Be brave and tax UK property

With the housing green paper, the government has at last recognised that an important factor behind Britain’s high house prices is a lack of supply. It is less clear that it has grasped the fact that high house prices are supported by the twin pressures of supply and demand. A coherent policy would address both blades of the scissors.

Much housing is under-taxed. Someone who buys shares has to pay income tax on the dividends and possibly capital gains tax on the capital appreciation. Someone who buys a house is able to live in it paying council tax but no other taxes. This creates a strong incentive for people to save by buying housing rather than by buying shares, with the consequence that house prices are driven up. People who bought their houses cheaply some years ago enjoy capital gains that are not, from the point of view of the country as a whole, additional saving, but simply a transfer from those who do not yet own houses to those who do.

A government policy that makes it easier for people to buy houses, through shared ownership and help with deposits, increases demand and is likely to make the overall situation worse rather than better. At the same time rising house prices make stamp duty more of a disincentive to move, probably encouraging people to stay in houses that have become too big for them.

Until 1960 income tax was collected on the notional rent that accrued to owner-occupiers of land and property, providing a justification for the relief on mortgage interest that outlasted it by more than 35 years. Abolition of the tax did not remove the case for treating non-cash benefits arising from owner-occupation in much the same way as other income from capital. We sometimes hear the suggestion that capital gains tax should be levied on owner-occupied housing, but it is easy to see that this would act as a super stamp duty locking many more people into unsuitable housing. Given that most house prices can be estimated relatively straightforwardly, a much better idea is to levy a property tax on the capital value.

If one assumes a notional return of 4 per cent per year, a tax at 1 per cent of the capital value would amount to a tax on notional income at 25p in the pound. Such a tax levied last year on the basis of 2005 values would have delivered revenue of £33bn, compared with council tax of £22bn and about £5bn from stamp duties on residential property. So a change to a 1 per cent tax would allow room for a cut in other taxes, such as a cut in the standard rate of income tax by 2p in the pound.

But the redistributional effect of the tax would be substantial. Although houses are banded for council tax purposes, the tax bill increases much less than in proportion to the value of the house. A property tax would be collected from non-domiciled people with housing in Britain as well as from conventional residents. At present the combination of stamp duty on moving and council tax relief for single occupancy encourages people living in large and possibly unsuitable houses to stay put, while an annual property tax would encourage them to move. If the change from council tax/stamp duty to a property tax were spread over a 10-year period, the implications of the altered structure for house prices and thus people’s tax bills would be taken into account.

Such proposals are not new. The Lyons inquiry into local government pointed out that proportionate property taxes are used successfully in a number of jurisdictions, although Lyons was more concerned with finding a tax that might replace council tax than with addressing imbalances between housing and other forms of investment.

Following the principle that an old tax is a good tax, the government did not show much willingness to think outside the box in its response to the Lyons inquiry. In a country where 70 per cent of the population are owner-occupiers it is easy to see the obstacles to serious reform of housing taxation. But a few years ago rising house prices were seen as unalloyed good news; now there is much more understanding that they create very real economic problems for young people.

Perhaps, just as it was possible to build a bipartisan consensus for the abolition of mortgage tax relief, so all political parties will come to see that the imbalance that has developed from doing nothing is harmful to the economy.

The author is director of the National Institute of Economic and Social Research