The UK Seeks to Reduce Tax Distortion in Their Housing Market

December 3, 2014

Her Majesty’s Treasury in the UK released its autumn statement today with changes to the Stamp Duty Land Tax (SDLT), which is a tax on the purchase or transfer of property or land. The changes reduce taxes for 98 percent of those who pay the tax but increase the effective tax on all sales above £2,100,000, roughly $3,300,000.

The key provision is a switch from a single-rate bracket system to a marginal-rate bracket system. Under the single-rate system, the rate within the bracket is applied to the entire sales price of the real estate purchase. For example, a £400,000 home falls within the 3 percent bracket. As such, the home owner pays 3 percent of the total sales price, or £12,000.

Under the new marginal-rate bracket system, the portion of the sales price which falls within the tax bracket is taxed at the bracket rate. The treatment is similar to the function of a progressive income tax system with marginal income tax brackets and rates. For example, assume there are two brackets: 0-£100,000 and above £100,000 with a tax rate of 1 percent and 3 percent, respectively. If we have the same £400,000 home from the first example, the home owner pays 1 percent on the first £100,000 and 3 percent on the next £300,000 for a total of £10,000.

The change is an attempt to reduce distortions in the housing markets at the edge of the brackets. This is particularly important in the rapidly appreciating London housing market. The typical London home sells for £514,000, just above the £500,000 threshold of the 4 percent bracket of the SDLT. London home owners are reluctant to price their homes just above the threshold, knowing that crossing the threshold meant a 1 percent increase in the tax rate on the entire sales price or an additional £5,000 in taxes for increasing the sales price by £1 past the threshold. In other words, there is an effective marginal rate of 500,000 percent at the threshold. This causes stickiness in the price around the bracket edge, clumping the price of real estate into a narrow band before the threshold.

I would like to believe that Americans don’t make the same obviously economic mistakes, but several states use a similar single-rate system at the top of their income tax brackets. Referred to as Income Recapture, once an income threshold is crossed, the entire income of a taxpayer is subjected to the top rate. As stated in our 2015 State Business Tax Climate Index:

New York, Nebraska, and Connecticut apply the rate of the top income tax bracket to previous taxable income after the taxpayer crosses the top bracket threshold. New York’s recapture provision is the most damaging and results in an approximately $20,000 penalty for reaching the top bracket. Income recapture provisions are poor policy, because they result in dramatically high marginal tax rates at the point of their kick-in, and they are non-transparent in that they raise tax burdens substantially without being reflected in the statutory rate.” – (pg. 30)

The UK realized the SDLT was poor tax policy and took the appropriate steps to remove the problem. So why do these U.S. states continue to keep them? The answer is in the London housing market.

Before the London housing boom, the upper brackets affected only a small group of voters. With the appreciation of houses in London, housing prices began to exceed the bracket threshold and drastically increased taxes on real estate transfers. With a critical mass of voters being affected by the policy, the political environment shifted to change the policy.

Unlike the Stamp Duty Land Tax, income recapture is unlikely to change anytime soon. Though it is bad policy, income recapture only effects a small number of taxpayers. Nonetheless, it would be good for these states to fix this poor policy, even in the absence of public outcry. Or perhaps tax policy analysis can be as loud as the squeaky wheel.

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