Posted by Christian Hilber and Olivier Schöni
This article was originally published on Asia Pathways, the blog of the Asian Development Bank Institute
Lack of affordable housing is a serious policy concern in many countries. In large prosperous cities such as London, New York, Beijing, or Tokyo, the affordability crisis is particularly acute. In these cities, households often live in excessively expensive and crammed spaces. Homeownership remains an unachievable dream for many. Not surprisingly, voters in these places pressure politicians into implementing policies that tackle the crisis. The solutions typically offered focus on the demand side. Policies such as the Help-to-Buy scheme in the United Kingdom (UK) or mortgage interest deduction (MID) in the United States (US) aim to lower borrowing constraints, and thus allegedly help low-income and young households to achieve their dream of homeownership. These policies tend to be popular because of the alleged benefits for the targeted households and the hidden costs for taxpayers. Yet, apart from the fact that these policies are extremely costly—the US MID, for example, costs about $100 billion per annum in foregone tax revenue—tragically, they all too often end up making the targeted households worse off.
The fallacy of demand-side policiesTake the example of the Help-to-Buy scheme implemented by the UK government in April 2013 in response to the severe affordability crisis observed in large parts of England and particularly in the Greater London area. The main aim of the policy has been to help first-time buyers get their feet on the owner-occupied property ladder. The government argued that the scheme would stimulate demand for owner-occupied housing and this should translate into new owner-occupied housing being supplied, leading to a higher homeownership rate. Yet, in the year following the announcement of the policy, house prices in London shot up by 25.8%, a residential building boom failed to emerge, and the homeownership rate continued to decline.
So why did the policy fail so miserably? The fallacy was that policy makers assumed that housing supply would respond to demand stimuli. But this did not happen. One problem was that the UK had—and still has—an extraordinarily rigid planning system. Height restrictions, view corridors to protect certain vistas, conservation areas, and listed buildings, among other restrictions, are widespread. Arguably even more important is the fact that the UK, unlike most other developed countries, does not have a rule-based zoning system. Instead it operates a development control system: The 1947 Town and Country Planning Act expropriated the development rights of landowners, so since then any change in the use class for any parcel of land requires development control permission. This is granted at the local level. The trouble, in this context, is that the UK is a highly centralized country with virtually no fiscal powers at the local level. Local authorities face most of the costs of local development but reap virtually none of the benefits in the form of greater local tax revenue. This diminishes incentives to permit local development. To make matters worse, by trying to protect their nice views, green spaces and—ultimately—their asset values, not-in-my-backyard (NIMBY) residents will oppose any new development. Because NIMBY residents are also local voters, locally elected politicians have not only no fiscal incentives but also no political incentives to permit residential development. In such a setting, demand-side stimuli will not increase supply; they will merely push up house prices further, making it even more difficult for young would-be buyers to accumulate the necessary deposit to purchase a house.
Sadly, as we discuss in our forthcoming ADBI Discussion Paper, the fallacy of demand-side policies is not confined to London or even the UK. It applies to any country and city that has fairly tight long-term supply constraints—be they of a regulatory, physical, geographical, or topographical nature. The US provides a particularly interesting laboratory in this context because it contains both, tightly regulated and geographically constrained metropolitan areas—such as Los Angeles, San Francisco, and New York City—and metropolitan areas that are pretty unregulated and geographically unconstrained—such as Houston, Dallas, and Columbus. Hilber and Turner (2014) exploit these spatial differences in restrictiveness to explore the differential causal effect of the US MID on homeownership attainment depending on the degree to which metropolitan areas are tightly regulated. They find that due to the capitalization of the MID-subsidy into higher house prices, the MID has a negative impact on homeownership attainment in strictly regulated metropolitan areas. The positive effects on homeownership are confined to higher income classes in less regulated metropolitan areas. All in all, the US government foregoes about $100 billion in annual tax revenue to achieve essentially a zero net effect on homeownership attainment. Similar to the UK’s Help-to-Buy scheme, policy makers in the US appear to have ignored the fact that in supply-constrained places, demand-side policies are bound to mainly push up house prices.
