Summer Budget: Housing Market Consequences

The Summer Budget contained two substantive housing market related policies. First, the effective raising of the inheritance tax threshold for property by £175,000 per person, meaning a couple can bequeath their family home to their children or grandchildren without any tax due up to £1,000,000 (after the mortgage). Second, buy to let landlords who claim tax relief on their mortgage interest payments will only be able to do so at the basic rate of tax from 2017 (phased in over four years). Working out the net effect has some subtle twists.

One way to interpret housing policy changes is to recognise that, unlike a standard commodity market, the housing market is dominated by the existing stock.[1] The existing stock of UK houses is 23.4 million while the net supply of new housing is 137,000 per year, or 0.59% of the stock.[2] The number of transactions of existing homes is nine times greater than of new homes. This is all another way of saying that the existing housing market is dominated by existing rather than new supply.[3] While everyone knows we need more new housing supply, in the short and medium term the supply of existing homes tends to dominate.

The dominance of the stock means that, for a given change in demand, the willingness of current owners to put their homes on the market (and downsize or rent) matters as well as net new supply. For a given change in demand, the impact on prices will be bigger the less responsive or more inelastic the supply of existing homes. So what does this depend on? It depends on transaction costs which are partly fixed but also negatively affected by taxes like stamp duty and the more that houses are used as an after tax store of wealth. This is where the tax changes come in.

A less responsive, or more inelastic supply curve, means that for any given change in demand the change in price will be greater, all else equal. Therefore, the housing market is likely to be more cyclical to future changes in demand, feeding into financial stability, as a result of the policy change.

Why does this matter for the current proposals? Let’s take the rise in the inheritance tax threshold first. A number of consequences follow. First, the increase in after tax returns from investing in housing relative to alternative assets is shown will lead to a shift in demand from D0 to D1 and the higher prices and number of transactions. Second, existing home owners are now less likely to sell or downsize as the after tax returns are now higher. This will reduce the elasticity of supply of existing homes with the supply curve shifting from S0 to S1 with the result of higher prices again. There may even be a third effect. The increase in household wealth in housing may lead to an even less flexible planning system. Incumbents will want to restrict supply to protect their own wealth. All told, this simply gums up an already inefficient market. [4]

And what of the reduction in tax deduction for landlords? This has the opposite effect of making buy to let activity less attractive than other forms of investing. As a consequence, there is likely to be a fall in demand with the demand curve shifting back towards D0. This will lead to a lower level of house prices. Existing landlords are less likely to hoard properties as after tax income is lower and the supply curve is likely to become more elastic or flatter – closer to S0. The reduction in tax relief is a welcome policy and will make the housing market less expensive and less prone to house price cycles for given demand shocks.

One metric by which to judge these policies is the extent to which they lead to a more elastic supply of existing homes for a given demand shock. The more elastic the supply of existing homes, the less impact a demand shock will have on price and the more likely that we will see families living in suitable sized homes. From this regard we see one negative policy (the inheritance tax change) and one positive policy (the buy to let change). This is a missed opportunity. Indeed, much of the home ownership, aspiration and added tax benefits look similar to government policy before 2007.

Figure 1: Transactions model of the market for existing homes