House prices are surging because of low supply – it's Economics 101

Thu, 27 Oct 2016  |  

This article first appeared on The Guardian website at this link: https://www.theguardian.com/australia-news/2016/oct/27/economics-101-house-prices-are-surging-because-of-low-supply?CMP=share_btn_tw 

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House prices are surging because of low supply – it's Economics 101

As housing affordability becomes a live political issue there is a consensus from the government and opposition that housing supply can address the problem.

They are correct.

Tax rules on capital gains and negative gearing – which became central issues in the federal election campaign – distort the housing market, as do interest rates. But there is a basic economic principle that dominates these distortions over the longer run, and that is the interplay of housing supply and demand.

Until very recently, Australia’s strong population growth fuelled unrelenting growth in underlying demand for dwellings at a time when new building was not adding sufficiently to supply. This housing shortage, mixed with aggressive interest rate cuts and tax rules, underpinned strong house price gains.

Economics 101 suggests that for a given level of growth in demand (population growth and household formation rates) a larger increase in supply will lower prices, regardless of tax rules. Why would a potential investor in housing, for example, buy a property when house prices and rents are flat or falling?

New housing supply relative to a given level of demand will lower house prices and address housing affordability and issues such as negative gearing and capital gains tax will be largely immaterial. One only has to look at the recent trend in house prices in Perth (down 10% from the peak), Darwin (down 7%) and Karratha (down 65%) to show how a drop in demand relative to supply affects prices and therefore affordability. Anecdotally, there are very few investors lining up in those cities.

The tax rules still apply in those cities, which makes it a furphy to focus on capital gains tax and negative gearing rules as a long-run driver of house prices. They are still absolutely vital issues in terms of tax efficiency, fairness and equity but in terms of driving house prices, they are a second-order issue behind supply.

Investors see little or no benefit gearing up to invest in the stock market, where the returns have been problematic for many years, and prefer to invest in residential property where returns have generally been strongly positive.

The supply issue gets complex when the issue is boiled down to a state, city, regional or even a suburban level. It is not easy to add to supply around Sydney harbour, for example. But that should not distort the fundamental need for new building across Sydney.

A greater supply of dwellings will mean that both buyers and renters will be met with lots of choice. If the supply of dwellings increases by 1,000 and demand either from buyers or renters, from population growth and household formation, is an extra 900, the price of the house or rent must fall. This is regardless of tax rules. Why buy a property for investment purposes when the price is set to fall and/or the rental yield will fall given the glut of supply?
Note Perth again in this context, where the 10% fall in prices over the past 18 months or so has been matched with a 25-year-high rental vacancy rate and rents are falling sharply.

As noted, negative gearing rules and the very generous tax rules distort the market for investors when they judge the rental yield, capital gain and tax deductions will outpace the costs of undertaking that investment. It increases the amplitude of the house price cycle. It is not inconceivable that in a climate where prices and rents do fall, investors flee the market and sell into the falling market, driving yet more weakness.

It is also true that income tax scales influence investor behaviour as those paying the top marginal tax rates have a strong incentive to structure their affairs to reduce their tax. By way of illustration, if the income tax scale was zero (absurd, but this is to illustrate a point), negative gearing would not be possible. If the top rate was high and cut in at a low level, there would be a strong incentive to negatively gear.

The fact that the top tax rate has been increased in recent years and the threshold held constant has increased demand for investment properties. The end point is that tax issues, however broad, would count for little if a surge in housing supply swamped demand.

To be sure, it is difficult to engineer a lift in supply in the short run given the state and local governments largely control this space and new supply needs to be serviced by high-quality infrastructure (transport, schools, shops and the like) to make it desirable. But if Australia was ever able to sustain a lift in new dwelling construction, affordability would improve and the tax system would be debated on issues of fairness, equity and distortions.

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