The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Sunday, May 2, 2010

Updated: What does the Henry Review mean for housing?

It is Australia’s largest investible asset-class, and the most significant store of household wealth. So what does the Henry Review (the “Review”) and the Government’s response mean for both owner-occupiers and families that own rental properties? In the short-term, next to nothing, since the Government has emphatically ruled out implementing ‘at any stage’ all of the relevant Review recommendations:

* Including the family home in means tests (R. 88c);
* Abolishing stamp duties and replacing them with a land tax (R. 52 & 53); and
* Cutting the CGT discount and applying a discount to negative gearing deductions (R. 14 & 17c).

While many of the Review’s suggestions make theoretical sense, and would be unlikely to have any materially adverse impact on long-term housing market dynamics, they are either politically unpalatable or operationally too complex (eg, measuring unencumbered land values is a notoriously difficult exercise given that we do not observe market prices for the land that forms the basis of most homes).

The Review’s most enduring contributions will, therefore, be to further advancing our understanding of the unique role housing plays in the community, and highlighting reasons why the cost of securing shelter has tended to grow over time.

Here the Review pointedly reinforces all of the findings of the 2003 Prime Minister’s Home Ownership Task Force report, which I co-authored with academic economists from Harvard, Cambridge, and NYU, and adds further weight to the arguments I’ve made more recently about why the provision of established or new ‘housing services’, which is economic jargon for putting a roof over folks’ heads, is intrinsically a ‘productive’ economic activity.

The Review begins by declaring that its approach is entirely consistent with the attitude adopted by Australian governments past, which is that owner-occupied housing is the ‘preferred’ form of tenure in recognition of the “the benefits ownership can bring both the community and homeowners, such as greater security in retirement.”

Arguably the best characterisation of the value of the ownership aspiration can be found in Robert Menzies’ iconic 1942 speech entitled, The Forgotten People. For those who have not been exposed to his words before, Menzies claimed:

“The home is the foundation of sanity and sobriety; it is the indispensable condition of continuity; its health determines the health of society as a whole. I have mentioned homes material, homes human and homes spiritual. Let me take them in order. What do I mean by "homes material"?

The material home represents the concrete expression of the habits of frugality and saving "for a home of our own." Your advanced socialist may rave against private property even while he acquires it; but one of the best instincts in us is that which induces us to have one little piece of earth with a house and a garden which is ours; to which we can withdraw, in which we can be among our friends, into which no stranger may come against our will. If you consider it, you will see that if, as in the old saying, "the Englishman's home is his castle", it is this very fact that leads on to the conclusion that he who seeks to violate that law by violating the soil of England must be repelled and defeated.

National patriotism, in other words, inevitably springs from the instinct to defend and preserve our own homes.

Then we have homes human. A great house, full of loneliness, is not a home. "Stone walls do not a prison make", nor do they make a house. They may equally make a stable or a piggery. Brick walls, dormer windows and central heating need not make more than a hotel. My home is where my wife and children are. The instinct to be with them is the great instinct of civilised man; the instinct to give them a chance in life - to make them not leaners but lifters - is a noble instinct…

And finally, we have homes spiritual…Human nature is at its greatest when it combines dependence upon God with independence of man. We offer no affront - on the contrary we have nothing but the warmest human compassion - toward those whom fate has compelled to live upon the bounty of the State, when we say that the greatest element in a strong people is a fierce independence of spirit. This is the only real freedom, and it has as its corollary a brave acceptance of unclouded individual responsibility. The moment a man seeks moral and intellectual refuge in the emotions of a crowd, he ceases to be a human being and becomes a cipher. The home spiritual so understood is not produced by lassitude or by dependence; it is produced by self-sacrifice, by frugality and saving.”

