Tax incentives and the housing bubble: the Spanish case.

Transcription

1 UNIVERSIDAD COMPLUTENSE DE MADRID Tax incenives and he housing bubble: he Spanish case. Tuor: Miguel Sebasián Dpo. Fundamenos del Análisis Económico II Grado en Economía Jorge Meliveo June 2014 Absrac In his paper we analyse he effec of removing morgage ineres deducions in he Spanish real esae marke. We sar by esimaing he housing price bubble as deviaions of acual house prices, during , from heir fundamenal (heoreical) value. Expecaions played a key role in he residenial consrucion boom and, hus, by means of a raional inrinsic bubble model we are capable of esimaing he behaviour of house prices more accuraely. We hen simulae wha would have been he effecs over he bubble had morgage ineres deducions been eliminaed in For ha purpose we esimae he effecs boh on he fundamenal price and on he bubble componen. The resuls sugges ha even removing morgage ineres deducions in 2004 would have had significan effecs on he acual increase in house prices and herefore on he bubble. Moreover, if he speculaive bubble in he housing marke had been deal wih sooner, in 2000, he effec would have been much greaer and a subsanial porion of he price bubble would have been avoided.

2 Index 1. Inroducion Sylized Facs Characerisics of he Spanish housing marke The role of fundamenals on he evoluion of prices Tax subsidies from a hisorical perspecive The Fundamenal Value of Houses The model Calibraion process Daa Removing morgage ineres deducions: he fundamenal price The inrinsic bubble in he real esae marke Calibraion process Removing morgage ineres deducions: he bubble Conclusions Bibliography Appendix A Inrinsic bubbles in a presen-value model

3 1. Inroducion The housing marke among oher hings is known o hold a worldwide favourable ax reamen. The marke iself can be described as imperfec and inefficien relaive o oher financial markes. Some reasons for his are he characerisics of he own marke, which include hings such as he few number of paricipans and ransacions (in comparison wih he sock marke for example) or supply rigidiies. Oher reasons come from ouside of he marke, and here s no doub he ax reamen is one of hem. The housing marke plays an imporan role in many economies, and especially so in he Spanish economy. In our case, consrucion conribued for an average of approximaely 10% of GDP and oal employmen in he las 20 years. The evoluion of house prices is of grea imporance. The long lasing profile of houses and is subsanial weigh in he porfolio of households aler resource allocaion decisions made by consumers. House price increases are associaed wih a considerable wealh effec which alers he macroeconomic equilibrium (Ho, 2006). Similarly, falls in house prices disor he decisions of agens as he already menioned characerisics of he real esae marke do no allow hem o modify heir consumpion decisions opimally, and in many cases, hey will no adjus heir consumpion of housing sock, bu insead reduce consumpion of oher asses. This makes consumers o sick o heir homes even hough prices are plummeing. Houses are no only consumpion goods, bu also an invesmen decision which should herefore have posiive reurns similar o hose of similar asses. This is why i is ineresing o compare he evoluion of house prices wih he evoluion of alernaive asses. Real house price indexes (RHPI) in Spain grew by 120% beween 1997 and 2007; his mean a compound annual growh rae (CAGR) of 7%. Figure 1.1 shows he annual reurns of he real esae marke, of he sock marke (IBEX-35) and of he Spanish 10 year bond. The housing marke ouperformed he sock marke for grea par of he boom years ; beween 1999 and This informaion suggess ha a bubble in he real esae marke exised as house prices grew oo much relaive o he behaviour of alernaive invesmens. 80% 60% 40% 20% 0% -20% -40% Figure 1 - Asse marke profiabiliy Housing Bonds Socks 2

