Testing for Persistence in Housing Price-toI ncome

Questions: 1.In your own words, summarize the article, Long-run Trends in Housing Price Growth, by M. Kohler and M. van der Merwe, Bulletin, September 2015, Reserve Bank of Australia. In particular, what are the main messages of the article? 2.Using appropriate diagrams, figures and data to answer: Are the Melbournes housing prices overheated? Why or why not? 3.Examine the impacts of this buyers tax on the equilibrium housing prices, consumer surplus, producer surplus, and total surplus 4.Can an increase in the buyers tax raise social welfare? Why or why not? 5.Can an increase in the buyers tax raise city governments tax revenue? Why or why not? 6.Provide your views or suggestions on the best measure to stabilize the housing markets that could be considered or used in Melbourne? Answers: 1. Summary of the article Kohler and Van der Merwe have discussed in the article Long run trends in housing price growth on housing price growth. Housing is regarded an important asset in Australian economy as it serves a role of investment vehicle and durable goods. Therefore, fluctuation in housing price affects the housing consumption and other investment in the economy (Nicholson and Snyder 2014). This article highlights the Tobins Q relationship between investment and interest. Interest rate charged by the financial institutions is cost of investment. Therefore, Tobins Q theory depicts that investment in an economy is taken place as long as the expected return from the investment is greater than the cost of investment (Hall and Lieberman 2012). Fluctuation in housing price mostly affects the small business investment in the economy. The article has highlighted that housing price of Australia has risen more than 7% yearly on average. Housing price fluctuation and its effect on economy has been highlighted in this article. The long run housing price growth has been discussed with stock flow model. Impact of several economic variables such as demand and supply, inflation rate, cyclical factors has been considered in this analysis. The stock flow model shows a negative relation between the demand for housing asset and user cost. In the short run, adjustment of demand for housing is easier compared to the supply of housing as time lag is associated with the construction of new building (Alcock et al. 2013). Demand for owning a new building depends on permanent income of the households, borrowing cost of fund, depreciation of asset and expected real rate of housing price appreciation. Inflation is a crucial factor that affects the housing market. The trend of Australian housing market shows that housing price is positively related to the consumer price index. Housing prices, value of new dwelling and new dwelling cost have risen along the same line with CPI. However, after 1990, housing prices grew at a faster rate than value of new dwelling and CPI. The possible reason mentioned in the article for this drastic housing price growth is improvement in quality of housing such as increase in floor space, addition in modern convenience (Bouchouicha and Ftiti 2012). Housing price in Australia has been affected by financial deregulation, low inflation rate, population growth and cyclical factor. Financial deregulation in Australia after 1990s resulted in low inflation and interest rate. Therefore, borrowing cost had been reduced to make user cost less costly (Yunus, Hansz and Kennedy 2012). Hence, demand for housing price rose, which escalated the price of housing at a greater pace compared to the value of new dwelling. Underlying demand for new dwelling is unobservable. However, three components of underlying demand for new dwelling in the context of Australian economy have been mentioned in the article such as vacant dwelling, replacement demand and demand from newly built dwelling. Population growth and net immigration in Australia were during 1990-2000 and started to increase after 2000. As demand increased, the average household size started to decrease to adjust with the supply side rigidity in the short run (Bordo and Landon-Lane 2013). This supply side lag plays an important role for the developers in the decision making process. The gap in demand and supply is mostly seen in New South Wales, Queensland and Western Australia. The factors such as population growth, inflation rate, and underlying demand for housing are the determinants of long run housing price movement. However, cyclical factors influence the short term growth of housing price. Monetary policy is considered to have a strong effect on the new dwelling market (Jord, Schularick and Taylor 2016). Mortgage rate in Australian capital market has been kept low to encourage consumption of housing in the economy. The article has found out a positive relation between the growth rate of nominal housing price and debt income ratio of the household. Debt to income ratio is the ratio of recurring monthly debt such as mortgage, credit card payment, student loans and gross monthly income. It indicates that as demand for housing increases, debt to income ratio increases and that pushes the housing price upward (Evans 2012). Statistical result shows that gap between underlying demand and supply is also positively related with the housing price in the Australian housing market. Empirical study in this article found that real income growth has accelerated the housing price in the Australian economy. Therefore, this article discusses the reasons of booming housing market in the Australian economy. 