A report on the impact of the property market on the public finances has estimated, in a worst-case scenario, a severe downturn in the construction sector could result in a 3 billion shortfall in tax revenue next year.
The Davy Stockbrokers report prepared by economist Rossa White, also says that the abolition of stamp duty on property is 'risky', saying the Government would have to plug a 2.7 billion revenue gap. It says this could amount to 'an inequitable cash transfer', as existing home-owners and developers would gain.
The Davy report says tax revenue from the property market - including VAT, stamp duty and capital gains tax - has tripled since 2002 and will account for almost 17% of tax receipts this year. It says the public finances are now exposed to a downturn in the property market.
Property market accounts for one-sixth of tax revenue
- Tax revenue from the property market (VAT, stamp duty and capital gains tax) has tripled since 2002.
- Revenue from the property market will reach almost 7.5bn (5% of GNP) this year and accounts for almost 17% of total tax revenue, up from 5% eight years ago.
- Government finances now exposed to property market downturn
- Davy estimates that each 1% change in the volume of property built or traded could cost as much as 105m in tax foregone; each 1% change in price is worth about 75m.
Deficit may approach Maastricht limit in the event of severe correction
- Davy models the direct and second-round effects of a construction downturn on tax revenue: in the worst case scenario, tax revenue may undershoot the Budget 2007 target by more than 3bn.
- The general government deficit may near the 3% Maastricht limit if price and volume both drop 20%.
Assumption that the government will raise infrastructure spending to compensate for slowing market is dangerous
- Shrinking tax revenue may limit that option.
Abolition of stamp duty on property risky
- Davy says this measure would cost around 2.7bn. Existing home-owners and developers may gain, but the government would have to plug the revenue gap.
Property market accounts for increasing share of tax revenue
Record housebuilding; healthy investment in retail space, offices and warehouses; and surging prices for houses and commercial units have led to rampant growth in property-related tax receipts.
The key property tax rates are as follows:
− VAT is charged at 13.5% on new housing (the end-buyer pays the VAT-inclusive price).
− Stamp duty is charged on new and second-hand housing, based on a rising scale in line with price.
− Stamp duty is charged at 9% on commercial property sales and the disposal of lands.
− Capital gains tax is charged at a rate of 20% on the disposal of residential (as long as it is not a principal private residence) and commercial property as well as the sale of lands.
VAT on new housing has increased eight-fold since 1997
By the end of this year, annual VAT accumulated on new housing sales will have jumped eight-fold since 1997. Total revenue from that source was less than 400m nine years ago; it rose five-fold to reach 2bn in 2004 and may amount to 3.2bn for full-year 2006.
Property-related stamp duty growth almost as strong
Property-related stamp duty receipts (stamp duty is also charged on purchases of securities) were lower than housing-related VAT in 1997.
Revenue from that source has jumped from 323m in 1997 to 2bn in 2005 and to about 2.7bn in 2006. Housing, lands, sales and commercial property transactions all affect this aggregate (the rate of duty charged has been fiddled with slightly during that period).
Property-related stamp duty accounted for 73% of total stamp duty receipts, up from 60% nine years ago.
Boosting infrastructure spend to compensate for housing downturn far from certain
Davy says that a popular view is that the government can simply lift infrastructure spending to compensate for a housing downturn. The theory goes like this: increased investment expenditure by the Exchequer would soak up redundant construction workers because their skills would be transferable, helping to smooth the economic downturn.
However, this theory ignores an important link between housing and infrastructure spending: tax revenue.
The building boom has led to a surge in tax revenue, as discussed earlier. If a severe property downturn occurs and the country is close to breaching the euro area budget deficit criterion (3% of GDP limit), it would be very difficult for the government to scale up investment in infrastructure.
In theory, Davy says that we have a good deal of leeway to borrow for investment purposes due to our low debt to GDP ratio (the second-lowest in the euro area at 26% this year). In addition, a property downturn where price and volume both drop 20% in one year is unlikely. But even in a more gradual slowdown, where tax revenue is coming under pressure without threatening the SGP limit, the question begs: will any administration borrow significantly for capital spending purposes while being mindful of the mistakes of the late 1970s/early 1980s?
Reduction/abolition of stamp duty on property is risky
One of the incumbent government parties recently mooted that the reduction or abolition of stamp duty is a possible measure for the forthcoming Budget in December. We wonder if this party is aware of where all the bonus tax revenue is coming from.
Davy says that the total abolition of stamp duty would be a misguided policy. Stamp duty receipts from property rocketed from 0.3bn in 1997 to 2bn last year. Since 2003, receipts from this source have tripled. Three years ago, property-related stamp duty receipts made up 3.4% of total tax revenue; this year they will account for 6.1% of the total.
Had the policy been enacted this year, the Department of Finance would have foregone 2.7bn in revenue. Stamp duty on residential property alone amounts to about half that total.
Davy says that the problem is that the shortfall has to be made up elsewhere.
"Let us say that stamp duty on property transactions was abolished. That equates to 1.8% of this years nominal GNP. Taxes would have to be raised elsewhere or expenditure growth curtailed to compensate. Depending on what other taxes were increased (or expenditure cut) to fill the gap, it is possible that the policy would not actually be neutral for the economy as a whole, but mildly deflationary. In practice, abolishing stamp duty may lead to the ex-stamp duty prices re-adjusting relatively quickly to the previous stamp duty-inclusive level. It may amount to an inequitable cash transfer from the government to vendors and developers.
Consumption tax (either excise duty or VAT) would probably be hiked to fill the revenue gap. The consequent impact on economic growth depends on the marginal propensity to consume of those who benefit (cut in stamp duty) versus those who suffer (compensating hike in consumption tax) from the policy. In that regard, we anticipate that younger age-groups will suffer more than older cohorts from such a policy change, thus leading to a slight deflationary impulse," Davy says.
Fortunately, the government has been prudent (so far)
Davy says that "luckily, the government has so far been prudent in its assumptions for the property market. Evidently, it would be folly to assume strong growth in the sector given the potential for a massive swing in tax revenue, as shown in our sensitivity analysis.
For example in Budget 2005, it conservatively budgeted that (total) stamp duty would drop 1.5% in 2006 over 2005 and for an increase of 8% in (total) VAT receipts. It expected CGT to rise a meagre 4%.
Its exact assumptions for the property market are unclear, but it is reasonable to assume that any overshoot on revenue under the key property headings (viz. stamp, VAT and CGT) is due to the unexpected buoyancy of the sector. Based on the tax profile for January-September, we think the property bonus amounts to about 1.25bn year to date. It could be 2bn for the full year.
Big problem: cyclical revenue leads to structural liabilities
Davy says another problem is evident from ongoing (and unbudgeted) windfall gains from the buoyant property market. Those windfall gains are often flushed back into the system. Pro-cyclical fiscal policy is the result.
Huge growth in revenue from a cyclical sector such as construction has been used in recent years partly to finance a binge in public sector employment. This is superficially fine while tax revenue continues to gush; the structural problem only becomes noticeable when property related receipts dry up.
Public sector workers are not only paid more on average than any other workers in the economy, but their pension entitlements are generous.
Moreover, job security is recognised to be higher than in the private sector.
In the medium-term, this leads to increased strain on the public finances
similar to an increase in the number of government bonds outstanding.
The difference is that the coupon to be paid on these bonds (i.e. public sector workers) is at a minimum index-linked.
Public sector wages are set to grow indefinitely at least in line with inflation, based on national wage agreements and benchmarking exercises.