Economic Development

Introduction

The government applies several policies to make changes in economic environment of the country to ensure the socio-economic development. In relation to this, this report analyses the economic aspects mentioned in the article, “Australia,” IMF Country and a news article, “New duty and land tax surcharges for foreign buyers of land in Australia,” by Clayton Utz.  It summarizes the article and provides the reasons for the overvaluation of the housing prices in Melbourne. Apart from this, it also evaluates the impact of increase in the foreign buyer’s stamp duty (tax) on the equilibrium housing prices, consumer surplus, producer surplus, and total surplus or social welfare. Finally some policies are also suggested to stabilize the housing market.

Question 1.

Summary of the IMF report article and key arguments

Answer- This report article by International Monetary Fund (IMF) provides an analysis of the house prices in Australia. The report highlights the increase in housing prices from the last twenty years. The main argument presented by the staff of IMF is that housing prices in Australia has increased rapidly that other countries and as a result house prices in cities like Melbourne, Sydney and others are overvalued. The report highlight two major factors related to sharp and fast rise in housing prices.  First is rise in house price to income ratio. This is important as the use of inherited by Australian people to afford houses is a reason behind increase in house price to incomes. This increase has impacted the valuation of houses based on deviation from historical long run such as price to income ratio and price to rent thus, causing overvaluation. Secondly, the rise in household debt to income ratio indicates the risk faced by households due to rise in house prices.

The report presents six counter arguments that state why such measures are inconsistent. The first counter argument put forwards is house prices are in line on complete basis. This put forward that over or undervaluation of house prices should be done and based on comparison with the actual prices of house prices from the initial point and should not be derived from considering the changes in house prices over time. It is also states that housing as a necessity and luxury good, the household will spend on housing with increase in income. The rise in household income is less fast than house prices which result in rise in price to income ratio over a period of time. This has affected the affordability factor determine by this house price and earnings ratio and led to housing affordability crisis in the country. The affordability factor has impacted the houses for both buying and renting in the country. In comparison with other advanced economies such as Canada, France, UK and absolute price to income ratio in Australia is in line with them whereas it is above OCED average. Another counter argument is about the rise in equilibrium level of household debt and prices. The reasons given are disinflation and liberalization. It is stated that due to low inflation, low interest rates and financial liberalization there has been easy access to credit services and financial availability that has increases debt. The household debt as a proportion of disposable income has grown. The housing demand is booted by demand side factors such as low interest of mortgage banks. The report underlines that analysis of equilibrium level of house prices with use of economic demand and supply factors is difficult and require high caution. Under the econometric approach the house prices changes are modeled with income, credit, dwelling stock can represent demand and supply factors for analysis of house process the demand and supply show 9 percent house price gap from 2000 to 2014 and time series approach for show 17 percent stronger than economic fundamentals.  Another approach suggested is user cost approach that compares the buying vs. renting houses and resulted in 0-19 percent overvaluation of prices in from 2000 to 2014 and trend approach which highlight that real houses prices are overvalued by 4 percent in the same period. Thus, the different house price modeling approaches highlight that prices of houses in Australia have been strong than as proposed by economic fundamentals. Also, the report discuss that high prices indicate low supply of houses as vacancy rates are low since 2006 and residential investment have been consistent around 5 percent. The prices in cities are higher related to rural/remote areas thus, high urbanization tend to increase house prices whereas supply of housing will become inelastic due to lack of infrastructure and limited land availability and political factors such as provision of infrastructure, land use regulations and funding provisions. It is also pointed that construction cost and cost of land has not been increased at a fast pace. The counter argument state that house price overvaluation problem if restricted to only Sydney as property price has grown by 16 percent year on year, investors loan have doubled and due to increase in demands from foreign purchases in Sydney and Melbourne. It is also counter argued that economy show no signs of lowering the lending standards as mortgage lending are growing stronger and growing share of interest and investor loans are focused in market like Sydney which causes distress. Lastly, it is states that even houses are overvalued it will not matter much and any decline in house prices, the banking sector will be able to withstand by using capital conservation buffer but face restrictions in bonus payout and dividend. Thus,  this report has stated that the price to income ratio in Australia is in line with Canada, France and other advanced countries and given argument related to stronger housing prices in Australia that are in line with exiting economic fundamentals but less when compared to international average.