4 The concep of bubble defined as asse prices flucuaing more han fundamenally jusified comes from he early works of Shiller (1981). In oher words, increases in he value of an asse alone do no jusify he exisence of a bubble. There are wo main approaches for deecing bubbles, he macroeconomic approach and he financial approach. The macroeconomic approach ries o explain he evoluion of fundamenals and deec a bubble if here is a persisen deviaion from hem. I has been menioned ha he Spanish ax sysem, as many oher worldwide, favoured home-ownership. Through he concep of he user cos of home-ownership Poerba (1984) opened he way for he analysis of he housing marke, boh o analyse he deerminans of prices and o measure he effec of policies over hem. A favourable ax reamen decreases he user cos of ownership and, hence, makes owning more aracive han in a neural ax sysem scenario. The non-axaion of impued rens, he basically unaxed capial gains and he morgage ineres paymens deducion (MID) are common feaures o many ax sysems. In Spain, one sep ahead was given and paymens of he principal were also deducible from he Personal Income Tax (PIT). There is a quesion of up o wha poin hese deducions and benefis have conribued in he pas o he boom and he bubble. The imporance of his has been noiced by governmens (oo lae) as i was removed in 2011, brough back in 2012 by he incoming governmen wih he hope of resaring he consrucion secor (and falling ino he same misakes made in he pas) and removed again in 2013 by command of European decision makers. There are several conribuions in he recen lieraure which ry o deec an overvaluaion of he housing marke. There exis some oher conribuions which measure he effec of ax subsidies on housing prices. However, I would say here is no oher work which combines hese wo aspecs. I is ineresing o ask wha would have been he effecs over house price, and hence, over he bubble, if an implici subsidy o home buying, such as MID, would have been removed on ime. This is precisely wha we will ry o do in his paper. In order o do so, we define he housing bubble as he difference beween he acual (observed) price and he fundamenal (heoreical) price. Measuring he effec of he fiscal policy over he bubble is no a simple ask as here are many facors which should be aken ino consideraion. On he one hand, we have he effecs over fundamenal house prices; here we include how consumers and consrucors would have behaved in an efficien marke scenario. On he oher hand, such a policy would have had an effec over he speculaive componen of house prices; his par caches he effec of he expecaions of fuure capial gains, which are no backed by he evoluion of fundamenals. In oher words, demand increases because prices are expeced o increase and his feedback mechanism is no susainable. The roue map looks as follows: firs we obain he heoreical impued ren as he equilibrium resul in he marke of housing services, we hen use his ren o calculae he fundamenal house price. The comparison beween he fundamenal house price and he acual one indicaes ha house prices flucuae more han fundamenally jusified. In he model we will assume raional invesors wih perfec foresigh, wo srong 3

5 assumpions which are no compaible wih he exisence of a bubble. In order o explain hese excessive flucuaions we will consider alernaive assumpions abou expecaions, more precisely, we will consider an speculaive bubble model. This approach is based on Froo and Obsfeld (1991) inrinsic bubble model. Typically, raional bubbles are viewed o be driven by exraneous variables; however, inrinsic bubbles are driven exclusively, hough nonlinearly, by he exogenous fundamenals of he model. The price of an asse is hence given by he sum of he presen-value of fuure dividends (or rens in he housing marke) and a bubble erm which depends on he evoluion of fundamenals. Once we have he heoreical house price we esimae he effec of removing MID over i. If MID would have been eliminaed in he pas, no only would he fundamenal price changed, bu also he acual price would have evolved differenly. In order o properly address he effec of removing MID on he bubble, we use he inrinsic bubble model where we can obain a new bubble erm wih he differen fundamenals. Wih all his informaion we are able o conclude ha a hird of he bubble could have been avoided if he ax reform had been implemened in 2000, and around a 10% if acion was aken in The res of he paper will be organized as follows; secion 2 explains he main feaures of he Spanish housing marke, he role ha fundamenals have on he evoluion of prices, and a hisorical review of ax subsidies in Spain. Secion 3 conains he model ha deermines he fundamenal price of houses and analyses he effec of he MID removal on hem. In secion 4 we presen he inrinsic bubble model. Finally, we sum up all he ideas and resuls of he paper in he conclusions. 2. Sylized Facs 2.1. Characerisics of he Spanish housing marke The Spanish housing marke has been laely characerized by skyrockeing house prices ( ); by a boom, measured as he amoun of houses buil during he same period; and by an increasing weigh in he whole of he economy. Bu here are also some underlying feaures which are no recen bu have been like ha for many years, especially hose regarding he ype of ownership and he use of he house. I is imporan o sae clearly he difference beween boom and bubble. As explained by Balmaseda, San Marín and Sebasián (2002) he boom is defined by he quaniies, in oher words, by he number of houses buil. On he oher hand, according o Case, Shiller (2004), a bubble is a siuaion in which prices are excessively elevaed (relaive o heir fundamenal jusificaion) due o excessive public expecaions of fuure price increases. Poenial homebuyers hink ha a home which oherwise migh appear o be oo expensive for hem is now aracive as hey will be compensaed by fuure price increases. Furhermore, firs-ime homebuyers migh also hink ha in he fuure houses migh become unaffordable and hence hey mus buy now. In addiion o his, he housing marke has he unique feaure ha people end o hink ha prices are no likely o fall and hence i is a safe invesmen (relaive o he sock marke). 4

