The effects of inflation and taxation on the costs of home ownership : a theoretical analysis / R. Anstie.

Abstract

This paper analyses the costs of home ownership compared with the costs of renting a home. It concentrates on the effects of inflation and the taxation system on these costs. The present taxation system does not tax imputed rental income or (most) capital gains. Such a system favours the home-buyer compared with the renter. However, in times of inflation, the present taxation system has the effect that it taxes in the hands of a lender some repayment of the principal value of a loan (rather than just the pure interest component) and allows as a tax deduction to the borrower this part repayment of the loan. Such an effect will result in the market rate of interest rising above what it would otherwise be in the absence of taxation. This imposes a cost on home-buyers because they are unable to deduct any part of their loan repayment from assessable income (whereas other borrowers can). This addditional cost is higher, the larger the size of the loan. Furthermore, the subsidy to the home-buyer (in the form of non-taxation of imputed rental income) is proportional to the level of home-buyer's equity in the house. This means that, for low levels of equity, the additional cost may outweigh the subsidy, in which case, renting would be the cheaper alternative. An expression for the critical proportion of home-buyer's equity is derived. This critical value depends on the rate of inflation and on marginal tax rates. Two methods of eliminating the critical value are presented. The first method involves taxation of imputed rental income, hence removing the tax subsidy to home owners. Individuals on low marginal tax rates will still find renting a cheaper proposition in times of inflation under this scheme. The second method requires indexation of the tax base. Such a system would allow the retention of the tax subsidy, but would remove the additional cost imposed on home-buyers in times of inflation. It is stressed that tax deductibility of mortgage interest without taxation of imputed rental income is not a suitable way of reducing the inflation-induced costs imposed on home-buyers. The policy recommendation arising from this paper is indexation of the tax base. This could be in conjunction with taxation of imputed rental income, in which case a subsidy to home-buyers could take the form of a tax rebate. Such a scheme would remove the regressive nature of the present form of the subsidy. Show more