The Price Cannot be Right: Taxation, Sub-Intrinsic-Value Housing Bubbles, and Financial Instability
Abstract
A “general formula” for the rental yield of a property is derived in terms of an exponential appreciation rate, a discount rate, a holding time, and a set of tax parameters, on the hypothesis that prices reflect net present values (NPVs) of future cash flows. Special cases are noted and interpreted. The formula explains the counterintuitive observation that a stamp duty on the purchaser can reduce the price by more than the value of the duty, and similarly predicts that a subsidy for the purchaser can raise the price by more than the value of the subsidy. But for some combinations of inputs, the formula predicts prices that clearly exceed buyers’ capacity to service loans. If the financial system tries to support such high prices, there will be a sub-intrinsic- value bubble – a condition in which prices, although lower than NPVs, are unsustainable due to unserviceable debt. The suggested remedy is to change the tax mix so as to bring NPVs within buyers’ capacity to service loans. This can be done by relying more heavily on land tax or capital-gain tax. As the latter does not need to be paid out of current income, it is more conducive to home ownership.