Bubble Dependency

As we noted last week, the government's projections of tax revenue rest on some wildly optimistic assumptions. And none more optimisitic than what they are apparently assuming on house prices.

The chart shows what the Pre-Budget Report projected for total tax receipts from the housing and finance sectors combined (see here). Receipts have slumped since the onset of the financial crisis, but by 2014-15 they are projected to bounce right back up to 3.5% of GDP, or £64bn.

The projection is not broken down into its components, and the bulk is presumably reckoned to come from taxes on the finance sector. But you can bet they are also assuming a pretty sharp rebound in housing taxes - specifically stamp duty.

When Labour came to power in 1997-98, stamp duty on residential property brought in £0.8bn (see here). But a decade later, in 2007-08, it had increased eightfold to £6.6bn. After Labour's rate increases and the boom in house prices, it had become a major source of tax revenue.

Unfortunately, as the property market slumped, so did stamp duty revenues. In 2008-09, revenues more than halved to £2.7bn, and they are likely to fall further this year. That is the price of making your tax revenues dependent on asset bubbles.

So what will happen to house prices now?

The honest answer is nobody has the faintest idea.

But what we do know is that UK prices remain very stretched, both by historic standards and by comparison with housing markets internationally. One standard yardstick is house prices relative to income, and on that measure the OECD reckons we have the fourth most highly priced market in the developed world. Moreover, since Labour came to power, our price-to-income ratio has increased more than any other country's (see here).

Now, of course, you can argue that our valuation ratio has increased because with low low interest rates home buyers can afford to borrow more, thus jacking up prices. And there's some truth in that. But how long are interest rates going to remain at these rock-bottom levels?

And then there's the argument that we have very limited land resources, and what with our tight nimby-led planning restrictions and continuing mass immigration, house prices are pretty well a one-way bet.

Which puts Tyler in mind of conversations he had during a business trip to Japan in the late 80s. At the time, the Japanese property market was in the stratosphere, but nobody seemed at all concerned. Tyler was told it reflected the extreme shortage of habitable land combined with powerful demographic factors - in other words, a one-way bet.

I think we all know what happened to Japanese property prices over the two decades since then - they've been a one-way bet all right, but down rather than up.

Lessons for the UK? Here's a chart showing the Japanese and UK property markets over those two decades:

It couldn't happen here?

You wouldn't want to bet your fiscal projections on it.

Nor your retirement planning.