In a much more contemporary setting, the Review does an excellent job of reminding us of the role of housing in the community. As I noted here when explaining housing’s productivity, we tend to take our food and shelter so for granted, and are so conditioned to simply expecting to have a home, that we forget what the economic utility of both new and established housing actually is. In this context, it is worthwhile quoting the Review in full:

“In its myriad forms, housing provides shelter, security and a savings vehicle to millions of Australians. Adequate shelter is fundamental not only in meeting basic human needs, but also in providing a base from which to develop individual capabilities, to raise a family and to participate in the community and the workforce.

The value of housing derives from more than the day-to-day shelter it provides. More than two-thirds of Australians enjoy the benefits of owning their own home. Whether they are a first homeowner with little equity or a retiree whose mortgage has been paid off, the security of tenure associated with home ownership provides an additional benefit over and above physical shelter. In many areas, a stable base of home ownership underpins social integration. Home ownership can benefit not only homeowners, but their communities too.

As well as providing vital services to individuals and communities, housing also forms a large share of Australia’s savings. Houses are built to last — many people work hard to pay off their house during middle age, in order to ensure they have access to accommodation with no cash payment obligations when they are old. As a form of savings, housing has additional benefits over other savings vehicles because it not only acts as a store of value, but also reduces exposure to fluctuations in rental costs. In particular, those on fixed incomes are insulated from housing cost fluctuations, ensuring that other necessities like food or energy are affordable and they are protected from the risk of poverty.

The Review’s recommendations are intended to support this policy goal. There is a strong case for continuing Australia’s approach of ensuring that owning their own home is within the reach of ordinary families. The role of owner-occupied housing as the key source of voluntary retirement savings is a major reason for continuing to exempt it from income taxation (see Section A1 Personal income tax). Further, owner-occupied housing plays a particularly important role in providing financial security for the large majority of Age Pension recipients who own their own home. Continuing the means test exemption for owner-occupied housing, up to an indexed threshold to ensure fairness of the test, will support this objective (see Section F2 Means testing).”

While the Review presents mixed analysis on housing affordability, it generally concludes that the cost of well-located accommodation (ie, capital city houses) has risen over time. More specifically, the Review finds that “current measures of housing affordability indicate that Australia faces significant challenges in providing sufficient affordable housing.”

The Review broadly confirms estimates recently disclosed by Rismark International that Australia’s house-price-to-income ratio is under 5x, with a long-term average since 1993 of just over 4.5x (see first diagram on left-hand-side below).

Here the Review appears to be comparing capital city detached house prices (notably disregarding apartments, semis and terraces, which make up 25 per cent of the stock) to national (ie, metro and non-metro) disposable incomes, which is a common mistake. Rismark’s most recent approximation of Australia’s ‘all regions, all dwelling types’ average home price-to-average disposable income ratio is 4.7x as at March 2010 (this has been revised based on the latest price data).

In the right-hand side chart below the Review publishes an RBA housing affordability index, which suggests that home loan repayments as a share of incomes are no worse than the long-term average since 1987. Yet a more sophisticated affordability index employed by the RBA, which goes back to 1980, implies that affordability it currently slightly worse than the 30 year average.

One gets a rather more mixed picture on rental affordability. On the one hand rents as a share of average earnings (see left-hand-side chart in the next panel below) are only a little greater than the long-term average since 1985, and substantially less than the highs recorded in the late 1980s and early 1990s. That is, renters today are better off than they have been in periods past, although likely worse than average. On the other hand, rental stress proxies (right-hand-side chart) have been rising over time.

Overall, the Review opines that affordability has deteriorated. To emphasise this point, it highlights that that the share of younger owners has fallen while indebtedness has increased:

“The proportion of Australians under 35 who own their own home declined from 44 per cent in 2001 to 38 per cent in 2008. Similarly, higher house prices may mean fewer people own properties outright. The proportion of Australians aged 55 to 64 with mortgages has increased from 13 per cent in 1996–97 to 30 per cent in 2007–08.”

