Mike Peacey, Post Graduate Research Student, Centre for Market and Public Organisation

It was the best of times. The UK economy was booming and mortgages could be taken out with a loan-to-value ratio (LTV) of 125%. It was the worst of times. The house price bubble had burst and inaugurated the worst financial crisis since 1929.

Fast forward five years and astonishingly the best of times seem to be coming back. Asset price inflation in the housing market is once again hitting the headlines. It’s no surprise that people want to get on the housing ladder after seeing how well their parents have done. The expectation that house prices will rise faster than other assets has been vindicated by decades of experience.

Many people hoped that the experience of the financial crisis might change these expectations, but recent events suggest this is wrong. Asset price bubbles present policy makers with politically difficult choices – particularly in the conduct of monetary policy.

Notoriously, the advantageous tax treatment of housing contributes to these problems. Today the most important advantage homeowners enjoy is private residence relief (PRR). In contrast to other assets, where capital gains are taxed, PPR exempts the payment of capital gains tax (CGT) on our homes.

This gives homeowners an unfair advantage over those with most other assets, and encourages asset price inflation – as one is willing to spend more on assets with such tax relief. Written by a youngster this blog post might just seem like a selfish way to buy a cheap house. The experienced forty-something shakes her head explaining “although I made £50k when I sold my flat, I needed this money to move up the ladder.” Removing the PRR exemption would mean less money to put towards her next property – but her next property would most likely be cheaper!

The losers from the elimination of CGT exemption will be “Last-time sellers” (LTS) – In practice the baby boomers. For future generations, the tax payments they make when they sell will be offset by lower house prices when they buy. The result is the necessary wealth transfer from the current baby boomers to the increasingly indebted youth. Moreover, the introduction of what would amount to a kind of Tobin tax should ensure the problem is never repeated.

The conventional wisdom is that the exemption of homes from the current system of CGT is politically impossible to reverse. However, the elimination of MIRAS (Mortgage Interest Reduction at Source), and the recent tightening of the rules in the coalition’s autumn statement (i.e. on 2nd homes and foreign owners), demonstrate that tax reform in the field of housing is possible.

Housing is not entirely exempt from taxation. Stamp Duty Land Tax (SDLT) is the transaction tax which is payable on the purchase of property. The infamous feature of SDLT is that the marginal tax rate will exceed 100% every time the price crosses one of the thresholds, because a single tax rate applies to the whole transaction. If CGT on housing is unacceptable to public opinion, SDLT is equally unpopular with economists (e.g. here, here, here, here, etc!). If it is accepted that an explicit extension of CGT to housing is politically impossible, perhaps SDLT could be reformed to incorporate an element of capital gains taxation whilst removing the distortions so disliked by economists.

This reform I am proposing would incorporate two elements, which together imply that the notorious ‘cliff edge’ would be removed.

The first change is that the tax would be paid by sellers rather than buyers. As every first year student knows this change should make no difference – since who pays the tax will depend of the relative willingness of buyers and sellers. However, it is not widely understood that, when buyer and seller bargain over the house price, the presence of a cliff edge tax means that this result does not hold. These cliff edges have been shown to suppress prices, so badly chosen alterations could increase house prices.

The second change is that the tax paid would be paid at a constant rate, which would depend on the seller’s capital gain. The cliff edge property would be removed (since any increase in the sale price would have a constant effect) and the rate at which these capital gains would be taxed could be very different from other assets.

In contrast to the current system the tax is only paid by the lucky winners, with those experiencing the largest gains paying the most. The proposal that the new tax should be paid by the seller has one further advantage. It will be much harder for the seller to “pass on the tax” by charging a higher price, than with a more conventional sales tax. This is because similar houses must sell for the same price – but the capital gain will be unique to the seller.

Finally, the principal should be established from the beginning that the treasury can change the rate in response to house price inflation.

This blog was first posted on the Centre for Market and Public Organisation (CMPO) blog on 3rd March 2014.