The answer to the mess of property tax

Tax reform is a crucial part of the solution to the UK’s housing problems. Some proposals—such as taxing sites with unbuilt planning permissions—come around frequently despite their lack of merit. Improvements in the taxation of housing have little attraction for politicians, as they need to be gradual—so they don’t offer quick fixes—and are controversial.

Tax proposals should come from a clear diagnosis of the housing market. The key issues can be expressed simply, although details may differ according to location. Because England is densely populated, we are reluctant to build as much new housing as rising incomes and a growing population demand. Consequently the price of housing space tends to rise relative to incomes.

The expectation that price rises will continue encourages first-time buyers to stretch their mortgage capacity and older home owners to remain in larger houses. These incentives are enhanced as principal residences are free from capital gains tax and increasingly from inheritance tax.

Housing has a particular combination of features. It is regarded as a good to which all should have access. It is both a consumption good and a long-term investment and new supply carries environmental costs. Arguably the consumption of housing is already taxed, through council tax, but this bears little relation to housing values. Investment returns to owner-occupiers are little-taxed. VAT is not charged on new housing, though it is levied on renovations and extensions. Finally, stamp duty is charged on housing transactions, though most economists regard this as a bad tax in principle.

Tax changes are needed that encourage more housing supply (including expansion of the existing stock) and discourage housing as an investment (although to some extent housing will always be part of financial planning). I’ll make five proposals.

First, it’s often argued that a land value tax would boost new housing supply, and there is a case for such a tax at a low level for reasons of equity. However, the planning system means that there is already a very large incentive to use land for housing, so unless this tax were rather high it is unclear that it would change new supply significantly (although it would lead to an immediate fall in land values). More helpful would be to tax vacant or underused brownfield land as typically these are areas the planning system wishes to see brought into use. Revenue from this tax could fund a reduction in stamp duty. Adjusting the duty rates can be a useful tool for short-term housing market management.

Second, there is a troubled history of taxes on development gains—as every site is different, it is hard to devise a charge that is simple and effective. Too much is expected from new construction in terms of infrastructure contributions; it would be better to look to the existing stock of property.

A revaluation of property for council tax purposes is overdue. Since this exercise will create losers, changes should be brought in gradually to avoid market disturbance. This should be coupled with adding more bands to council tax at the top, and phasing out the single person discount, or at least making it less generous. The increased revenue would then fund better infrastructure.

Third, VAT on significant renovation or extensions should be abolished, to support densification and better use of the existing stock. Fourth, keeping council tax more in line with housing values will complicate local government finance, but reduce the incentive to use homes as investments.

A radical tax change would be the introduction of a capital gains tax, starting from these new valuations, charged at the time of the last lifetime sale.

This would bring complexity, including to the valuation basis for mortgage lending, but would be a really important shift away from allowing the unearned house price gain to accrue to the homeowner. It would also signal to landowners that future land price rises will be more limited.

Five, the taxation and regulation of the private rented sector should be reviewed to ensure landlords are not unduly favoured by the tax system.

New housing is often locally unpopular, but we need to increase new supply. With the Conservatives apparently set for a long period of power, we should start moving towards a system of housing taxation that would encourage better use of existing stock, provide more funds for infrastructure and discourage the investment motive in house purchase. Without this it is hard to foresee a housing market which works better for today’s young people.