6 On he lef-hand side graph of figure 2.1 we can see he evoluion of house prices in real erms. Real house prices in Spain grew since he mid 80 s unil Back hen, he probably firs recorded housing bubble in Spain bursed afer prices had doubled in real erms beween 1985 and There was a fairly quick adjusmen process as prices fell by 14% in 5 quarers, and since hen, here was a period of sabiliy in house prices. For he nex years (unil 1998) prices were basically consan (beween 1993 and 1998 RHPI grew by 1%), however since 1998 and he creaion of he euro in 1999 prices have increased drasically. Balmaseda, San Marín and Sebasián (2002) esimae ha up o 13% of he increase in prices beween 2000 and 2002 can be aribued o he so called euro effec. On he righ-hand we have he inerannual growh raes. House prices grew a an average of 7% during reaching growh raes close o 20% in Figure Real House Price Indexes % 10% 0% -10% -20% House Price Indexes (annual growh raes) Miniserio Fomeno Miniserio Fomeno INE Source: Insiuo Nacional Esadísica, Bank of Spain and Dallas FED The consrucion secor is a key variable of he Spanish economy and he main driver of he boom. To measure he weigh of his secor we look a he raio of consrucion s GVA (Gross Value Added) over he oal economy s GVA 1. In figure 2.2 we have a European comparison of his raio. Spain clearly rises above all oher counries as he counry where consrucion has been more imporan for he oal economy during he whole period Ireland, which also suffered a housing bubble, has a very similar evoluion, hough a lower levels. Regarding Spain, during he firs par of he 90 s, he rend was o reduce he raio, however, since 1997 i boosed, reaching is maximum in 2006 poin a which i had grown by 55%. The consrucion secor also has grea imporance regarding he employmen of he Spanish economy. In 1997, he employed in consrucion accouned for 10% of all employees, number which grew wih he boom reaching more han 13% in The GVA as defined by Eurosa is he value of oupu less he value of inermediae consumpion. I is a measure of he conribuion o GDP made by an individual producer, indusry or secor. The oal GVA of he economy is calculaed as GDP a marke prices minus ne axes. 5

7 Figure Consrucion GVA/Toal GVA 15% 13% 11% 9% 7% 5% 3% Germany Ireland Spain Ialy Norway UK I is imporan o define wha is included in he consrucion secor. Consrucions are usually differeniaed beween buildings; residenial or non-residenial, and civil engineering works. Up o now, we have referred o all kinds of consrucion, however, i mus be saed ha when we alk abou he boom we refer o he boom in residenial invesmen. In he case of Spain, he Miniserio de Fomeno offers daa since 2001 abou he business volume divided beween hese hree caegories. Beween 2001 and 2007 residenial invesmen accouned for more han 50% of he consrucion secor on average, wih non-residenial invesmen fairly consan a 20% and civil engineering he res. Figure % 80% 60% 40% 20% Business volumes by ypes of consrucions 0% Residenial Non-residenial Civil engineering Thousands of unis Number of houses sared each year Source: Bank of Spain, Miniserio Fomeno The graph on he righ shows he flow of houses sared each year beween 1990 and On average, beween 1990 and 1998, 210,000 homes were iniiaed each year (represened by he red line in he graph). The boom in residenial consrucion mean ha each year more and more houses were buil, reaching he maximum in 2006 of nearly 700 housand homes. The average for he period is 550,000 each year (his is represened by he green line), more han wice he number in he previous period. Wih increasing house prices, he demand could no susain his level of new homes forever, his is why, since 2006, he consrucion of new homes has plummeed. In addiion o his, anoher figure which gives us an idea of he magniude of he boom, he sock, increased from 18.7 million homes in 1997 o 24 million in