2. Assessment of Melbournes housing prices Melbourne housing prices Year Index Annual % change 200203 54.1 n.a. 200304 60.1 11.2 200405 61.2 1.8 200506 63.9 4.5 200607 70.4 10.1 200708 84.1 19.4 200809 83.5 0.7 200910 100.2 19.9 201011 104.8 4.6 201112 100 4.5 201213 100.5 0.4 201314 110.3 9.8 201415 118.1 7.1 201516 131.2 11 Table 1: Housing price index of Melbourne (Source: data.qld.gov.au 2016) Figure 1: Melbourne housing price index (Source: created by author) Table 1 and figure 1 show that housing price index of Melbourne has positive trend over the years. The data table shows that housing price fell during 2007-08 due to an effect of global financial crisis. The same consequence has occurred in 2011-12. However, the housing price index has risen over time due to increasing demand. During global financial crisis, the real estate market crushed in many countries. Australian housing market was also affected. As stated by Davey (2016), the reason behind high growth of housing price in Melbourne is increasing demand and sticky supply in housing market. Low interest is the reason, which increases demand over the supply. Moreover, as mentioned by Kusher (2016), population growth in Melbourne is growing. Population growth rate is important factor for increasing demand for housing. As supply of housing is inelastic due to high cost of construction, price of housing tends to increase. Case, Fair and Oster (2014) opined that falling interest rate is the main reason of rising property price in Melbourne. Australian monetary authority, Reserve Bank of Australia has kept mortgage rate and interest rate on housing loan at low level to encourage investment in real estate. Low rate of interest encourages investment. Therefore, demand for vacant housing and new dwelling have been increasing in Melbourne. However, in the view of Burda and Wyplosz (2012), the housing price is not overheated and still achievable to the households as the growth of price is single digit rather than double digit. Sweeney (2016) stated that Melbourne market is less volatile than Sydney market. Price rise and fall in Sydney market, both are faster than any other cities in Australia. On the other hand, Melbourne housing price movement follows a cycle. Housing price in Melbourne tends to rise during first two years of a cycle, which is around 20-25%. Housing price increases at a moderate rate, whic h is around 3-7% during remaining years of the cycle. According to the researcher of Melbourne University, Kate Raynor, housing patter is different in Melbourne cities, which reflects the growth in housing prices. Development of small inner city apartment has been occurred for the housing investors. In the view of Raynor, high density apartment in the CBD of Melbourne creates a demand supply gap in the housing market as investors are given more priority than the end users and occupants (Zhou 2016). Sweeney (2016) has mentioned possible causes of housing price boom in the Melbourne market such as mining boom, increase in oil company revenues. Demand for labour has increased in both the mining and oil companies and hence, demand for housing has increased as well. As cited by Zhou (2016), temporary boom factor influences the housing more than permanent or temporary shift of population. When an industry progresses due to economic growth, people comes to cities and try to occupy houses in the central business districts due to several facilities and to reduce transportation cost. In order to adjust supply with demand, housing sizes decreases per family. User cost of home owner, rent and investment property rise as a consequence. Shortage of suitable trade people, shortage of suitable zone and difficulties in building permit process are the main constraints of supply of housing in Melbourne. Interest rate on loan is 1- 1.5% during last 40 years in Australia, which encourages investment in housing market. Nominal interest remains low as the inflation rate in the Australian economy is stable and set at a very low level. Therefore, both the factors have kept housing price at high level. Lawless (2016) mentioned that rental returns move up and down with property prices and real rents during every cycle. Price of housing has increased in Melbourne housing market more than the value of new dwelling. Value of new dwelling in Melbourne market has increased due to improvement in housing quality. However, housing prices have been risen due to population growth, demand for labour, demand for rental and owner occupied housing, low interest rate and inflation rate. 3. Effect of buyers tax Melbournes housing market is perfectly competitive. If the buyers tax is imposed in the market of amount t, the situation will be as given in the figure below: Figure 2: Increasing price due to increase in buyers tax. (Source: As created by the author) The previous equilibrium according to the figure above shows that with previous demand curve and supply curve, the equilibrium quantity was Q and the equilibrium price was P. The new equilibrium, which is for the short run, states that the price is P1 and the quantity being sold at that price is Q1. As shown in the figure above, the supply curve will be the same in short run. As a consequence of buyer tax, the demand for housing would be reduced. Therefore, demand curve shifts towards left at a given price. When demand curve shifts downward by the amount of tax per unit. When demand is reduced, price falls to adjust with the existing supply of housing. At point B, the price is much lower. Therefore, people again tend to increase their housing consumption. Price further starts to rise due to increase in demand. New equilibrium is achieved at P1, where quantity demand for housing is Q1, which is less than initial equilibrium. According to Nicholson and Snyder (2014), this increase in price results in decrease in quantity demanded, following the law of demand. When other influential factors such as taxes on goods changes, demand curve shifts accordingly. Imposition of buyer tax reduces the purchasing power of people at a given price. When tax per unit, t is imposed on buyer, the demand curve shifts downward and the price reduced to p. At lower price, excess demand for housing is created in the market. According to Hall and Lieberman (2012), suppliers of housing for investment or residential purpose, they raise the price per unit. New equilibrium is achieved at the point E1, where new demand curve cut the supply curve at a higher price. GAP was the consumer surplus and AHP was the producer surplus before imposition of tax on buyers. The consumer surplus and producer surplus both change after imposition of tax. New consumer surplus is APH and producer surplus is E1P1H. As the supply of housing is less inelastic in short run, effect on producer surplus is more than the consumer surplus, as the equilibrium price is reduced and there remains excess capacity in the market. AE1B is the dead weight loss or total welfare loss in the economy. This portion of the market is accrued by none of the producers and consumers. 