Role of Taxes on Property in Containing Asset Bubbles & Consequent Recession

Abstract

This paper attempts to analyze the role of taxes on property in containing asset bubbles and its consequent recessionary impact, by developing a framework, wherein the housing market is conceived as consisting of several sub-markets i.e. rental housing market, house resale market, new construction market, housing capital market and land market, with each market having an intra-market equilibrium derived by its demand and supply function, as well as several inter-market equilibria, which get readjusted after any shock with time lags and friction. The resale market is perceived as an asset market largely governed by expectations of economic agents, who are forward looking and utility maximizing. However, the expectations are not assumed to be perfectly rational, and instead are derived by heuristic decision making amidst constraint of both information and analyzing capability, are therefore subjective and can vary from time to time. In the housing resale market, the demand as well as supply is governed primarily by future expectations of returns and additional capital gains. The capital gains have a perpetuating or exponential function, indicating a positive feedback cycle and unsustainability. The analysis of two episodes of asset bubble formation and bust, in Japan, in 1980s and in United States, in recent years, with the aid of this framework shows that the asset bubble-bust can be explained using this framework, and there does not appear any inconsistencies between the theoretical framework and the empirical evidence. Both the asset bubbles show evidence of positive feedback cycles indicated by a phase of exponential growth that seems to have resulted from the positive feedback created by the self realizing expectations of market participants. In both the episodes the bubble appears to have been finally busted by the falling ‘affordability’ that was a result of rise in prices, thereby indicating an inherent unsustainability in the positive feedback dependent bubble-bust cycle, which is captured in the framework. The analysis of tax measures related with property using the framework shows that empirical evidence of the incidence of taxes and their impact is largely consistent with the results obtained with the framework, and with its use it is possible to reconcile some of the differences in views, including those between the traditional and the new-capitalist view of property taxes. The analysis of taxes allows an easy way to analyze the impact of taxes in the development of asset bubbles, and also differentiates between tax measures that are pro cyclic and those that are counter cyclic. From the analysis, it is observed that deductibility of interest and capital gains tax can have a strong role in the development of asset bubbles. Capital gains tax has a complex impact as its reduction raises the expectations of capital gains which are central to the housing price in an asset resale market, while its increase causes a lock-in, which also increases the prices, indicating that its Impact on house/land prices may differ from time to time. It is observed that tax design plays an important role, by varying the effective tax rate, often widely among the taxpayers in the same jurisdiction, and that erosion of the tax base by rising prices can make the property taxes pro cyclic and aid development of bubbles. The analysis of tax measures in the two asset bubble episodes indicates that the tax environment may have significantly contributed to the development of asset bubbles, and that more informed tax policies can have a role in preventing asset bubble development in future. More elaborate analysis of tax incidence and impact, and efforts for developing a model that allows quantitative estimation of the impact of taxes in asset bubbles are recommended for further research.