How a (property transfer) tax could lower prices

Last week, Vancouver introduced a new property transfer tax for foreign buyers. As reported in the New Zealand Herald:

Foreign nationals buying Vancouver real estate will pay an additional property transfer tax of 15 per cent as part of an effort to address high real estate prices and low vacancy rates.

Wait - don't taxes raise prices? Won't taxing foreign buyers make prices even higher? No it won't - and here's why. Consider the property market as two submarkets - the submarket for sales to domestic buyers, and the submarket for sales to foreign buyers. These two markets are represented in the diagrams below. Note that a seller will be indifferent between selling to a domestic or a foreign buyer - it doesn't matter to them who the buyer is. So, the price is the same (P0) in both submarkets. However, note that demand in the foreign buyer submarket is more elastic (flatter), because foreign buyers have many more options (they can buy in Australia, Canada, New Zealand, Uruguay, etc.), so more substitutes are available.

Now introduce a tax, but only in the foreign buyer submarket. For simplicity, assume that the tax is paid by the sellers (since the seller is collecting money from the buyer anyway, their lawyers can simply collect more and pass the tax onto the government). This situation is shown in the diagram below - the Si+tax curve represents the effect of the tax on the market [*]. Note that the price that the foreign buyers have to pay increases to Pi. However, the effective price that sellers receive (after paying the tax to the government) falls to Ps. The difference between Pi and Ps is the tax. Note that the effect of the tax on the price is larger for the sellers than for the buyers - the price the buyers pay only increases a little, but the sellers are made much worse off. In other words, the burden of the tax on foreign buyers actually falls mostly on the sellers. So, because sellers are made (much) worse off by selling to foreign buyers, they would now prefer to sell to domestic buyers instead (where they can receive the higher price P0).

So, what happens next is that sellers start offering more houses to domestic buyers, increasing supply in the domestic buyer submarket to S1. (as shown in the diagram below). This lowers the price in that submarket to P1. Simultaneously, because there is more supply into the domestic buyer submarket, there must be less supply into the foreign buyer submarket - supply there decreases to Si1 (and note that the effect of the tax is now represented by Si1+tax). These shifts in supply in the two markets continue until eventually the price received by the sellers is the same in both submarkets (P1). The foreign buyers pay the higher price (Pi1), and after paying the tax the sellers in that submarket receive the price P1, which is the same as they would receive in the domestic buyer submarket. Importantly, note that the effect of the tax is to lower the price for domestic buyers, which is what was intended.

Having said that, it's only a partial solution to the unaffordability of housing. My preferred solution to housing is still to introduce stamp duty and use the proceeds to scale up house construction.

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[*] Note that I have shown the tax in these diagrams as a specific tax (i.e. a constant value per house) rather than an ad valorem tax (a tax that is some percentage of the value of the house), purely for simplicity. The overall effect on the submarkets is qualitatively the same for both types of tax.

More from my blog on Auckland housing:

• Be careful with producer surplus, because housing is different
• More on stamp duty for Auckland - why it should apply to all buyers
• The winner's curse and the Auckland housing bubble
• Matthew Goodson agrees with me on stamp duties
• Bring back stamp duty for Auckland!
• Out-of-control rent increases in Auckland - why?
• Housing policy: Subsidy vs. Supply