Question2.

Melbourne overvalued housing prices

The house prices in Melbourne city are overvalued. To determine this, first it is important to look at the house price to income ratios in Melbourne. The below figure indicates a growing trend of this ratio for Melbourne which was above 6 in 2010.  With the rise in ratio it will impact the housing affordability. The change in income to price ratio indicates that Sydney and Perth are highly unaffordable followed by Melbourne. Thus, it can be said that price to income ratio in Melbourne is high as it is shown to increase further thus; there are high housing prices relative to  household earnings which points towards overheating condition for the property market.

Figure 1: Melbourne dwelling price to income ratio from 1985 to 2010 (Reserve Bank of Australia, 2012)

The key drivers of movement of house prices in the city are dwelling stock, population growth, borrowing by investors, demand due to foreign purchase, increase in median income, low interest rate, and availability of mortgage finances and expected future prices (McLaughlin, 2012).  The increase in population growth in Australia has brought significant impact on the houses availability and for rental units. High population growth has led to high demands of houses in Melbourne. The population in Melbourne is reported to rise by around 2.1 percent for year 2014-15 and is forecasted to increase by around 25 percent by 2027-28 (Birrell and McCloskey, 2016). From above factors, it can be reflected that increase in market demands will increase the demand of housing and will lead to upwards movement of prices from P1 to P2 as shown in below figure. Moreover, this will also increase the cost burden in individual household and increase completion for housing units in buoyant market of Melbourne due to limited supply.

Figure 2: Growth in market demand causes rise in house prices

It can also be noted that lack of supply of housing units is a major factor behind the overvaluation of housing prices in Melbourne. This stresses the need of increasing the supply of housing units due to migration from rural/remote areas and population shift.

Apart from this, there has been a significant decline in the interest rate in interest rate in Australia (Trading Economics, 2018). Thus, interest rate factor impact the impact on aggregate demand for houses. This create scenario for overvaluation of the houses in Melbourne.

Figure 3: Interest rate trend in Australia from 2008 to 2018 (Trading Economics, 2018)

Figure 4: Median House Prices Melbourne from 2006 to 2016 (REIV, 2017)

The figure above highlight the median prices of houses, units and apartment with an increasing trend in Melbourne property market since 2006 September.  It can be said that there is a high rise in dwelling prices which leads to overheating of this market.

It can also be added that raise in per capita income have raised the house demand for household in terms of quality and big cities like Sydney and Melbourne (Birrell and McCloskey, 2015). This affects the prices for rental units and housing units. Hence, this demand momentum increases in house prices when houses supply is not adjusted due to geographical and political limitations. This can also be linked to the income factor as increase in median prices of houses relative to income lead to a situation where only few high income households would be potential buyers as they will be able to afford buying or renting costly housing units. In addition, it can be said that demand and supply gap is continue to broaden due to overvaluation of houses in Melbourne.

Question 3:

(a). Impacts of an increase in the foreign buyer’s stamp duty (tax) on the equilibrium housing prices, consumer surplus, producer surplus, and total surplus (or social welfare)

If the government applies additional tax for foreign buyers, it may have a significant impact on the equilibrium housing prices, consumer surplus, producer surplus and total surplus. It can be illustrated by using the below graph:

Without tax, there is an intersection point of supply and demand curves in the above graph at points P₁ and Q₁. This point shows the equilibrium price and quantity.  Based on this, it can be stated that buyers show willingness to pay (McEachem, 2016). In such condition, consumer surplus is the area between the demand curve and price covering areas A, B, and C. In addition, the supply curve indicates the costs of sellers in form of producer surplus. It is the area between the supply curve and price covering areas D, E and F. Therefore, without tax, total surplus will be total of consumer surplus and producer surplus including A, B, C, D, E, and F. In this condition, the government will not able to collect any tax revenue.

