Tax breaks are no solution for Ireland’s growing housing crisis

The pressures in the housing market are still growing and there is no "quick fix" available for what is, essentially, a shortage of supply.

Even if enough “shovel ready” projects were on hand, it would take a year or two to implement them. However, the pipeline of projects is thin. Thus the problem of rising demand, confronted by pretty fixed supply, is likely to result in continuing upward pressure on both rents and prices for the next year or two.

Faced with the social and economic problems that result from the escalating cost of accommodation, demands to find policy solutions are increasing. Unfortunately, the only true solution to the problems will involve tackling the constraints on increasing housing supply, something that will take some time to take effect.

Meanwhile, a wide range of other measures are being canvassed, many of which would, at best, have no effect and in some cases could make things worse. In particular, there are calls for tax reliefs of different types targeted on the housing sector. One suggestion is to reduce or eliminate VAT on new houses.

The Department of Finance recently published a useful ESRI analysis of the economics of such tax incentives. It shows how incentives, such as a cut in the VAT rate, would benefit only property developers and owners of zoned land at the expense of the taxpayer.

Earlier studies had shown the tax incentives for property, introduced in the late 1990s and early 2000s, were an important factor leading to Ireland’s disastrous property bubble. Given what the people of Ireland have been through over the past eight years as a result of the bursting of that bubble, it makes no sense to repeat the mistakes of the past by using scarce taxpayer funds to help property developers and landowners today.

The reason tax incentives are a bad idea under current circumstances, and why the Minister for Finance resisted lobbying for tax concessions for the building industry in the Budget, is reasonably clear.

Think of an auction with two bidders: one is prepared to pay €300,000 and one is prepared to pay €320,000 for the same house. Left to their own devices the house would sell for €300,001 to the person with the biggest budget, in other words, just above what the underbidder is prepared to pay.

If the Government eliminated VAT on the house, the price the two bidders would each be willing to pay would be unaffected and the house would still sell for €300,001. However, in this case the person selling the house, the builder, would obtain all of the benefit of the cut in the VAT rate, about €30,000.

Builders’ profits

If the end result were an increase in builders’ profits, this might not be a bad thing: it would encourage much more building. However, that would not be the end of it. Builders have to buy land and when the builder, who made an additional €30,000 on the house they had just sold, came to buy land for the next house, they would have €30,000 more to bid for the land.

Competition between builders would ensure that such a reduction in VAT would not significantly enhance their profits. Instead, all of the cut in VAT would result in higher prices for building land.

The ultimate effect of cutting VAT would be an increase in the value of land, a pure windfall gain for the original landowners. Housebuyers would still be spending the same amount, but the Government would have to raise taxes elsewhere to pay for the VAT giveaway. The net beneficiaries would be a few very happy land-owners, and the losers would be the people of Ireland who would have to pay higher taxes.

Property taxes

This example of how changes in taxes can end up affecting people other than the taxpayer is not an isolated case. In the 1970s, property taxes (then called rates) were abolished.

[ Subsequent research ]

by the ESRI showed an effect of abolishing rates was to increase house prices.

So, too, the decision by the Dublin local authorities to cut property taxes next year will put some further upward pressure on house prices, while leaving less revenue available that might have been used to tackle the problem of social housing.

An effect of the current housing shortage, and rapidly rising prices, is higher values for existing properties, especially much higher prices for building land. The long-term solution must involve increasing the supply of land available to builders.

However, it should also involve the introduction of new tax measures to claw back a substantial part of the gains that existing owners of development land will receive from the higher house prices.

Rather than trying to directly control or restrict the rise in price – something that could produce serious distortions in such a tight market – the best solution is to capture the gains from the rise in prices for the people of Ireland through suitable tax measures.

Looking for instant solutions to the housing problem will only end in tears. Care needs to be taken that any new policy measures will make things better for the large number of people seeking a new home.

The State needs to prioritise the really hard cases through rent support and finance this through recouping the windfall gains from existing property owners through the tax system.

A properly designed package of tax and welfare measures could help tackle the problem of homelessness and raise more revenue for the Government to fund future investment.

In the long term the only answer is to increase housing supply.

ESRI: Tax Breaks and the Residential Property Market is available at iti.ms/1MTKtLU.

ESRI: A Study of New House Prices in the Seventies is available at iti.ms/1KoKjpB