UK Housing Market
Effects of rates reform

The UK Government has brought forward legislative proposals to replace domestic rates in Scotland by a community charge, starting in 1989. A similar reform of the rating system in England and Wales had been expected to follow after the Scottish reform had been completed, but this process will now be set in motion earlier. The replacement of domestic rates will increase the demand for housing and may therefore increase average house prices by as much as 12% in the South-East and 26% in Scotland, Gordon Hughes told a CEPR lunchtime meeting on 8 January. These price increases were three times larger than those predicted in the Green Paper on rates reform. The consequent prospect of large capital gains on housing would make owner-occupation even more attractive, at least in the medium term. Hughes also discussed evidence which suggested that domestic rates fell more heavily on urban than on rural dwellings: removal of these rates would therefore shift demand towards urban housing. This might result in sharp increases in house prices in inner urban areas and unprecedented pressure on the planning system. It would be prudent to analyse the effects of the rates reform in Scotland before this policy is extended to England and Wales, Hughes concluded.

Gordon Hughes is George Watson's and Daniel Stewart's Professor of Political Economy at the University of Edinburgh and a CEPR Research Fellow. He has written extensively on the economics of taxation, housing and labour markets and has contributed to the forthcoming volume The Reform of Local Government Finance in Britain, edited by S J Bailey and R Paddison (Croom Helm 1987). The meeting at which he spoke was one of a series in which CEPR Research Fellows discuss policy-relevant research. The opinions expressed by Professor Hughes were his own, however, and not those of CEPR, which takes no institutional policy positions.

Most of the discussion of domestic rates reform has concentrated on its effects on the distribution of income, which will depend greatly on the rebates available to low-income households. Hughes chose to focus instead on the impact of rates reform on the housing market: this, he argued, would be more important in the long run. In his research, Hughes analysed domestic rates as a form of indirect taxation on housing services. In order to assess the tax rate on housing services, Hughes first had to estimate the annual value of these services to the user. He calculated this user cost by multiplying the estimated capital value of a property at current prices by a standard rate of return (3%) and then adding an imputed allowance for maintenance, and the rates. This calculation yielded an average 'tax rate' (i.e. domestic rates divided by the estimated cost of housing services) which in 1985 ranged from 26% in Wales to 48% in Scotland. The tax rate on housing services was much higher than that of other indirect taxes, e.g. VAT at 15%. It is not surprising, Hughes observed, that pressure to change the system is greatest in Scotland, where the average tax rate rose from 25% in 1974 to 48% in 1985.
Abolition of rates was equivalent to removal of an indirect tax on housing services. This reduces the relative price of housing services and so tends to increase the general demand for housing, relative to other goods and services. In order to estimate this increase in demand and its effect on the housing market, Hughes constructed a model of household expenditure patterns, based on a large sample of households taken from the UK Family Expenditure Survey. The magnitude of the increase in housing demand will depend on the responsiveness of households' demand for housing to changes in its price, i.e. the price elasticity of demand (the percentage change in demand divided by the percentage change in price).

The impact of rates reform also depends on the elasticity of housing supply, which determines how far this increased demand will be met by house price increases and how far by increases in the housing stock. Hughes observed that, in the short run, the supply of housing is relatively inelastic, and that the abolition of domestic rates will therefore lead mainly to increases in the prices of existing houses and of land already set aside for residential development. The longer-run impact of the reform will depend on how rapidly housing supply adjusts to changes in demand. The strong resistance to any expansion in housing supply which involves encroachment on 'Green Belt' areas in the South- East of England, for example, suggests that even in the long run the supply of housing is not highly elastic. Hughes analysed the likely impact of rates reform in each region separately, assuming that it would have no effect on the distribution of population across regions. He also assumed that the housing market clears and that the elasticity of supply was 1.0 in the medium term, which he regarded as an overestimate.

The Green Paper presents only illustrative calculations of the effects of rates reform on house prices, based on a price elasticity of housing demand of between -0.5 and -0.8. These calculations suggest that average house prices were likely to increase in England by at most 5% over ten years. Hughes's analysis, assuming a similar elasticity of -0.75, suggested that over a five-year period average house prices will increase in real terms by 12% in the South-East and 26% in Scotland. He found that for the Green Paper's estimates to be correct, it was necessary to assume a demand elasticity of -0.25, which is implausibly low.

Hughes also discussed simulations of the long-run effects of rates reform, in which he assumed that housing supply was perfectly elastic, completely accommodating the increased demand resulting from reform and leaving house prices unaltered. This is an extreme assumption, which showed the maximum possible impact of rates reform on the demand for housing. The simulations predicted an increase in housing demand which varied from 21% in the South-East to 43% in Scotland. Since the stock of housing in Scotland is unlikely to increase by over 40% without a substantial increase in both land and housing prices, the most plausible long-run effect of reform is a mixture of price increases and increases in housing supply.
The abolition of domestic rates will also have a significant impact on the composition and location of housing demand. Hughes's analysis indicated that rates represent a heavier tax on council housing than on owner-occupied housing. Replacement of domestic rates will therefore cause a proportionately greater increase in the demand for housing by council tenants. This need not, however, lead to higher demand for council housing. The net cost of housing services will fall in all sectors, and the prospect of a sharp increase in house prices will create short- run capital gains for owner-occupiers; both factors may encourage larger numbers of council tenants to opt for owner-occupation.

There are indications that, at least in Scotland, the ratio of rateable values to the capital value of the housing stock is higher in urban than in rural areas. The abolition of rates will thus reduce the cost of, and increase the demand for, urban relative to rural housing, particularly in central city or inner suburban locations where it is difficult to increase the housing stock. Increased demand may therefore lead to large shifts in the price of inner urban relative to rural housing, increase conflict over the granting of planning permission for residential development, and intensify the strains placed on the planning system.

The abolition of domestic rates in Scotland will be 'an enormous shock to the housing system', Hughes argued, and 'a classic experiment in economic policy'. The rate revaluations of 1978 and 1985 provide us with more data on the housing market in Scotland than elsewhere. Rates represent a very heavy tax on housing in Scotland, and the removal of this tax should have readily observable effects on house prices and demand. Rates reform in Scotland should therefore be accompanied by studies to allow the government to assess its effects more reliably, before deciding whether or how to proceed in England and Wales, Hughes concluded.

The audience of owner-occupiers was delighted with the prospect of capital gains outlined by Hughes, but questioned some of the assumptions behind his calculations. He had assumed that the pattern of central government support to local authorities under the community charge would be largely unchanged from the pattern of Rate Support Grant. But the Department of the Environment expects that authorities who spend less than their Grant-Related Expenditure Assessment (GREA) will gain significantly under the new system and that those who spend more relative to their GREA will lose out. It is possible, for example, that in the inner London Borough of Camden the average community charge per household will be twice the present rates, whereas in Buckinghamshire it may be about a half. It was also pointed out that the Department of the Environment chose a different measure of the rates burden than did Hughes, assessing it instead as a percentage of the costs to the user of rents, upkeep, etc. Hughes conceded that there had been very little serious analysis of the UK housing market at a microeconomic level. His model was drawn, however, from an investigation of housing demand by CEPR Research Fellow Mervyn King, and was based on a sophisticated econometric analysis of detailed survey data.