RDP 8907: Tax Policy and Housing Investment in Australia 1. Introduction

The housing market is frequently the focus of economic debate especially during periods of rapidly rising housing prices. Recently, Albon (1989) and others have questioned the efficiency of the tax advantages given to housing investment in Australia although rigorous modelling of the Australian housing market has been scarce. Nevile et al. (1987) incorporate the effects of taxation in a static housing model. Such a model is silent about the level of housing investment induced by tax changes and the resultant effects on rent levels, given changes in the stock of housing.

The purpose of this paper is to develop a dynamic intertemporal model of the housing sector that can be used to analyse the effects on housing investment, housing prices, land prices and rents, of various tax policies.

In the model we develop here, the level of housing investment is based on investment decisions by forward-looking managers (investors) who maximise the value of the firm subject to increasing adjustment costs. Under this framework, taxes and interest rates affect the profitability and market value of capital in the housing sector. This causes changes in desired investment levels as well as prices. The specification is a synthesis of the q theory of investment of Tobin (1969), the adjustment cost framework of Abel (1982) and the tax policy analysis of Hall and Jorgenson (1967). The specification of adjustment dynamics follows the approach formalised by Hayashi (1982).

The model employed here has several attractive features which extend previous studies in this area. Firstly it is a two factor model (land and capital). This allows us to discuss land prices which are an important component of house prices. Secondly we take care to pay attention to the Australian taxation system. In particular the model incorporates a real capital gains tax as well as depreciation allowances and the tax deductibility of nominal interest costs. The analysis includes the various tax rules relevant to homeowners and landlords and it accounts for the influence of these costs on rental prices, house prices and land prices as well as the stock of houses.^[1]

Section 2 of the paper describes the model and its development from the optimisation problem of a representative investor. The model is then calibrated to Australian data in section 3 and we discuss the technique used to solve the model. In section 4 we use numerical simulation techniques to examine the effects, both on the steady state of the model as well as the transition path between steady states, following changes in tax policy, inflation and interest rates. A summary and conclusion is contained in section 5.

Footnote

The major limitation of the model is that it is driven by investors to the exclusion of owner-occupants. This is an area for further extension of the model. The role of investors in the housing market is discussed in Section 2b. [1]