Lax planning systems and the problem of sprawlIn contrast to the UK and many American “superstar” cities, Switzerland appears to have a rather flexible approach to planning. In most of the country—with the exception of Geneva and perhaps parts of Zürich—housing supply can be considered to be fairly responsive to demand and housing affordability is, not surprisingly, not one of the hotter policy issues. Another housing issue is very high on the political agenda, however: the problem of urban (and rural) sprawl. Switzerland’s sprawl problem can be explained by its institutional setting, which is characterized by fiscal federalism. To begin with, income taxes at the local level—in conjunction with tax competition—provide strong fiscal incentives to local municipalities to zone desirable land for residential development. Such residential zones are often at the outskirts of existing suburban areas, presumably because wealthy mobile tax payers—the key target of municipalities—prefer large houses with plenty of garden space. Second, Switzerland has an exceptionally low homeownership rate, currently around 37%. Unlike homeowners, renters do not benefit from rising house prices and rents, so they have much fewer incentives to behave as NIMBYs. Lastly, Switzerland has a fairly flexible rule-based zoning system—that is, if land is zoned for residential purposes, landowners have in principle the right to develop it, subject to staying within the rules of the law. This, in contrast to the UK’s development control system, facilitates residential developments, especially on the outskirts of suburban areas, where land is often made available and NIMBY pressures are smaller.
Lessons to be learnedSo what are the lessons that emerging Asian countries and their governments might possibly learn from the cautionary tale told here? One view is that policy makers are doomed regardless of the system they implement: They either employ a planning system that focuses on urban containment—only to be haunted by a housing affordability crisis—or they implement a fairly flexible planning system, in which case sprawl will create another form of political backlash (as evidenced in Switzerland where voters recently approved an intrusive initiative to halt sprawl in touristic regions and another initiative that aims to drastically limit immigration). This is too coarse a view, however: Although a trade-off between housing affordability and sprawl exists to some extent, clearly there are worse and better planning systems and housing policies.
Let’s start with the worst kind of housing policy: demand-side oriented policies. Clearly, stimulating housing demand makes the situation worse, not better, independent of whether a country has a strict or lax planning system. In countries and cities with fairly tight supply constraints—be it because of geographical or regulatory constraints—demand-side policies mainly push up house prices and thus worsen the housing affordability crisis. Stimulating demand is also counterproductive in settings where supply is fairly flexible. This is because the demand push aggravates the sprawl problem.
What about supply-side policies? Blindly relaxing the planning system and providing huge fiscal incentives to local jurisdictions to zone land for residential development will, in all likelihood, create a sprawl problem, such as the one observed in Switzerland. Moreover, planning serves an important purpose: to correct for market failures by, for example, providing public parks, separating incompatible land uses, and protecting historic sites and buildings. So, abolishing planning would be a bad idea.
How should a planning system then look like and what would be good policies and instruments to tackle the key housing issues? First, a good planning system should be designed to focus on correcting market failures. Second, by (i) allowing vertical expansion (i.e., largely abolishing height restrictions) and thereby permitting densification in central parts of cities, (ii) imposing a land value tax, possibly with varying rates (to prevent excessive construction in areas where this is not desirable—tax rates could be extremely high, for example, in areas of natural beauty), and (iii) only allowing the construction of new housing near existing developments (thereby limiting the excesses of sprawl), policy makers could keep housing affordable and largely prevent sprawl. While implementing such radical reforms may be difficult and will undoubtedly attract resistance from vested interests, the political rewards in terms of sustained political support could be substantial. Now there is an idea for policy makers around the globe.
ReferencesHilber, C.A.L. and O. Schöni (in Press) “Housing Policies in the United Kingdom, Switzerland and the United States: Lessons Learned,” forthcoming as Asian Development Bank Institute Working Paper.
Hilber, C.A.L. and T.M. Turner (2014) “The Mortgage Interest Deduction and its Impact on Homeownership Decisions,” Review of Economics and Statistics Vol. 96, No. 4, 618-637.