Putting Property Tax on a Solid Footing

The increase in Stamp Duty of half a percent on houses worth £250,000 or more will do little to dampen the house price boom in substantial swathes of the UK. In contrast, property tax reform could have been extremely effective against this and other economic problems. The figure shows how the UK house prices/earnings ratio and how the South East minus UK difference in this ratio have evolved since 1970. At the end of 1999, year on year price rises as high as 20-25% were recorded in the South East and as low as 10% in the North.

Many of the forces driving the market are comparable to those of the 1980s: higher incomes; easy loan conditions; relatively low interest rates (even after tax relief vanishes); major rises in financial asset prices; rises in house prices themselves which increase the equity cushion of owners; and the feeling of consumers that recent high rates of return in housing will continue.

Spectacular rates of return are being achieved, since mortgage borrowers are gearing up and so investing relatively little of their own cash. For example, if prices rise 25% in the next year, and the interest rate is 7%, someone borrowing 90% of the price of a house and spending, say, 6% in total transactions costs including Stamp Duty, will make an 80% return in one year on the funds invested - and that leaves out the fact that home-owners pay no rent. With returns of this kind believed to be available by many in London and the South East, the rise in Stamp Duty will do little to dampen the market. Paradoxically, the impact of Stamp Duty will be felt more strongly in the next housing market downturn, when it will reduce mobility and have a larger effect on rates of return.

Consider the case for reforms to property taxes, currently the most distorted part of the UK tax system. The current system is perverse: the houses greediest for space, in the most expensive locations and belonging to those with more than one home attract the lowest tax rates. Council Tax rates are, for example, highest in Liverpool and lowest in Kensington and Chelsea. Moreover, within any local authority, it is small homes which are proportionately the most highly taxed, despite the trend towards smaller household sizes. Since Council Tax benefit is received by almost half of those in the lowest tax band, it also causes an unemployment trap.

Within a local authority where someone in a £40,000 house pays Council Tax of £500, a rate of 1.25 per cent, the tax rate drops to 1.07 per cent at £70,000, 0.47 per cent at £320k, 0.15 per cent at £1m. This is using (often hypothetical) 1991 valuations, increasingly remote from the market experience of valuers. Second or third houses attract only half the tax rate on first houses.

The New Policy Institute (info@npi.org.uk) have suggested ways of making Council Tax less grossly unfair. Reforms suggested by ourselves, see www.housingoutlook.co.uk, go further. They include allowing pensioners to defer Council Tax until the property is sold or it can be paid from their estate: this removes the biggest objection to a property tax, which is that pensioners in expensive houses often have little cash. We also propose regular revaluations and to reduce the regional inequalities in Council Tax rates. The introduction of a 35 per cent income tax band could compensate the more affluent whose Council Tax bills would rise.

For the macroeconomy, such a package would have helped to halt speculative fever in the property hot-spots and slowed the growth in spending in those areas, allowing interest rates and the exchange rate to fall. Instead, sterling rose 1% against the Euro after the Budget, in part, reflecting the market view of what the Monetary Policy Committee (MPC) would have to do.

In the absence of a stock-market crash, the house price boom has some way left to run. The MPC will surely push rates up only slowly, given the outcry over Rover, worries about much of the rest of the UK car industry and the parts of manufacturing and agriculture which have to compete against Europe. In any case, with the public finances in such good shape, gilt yields, against which fixed rate mortgages tend to be priced, will remain low and many borrowers will turn to fixed rate finance to escape higher floating rates.

The high exchange rate, moreover will raise relative unemployment and reduce relative earnings in the West Midlands and other parts of the economy more exposed to European competition. Migration to the South East will be supported by these trends, despite increasingly high housing costs, in turn tending to sustain higher house prices there. These patterns suggest that the South East - UK differential in the house price/earnings ratio could even surpass its 1987 peak.

A more level property tax playing field would have reduced many of these current and future problems - possibly saving Longbridge and Dagenham and helping to rescue farmers from bankruptcy. It would also prevent the waste of resources symbolized by empty homes in Salford and overbuilding in the South East.

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