue support grants would ensure that the extra funds generated would be recycled to reduce government borrowing.
• A further step towards reform that could be carried out in a year, is to make payment sin 1998-9 more nearly proportional to valuations, given that the banded system cannot be replaced by next April. This should, at the same time, lighten the load on the lowest house price groups.
• It will take two years to replace the current banded system, based on 1991 valuations, by a system based on current market values. However, it is administratively feasible to revalue within one year the 110,000 properties now in the top band and tax them on current market value in the 1998-9 tax year. Of course an important proviso would be a substantial exemption for stately homes (eg those for which one-third is open to the public for at least half the year) to avoid loss of national heritage. Indeed this provision might lead to more stately homes being opened to the public.

It is important that the reformed council tax be based on current market values, which can be indexed to local or regional price indices with a revaluation price indices with a revaluation every five years. The link to market values would make the reformed council tax a most effective automatic stabiliser. House prices tend to rise relative to incomes in an upswing particularly in consumption-led booms. After the reform, council tax revenues would rise faster than income in upswings, dampening the cycle.

In many Continental countries, the owner-occupied housing market plays a much smaller role in economic cycles because of high transaction costs, a less aggressively competitive mortgage market and a more extensive private rented sector. The UK therefore badly requires the economic stabilisers from higher stamp duty and particularly from reformed council tax.

The urgency is underlined by the fact that consumer spending, already raised by large gains in share prices, is likely to rise by a further £3bn or so in the next 12 months of the demutualisation of building societies and insurance companies.

Finally, property taxes in general have virtues in terms of allocative efficiency as well as equity. Public investment, good local schools and environmental planning controls all raise local property prices.

Not only is it right that the beneficiaries should contribute to the public purse in some proportion to the benefits, but the increased linkage should stimulate public investment in relevant projects.

(*) 'Booms and Busts in the UK Housing Market' by John Muellbauer and Anthony Murphy, The Economic Journal in November 1997.

(**)'The Great British Housing Disaster and Economic Policy' by John Muellbauer, IPPR Economic Study 5, 1990.
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