In a non-tax setting, the Review’s most significant input is eviscerating those who claim that the supply-side is irrelevant (or ignore it altogether). Dr Henry and his team are manifestly of the view that the cost of housing in Australia is being fuelled by artificial rigidities that impede the production of new supply. They also lend their imprimatur to the chorus of economic experts, including, latterly, the RBA, who contend that Australia is suffering from an underlying housing shortage.

The first public analysis to posit this supply-side thesis was the 2003 Prime Minister’s Home Ownership Task Force report. Interestingly, the Review draws attention to a fact that I have also belaboured, which is that such supply-side arguments were not in vogue at the time, and were explicitly rejected by both the Productivity Commission and the RBA, which preferred traditional demand-side explanations for the growth in housing costs. Once again, it is useful for the reader to get a full sense of the Review’s findings:

"The price level of any market good or service is set by its demand and supply. The Productivity Commission (2004) and Reserve Bank of Australia (2003) attribute the increase in house prices around the start of the decade primarily to strong growth in demand.

A persistent gap between housing supply and underlying demand…indicates that there are problems on the supply side of the housing market. Strong population growth in recent years has led to relatively strong underlying demand for housing. However, the supply response has not been able to keep pace. Over the past five years, the population grew on average 1.7 per cent a year, while housing completions fell on average 2.0 per cent a year. Thus sustained high levels and strong growth of housing prices are only possible when housing supply cannot increase to meet movements in demand.

There are a range of indicators of tight supply in the current housing market. Rental vacancy rates are currently around the record lows experienced during 2008 (see Chart E4–3). The National Housing Supply Council estimated that there is a substantial shortage of housing in Australia, …If the Council’s medium growth estimate of underlying demand and medium supply projection were met, there would be a cumulative gap by 2028 of 431,000 dwellings.

Of course, in markets demand always equals supply so long as prices can adjust. The Council’s projections should be seen as an indication of the degree of likely price pressures and the subsequent challenges facing the community. The growth in house prices largely reflects increasing prices of existing houses, rather than growing costs of construction (see Chart E4–3 Panel B). Land has made up a growing share of house prices, increasing from 53 per cent to 61 per cent in the 15 years to 30 June 2009...

Higher house prices are likely to result from restrictions on the supply of housing that result from zoning, lengthy approvals processes and building code and other standards imposed on building quality. Housing affordability needs to be considered against the other policy objectives that motivate these regulations.”

In the right-hand-side chart below, the Review replicates my 2003 Task Force analysis to demonstrate that it is the implicit price of land, rather than the costs of building homes, which has been responsible for much of the price growth that has been observed in recent decades.

The leads to the Review’s key conclusion on affordability, which is that “higher house prices are likely to result from restrictions on the supply of housing that result from zoning, lengthy approvals processes and building code and other standards imposed on building quality.” This in turns informs the Review’s ensuing policy recommendation, which directly echoes my findings from seven years ago:

“Recommendation 69: COAG should place priority on a review of institutional arrangements (including administration) to ensure zoning and planning do not unnecessarily inhibit housing supply and housing affordability.”

For the interested observer, this is what I had to say in an op-ed published in The Australian newspaper in 2003 after the release of the Task Force’s report:

“There is an affordability problem in Australia, but it has nothing to do with income levels, interest rates or a dearth of exploitable land. Rather, it is the result of oppressive local and State government regulations (often imposed with the enthusiastic support of proximate communities) that severely constrict the stock of low-cost properties and, when combined with ever-growing demand, artificially inflate the price of housing.

Viewed differently, these constraints on dwelling dispersion and the release of greenfield and brownfield sites act as a burdensome tax on new building, which leads to a mismatch between the accommodation needs of Australian households and the supply of available properties. This in turn produces a divergence between the price of homes and their underlying costs of construction. As a consequence, we recommend expanding the affordability debate to encompass local and state government reform, rather than confining ourselves to that perennial panacea, public housing.”