4. From the figure above it can be concluded that the implementation of the buyers tax will not increase the social welfare. On the contrary, it will reduce the social welfare. As the tax t is levied on the buyers, it will reduce the potential output. This will cause for market inefficiency. The society will lose ABE1 from the total welfare. The previous equilibrium came from the invisible hand of the market. It provided the efficient market price and quantity. Following the ideas of Case, Fair and Oster (2014), it can be stated that, the forced increase in the price level by implementing the buyers tax reduces the market efficiency. It will increase inventory accumulation for the suppliers. Without the implemented tax, the price level P corresponds to the output level of Q. After the city government of Melbourne introduces the buyers tax, the social welfare decreases due to the market inefficiency (Kumlin and Stadelmann-Steffen 2014). This loss in total surplus represents market fai lure, where the potential is not being achieved by the agents of the economy. Surplus accrued by producers and consumers are reduced after imposition of tax. Therefore, social welfare is reduced. 5. Figure 3: Tax revenue for the city government. Source: As created by the author. Following the figure above, it can be said that the implementation of the buyers tax will increase the tax revenue for the city government. The increase will be equal to the amount D. The total area of the tax revenue increase will be (t*Q). t is the difference between the new and old price level. But, in order to doing so, the government will witness that social welfare will not increase due to this policy measure on the city Melbourne. Following the ideas of Rubinfeld and Pindyck (2013), it can be stated that, this situation will drive some of the customers away. This will reduce demand and the quantity being sold. But the price level is apt for more production. Hence the occurrence of dead weight loss will happen. In the figure, there was no previous buyers tax. Hence the tax revenue from this section was zero. According the views given by Katzner (2015), the new tax implementation will increase the governments tax revenue by the D amount. It will stop the city from growing at its potential rate as there will be market failure in the economy. The inefficiency in the market will later result in the long run negatively (Andre, Gil-Alana and Gupta 2014). The government can use this tax revenue for the social welfare. But it has already reduced the total surplus for the society. 6. Explanations of housing policies Housing policies in US The first housing policy that is being discussed is about US. US state and local programme offers subsidised housing for low income households. It is also consistent with the increasingly important role that state and local governments play in the formulation and execution of housing policy. Regulatory reform at the late 19th and 20th century stated that every housing needs to have minimum standard of lighting, proper ventilation, fire safety and sanitation (Hilber 2014). It is commonly seen that, public housing mainly depends on government agencies and other housing demand depends on profit o non profit developers. State and local authorities have the right to say that what kind of building needs to build in the city. Federal government in US gives large housing subsidies to the affluent households in terms of tax benefits to the home owner. Investment in owner- occupied housing offers three types of tax advantages. The return on investment from owner occupied housing are untaxed in US under US internal revenue code. Instead, the dividend yielded by common stock is reported every year and is taxed (Rerat 2012). Huge capital gains exclusion is available to the person above 55 ages. Property taxes and mortgage interest payment are federal tax liabilities. Housing policies in UK Housing in UK is classified as per tenure such as owner occupied, local authority housing, registered social landlords and private rented housing. Housing prices in UK is up ward trending like Australia. Hilber (2012) mentioned that housing price in UK during 2014 was second highest in UK. Valuation of housing is also high. Supply side of London is less elastic due to small geographical area. Although housing prise is rising in UK, homeownership rate has decreased. Government and property developers cannot meet the rising demand and hence a gap between demand and supply is creating. Moreover, high population growth, rising real income are major reasons for rising demand. In order to stabilise the market, the government has decided to increase housing prices rather than removing supply side constraints. The mansion tax has been imposed by UK to make expensive houses affordable to all income groups. Bed-room tax is popular in UK. However, affordability crisis in UK housing market has influenced the housing price. () stated that improper housing policies is the reason that housing price is overheated in the market. Housing policy of Switzerland Switzerland is a highly decentralised economy. Interest rate in this economy is kept low with fixed mortgage 1%. The economy experiences foreign immigration and hence creates pressure on demand and price of housing (personal.lse.ac.uk 2014). Tax system in Switzerland is comparably neutral towards home ownership. Tax is imposed on imputed rental income for owner occupiers. Mortgage interest is deducted from owner occupiers and land lord. Supply side of housing market is flexible in this economy. Therefore, Switzerland is experiencing a construction boom since 2009 (Hilber 2012). Prices of housing have increased in this market, however less than UK and Australian economy. Figure 4: Real housing price index of Switzerland (Source: personal.lse.ac.uk 2014) Recommendation for stabilisation of housing prices Among the housing policies of three countries, that of Switzerland can be said to be successful. 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