But, if the government applies the buyers’ tax, social welfare can be enacted. Due to applying tax, the buyers will enforce to pay more from P₁ to P_B resulting in reduction in consumer surplus to the area A only. This area represents the area below the demand curve and the above buyer’s price. Similarly, there will be a decline in price received from P₁ to P_S as producer surplus that covers only area F. This area covers area above the supply curve and below the sellers’ price. It means producer surplus will also decline after applying tax (McTaggart et al., 2014). At the same time, the demand or the quantity sold will also decline from Q₁ to Q₂ due to increase in price. This will also allow the government to collect tax (area B and D). So, total surplus will be total of consumer surplus and producer surplus i.e. (A, B, C, and D). Based on tax application, it can be stated that the government will collect tax revenues. For calculating total welfare change, fall in consumer surplus (B and C), fall in producer surplus (D and E) and change in tax revenue (B and D) can be added that will result in the area covering C and E causing deadweight loss. It will have a negative impact on the social welfare.

 (b). Can an increase in the foreign buyer’s stamp duty (tax) raise social welfare? Why or why not?

The increase in this buyer’s tax cannot raise the social welfare. The reason is that the higher taxes may cause an increase in prices paid by the buyers on houses that will cause loss of consumer surplus. Similarly, the low price received by the suppliers after tax that will also reduce the producer surplus. This deadweight loss is referred as the excess burden on tax that is higher than tax revenue resulting in declining social welfare. The loss incurred for the buyers and sellers due to tax application is more than the tax revenue generated by the government (McEachem, 2016). Therefore, it can be stated that the new tax will cause a negative impact on the social welfare. From the following graph, it can be explained properly:

The above blue highlighted area shows the tax revenue collected by the government after applying tax. At the same time, red highlighted area shows the deadweight loss to the taxation. It is because some buyers will not like to buy houses due to higher prices on taxation than their willingness to pay price. At the same time, some sellers will not be interested to supply the houses in more quantity because of getting low prices to cover their economic costs (Hubbard et al., 2014). So, it can be stated that these buyers and sellers are not contributing to the tax causing deadweight loss and negatively impact the social welfare.

(c). Can an increase in the foreign buyer’s stamp duty (tax) raise city government’s tax revenue? Why or why not?

An increase in the foreign buyer’s stamp duty (tax) can raise city government’s tax revenue. The government will get tax revenue by increasing the stamp duty on purchasing houses by the foreign buyers (Burda and Wyplosz, 2012). From the above graph mentioned in part a, it can be stated that after applying this duty, the government revenue will increase from zero to area covered B and D.  However, the impact will depend on the amount of tax that can be explained by the below graphs:

Small tax will generate higher revenues for the government but if the amount of tax increases, it will increase the deadweight loss and decrease the tax revenues for the government (See in above grpahs). So, it cannot be stated that increase in duty can raise the tax revenue of the government as it will depend on the amount of tax (Kolmar, 2017).

Question 4.

Housing policies or measures to stabilize the housing markets and the economy

The role of government is essential to stabilize the economy and the real estate and housing markets (Kuttner and Shim, 2016).  This can be done by improving the tax and credit policies to make housing affordable and create a stable property market.  The restriction on foreign buyers investment in the property market and increase in stamp duty for foreign purchasers can be an important steps to meet the demands of the housing units. Similarly, increase in tax rate and initial down payment for second and multi-home buyers can be effective measure to stabilize the housing markets (Kuttner and Shim, 2016). The fiscal policy measure such as tax concessions that can stabilize the economy from the trouble of costly housing and affordability crisis as it will remove the discounting for the purpose of capital tax gains on the investment property (Worthington, 2012). Also, by establishing a fast system for mortgage foreclosure of abandoned and properties can reduce the deadweight losses in making efforts to protect owners of this kind of property.  Also setting limitation of housing loan i.e. loan to values (LTV) limit the mortgage loan in comparison to property value this will impress a minimum down payment to hold housing booms. Similarly, ceiling on debt service ratio (DSTI) in terms of borrowing of the home buyers and this will allow some restriction on the mortgage loan size to a fixed household debt (Kuttner and Shim, 2016). This also holds the unaffordable rise in terms of household debt.

