RDP 8907: Tax Policy and Housing Investment in Australia 5. Conclusion

In this paper we have constructed a simulation model of the Australian housing market which we argue incorporates many of the important features of housing. The use of an intertemporal framework allows us to examine the relationship between house prices, land prices, rental return on housing and the evolution of the stock of homes. We then use the model to examine the consequences of changes to tax policy and shocks which are exogenous to the model such as changes in real interest rates and changes in the underlying rate of goods price inflation.

Several interesting results emerge from this study. One result which is worth highlighting is the different relationship between a rise in nominal interest rates and housing investment. We showed that a rise in interest rates that reflected a change in real interest rates reduced the housing stock but a rise in nominal interest rates that reflected a rise in inflation with no change in real interest rates actually increased real investment in housing due to the tax distortions in the model.

Economists have been interested in the static effects of tax distortions for some time. Unfortunately tax distortions that affect the allocation of goods and production over time have received less analysis. This has been due to the difficulty of performing the analysis. Simulation models such as the one described in this paper are one way of performing analysis on intertemporal tax issues. Although the analysis is more abstract and perhaps less intuitive than shifting supply and demand curves, the magnitude of distortions suggested by our analysis indicates that research in this area is warranted.

We found that tax policy has a large effect on the housing market as we model it. Our most interesting result was that economy-wide inflation has an important impact on the housing market due to interactions of nominal and real magnitudes with current tax arrangements in Australia. One key result is that a change to the income tax rate of housing investors has a much smaller effect on the housing market than replacing the deductibility of nominal interest payments by real interest payment deductibility. Another is that for investment to remain constant real interest rates have to rise as inflation rises. This may help us explain why in Australia (a country with relatively high inflation) real interest rates are considerably higher than in countries with lower rates of inflation.

There are a variety of natural extensions of the basic model that we have developed including introducing population growth. We leave these for future research.