The reduction in country population is another measure that can stabilize the economy as it will not result in land valuation and lower the inflation as well as lessen the gap in demand and supply. Moreover, lowering the median prices of houses can be effective when there is some limitation on the purchase by owners of houses that can lower the demand to some extent and bring down to prices to a point that is affordable for first time home owners and lessen the dependence on loan for purchase and establish an equitable market.

Lowering the median prices of houses can be done by limiting the purchase by existing home owners or foreign purchases; this would lower the demands and eventually prices making it more affordable for Australian public as first time buyers and creating an equitable market (Yates, 2011). Also, provision for increasing the supply of low –cost houses can be also an effective measure to decrease the gap in demand and supply of houses (McLaughlin, 2012). The best suitable measures that can be considered to stabilize the situation of housing markets can be to put a ceiling on the foreign buyers’ purchases and second and third home buyers in the Melbourne city and to control the population growth in the city. This is important as it lead to increased valuation of land and high inflation in the property market of Melbourne. Both the measures will have an influence on the aggregate demands for houses to stabilize the housing markets.

Conclusion

From this, it can be concluded that the increase in foreign buyer’s stamp duty on purchasing houses will have a significant impact on equilibrium prices, producer surplus, consumer surplus, total surplus (social welfare). It can also be stated that houses prices in Melbourne are overvalued which is evident due to several factors such as changes in the income to price ratio, growth in population, increase in median prices, demands of non-resident purchases, etc.  Some measures to stabilise housing market and economy are ceiling for foreign and multi-home owners, tax concessions, reduction in population growth, and limitations on the LTV and DSTI ratios.

 References

Birrell, B. and McCloskey, D. (2015) The housing affordability crisis in Sydney and Melbourne Report One: The demographic foundations. Victoria, Australia: The Australian Population Research Institute.

Birrell, B. and McCloskey, D. (2016) Sydney and Melbourne’s housing affordability crisis report two: No end in sight. Canberra: The Australian Population Research Institute.

Burda, M. and Wyplosz, C. (2012) Macroeconomics: a European text. UK: Oxford university press.

Hubbard, R. G. Garnett, A.M. Lewis, P. and O’Brien, A.P. (2014) Microeconomic. Australia: Pearson Australia.

Kolmar, M. (2017) Introduction. In Principles of Microeconomics (pp. 45-53). Springer, Cham.

Kuttner, K. N. and Shim, I. (2016) Can non-interest rate policies stabilize housing markets? Evidence from a panel of 57 economies. Journal of Financial Stability, 26, pp. 31-44.

McEachem, W. A. (2016) Microeconomics: A Contemporary Introduction.  USA: Cengage Learning.

McLaughlin, R. B. (2012) New housing supply elasticity in Australia: a comparison of dwelling types. The Annals of Regional Science, 48(2), pp. 595-618.

McTaggart, D., Findlay, C. and Parkin, M. (2015) Economics. Australia: Pearson Higher Education.

REIV (2017) Property Data. [Online] Available at:  http://www.reiv.com.au/property-data/median-prices (Accessed: 9 January 2018)

Reserve Bank of Australia. (2012) Dwelling Prices and Household Income. [Online] Available at: https://www.rba.gov.au/publications/bulletin/2012/dec/2.html (Accessed: 9 January 2018)

Trading Economics. (2018) Australia Interest Rate. [Online] Available at: https://tradingeconomics.com/australia/interest-rate/forecast (Accessed: 9 January 2018)

Worthington, A. C. (2012) The quarter century record on housing affordability, affordability drivers, and government policy responses in Australia. International Journal of Housing Markets and Analysis, 5(3), pp. 235-252.

Yates, J. (2011) Housing in Australia in the 2000s: on the agenda too late?. In The Australian Economy in the 2000s, Proceedings of a Conference, Reserve Bank of Australia, Sydney (pp. 261-296).