8 García-Monalvo (2003) characerizes he Spanish housing marke by very low renal raes, by a high rae of vacan homes and a high proporion of secondary houses (he raio of houses per household beween 1990 and 2009 was on average 1.5, meaning ha 50% of home-owners did no only own one house bu wo). The informaion gahered in INE s census has been appoined as he mos convenien source o analyse he housing sock. Houses are classified according o 3 caegories: he principal house is he usual residence of a family. Secondary houses are hose which are occupied occasionally, during holidays or weekends for example. Vacan or empy houses are hose no occupied, which could be sold, rened or migh even be abandoned. From hose principal houses we can disinguish 3 ypes of enure: ownership, ren and cession. Figure 2.4 Houses by ypes and enure (average ) Unsold Housing Sock (Thousands of houses) Vacan 14% Secondary 16% Principal 70% Cession 6% Ownership 81% Ren 13% Min. Fomeno CEPCO Caixa Caalunya For a long ime, i has been a characerisic of he housing marke o have a high number of hese vacan homes; on average, 14% of houses beween 1991 and 2011 were vacan. However, he above menioned boom ogeher wih he fall in demand in he las years has muliplied considerably he amoun of unsold sock (his can be observed in he graph on he righ of figure 2.4). Beween 2005 and 2009/2010 his number ripled, passing from jus over 200 housand houses o housand depending on he source 2. On average, over he las wo decades 8 ou of every 10 houses were owned and jus 13% of hem rened. Orega e al. (2011) poin ou he low renal share of he Spanish housing marke (11% in 2007) as one of he feaures no analysed in a general equilibrium conex. Bover (2005) quanified ha housing asses accouned in he year 2002 for 79% of he households wealh, while shares represened jus 7.6% of i. If we look a he raio of real esae wealh/oal wealh of households, we can see how in 1998 his raio was 68%, very close o reaching is minimum, and by 2007 i had increased o 85%.There s no doub ha changes o he price of an asse which is so imporan for households has 2 CEPCO is he Confederación Española de Asociaciones de Fabricanes de Producos de Consrucción. Daa comes from he Informe de Coyunura Económica of March 2014 creaed by hem. The daa from Caixa Caalunya comes from he Informe sobre el secor inmobiliario residencial en España of January

9 many implicaions on heir wealh and heir consumpion decisions and, hence, in he macroeconomic equilibrium. Summing up, he housing marke is one of he cores of he Spanish economy. Tradiionally people in Spain end o own heir houses raher han o ren hem, his has made houses o represen mos of he household s wealh. Since he slowdown of he economy and he beginning of he crisis demand for housing has frozen and he sock of unsold houses has reached massive levels The role of fundamenals on he evoluion of prices The household s disposable income and he level of employmen are wo key variables deermining he demand for houses which are depiced in figure 2.5. From he figure in he lef we can see ha since 1994 real disposable income grew a raes ranging beween 2% and 6%. Beween 1997 and 2007 real GDP grew by 49% a a CAGR of 4%. This increase in he income of families is one of he main explanaions for he increase in housing demand and, hence, of he rise in he relaive price of houses. The imporance of he disposable income has been noiced many imes. For he Spanish case, Bover (1993) aribued up o 70% of he increase in real house prices during he period o he growh of real disposable income. A similar specificaion is used by García- Monalvo (2001) for he period , reaching he conclusion ha 61% is explained by disposable income, while in García-Monalvo (2003) for a larger ime horizon his number is reduced o 41%. Finally, Balmaseda e al. (2002) find ha for income growh conribued o 45% of he house price increase. Figure 2.5 8% 6% 4% 2% 0% -2% -4% Real disposable income (annual growh) % 30% 20% 10% 0% Unemploymen rae Toal Ages Source: Insiuo Nacional Esadísica Furhermore, here was a coninued decline in unemploymen which reached is lowes value since he end of he 1970 s of 7.95% in 2007-II. In he graph on he righ we can see he evoluion of he whole economy s unemploymen rae and he youh unemploymen rae. In his original esimaion García-Monalvo (2001) aribued 21% of he increase in house prices o he decrease in youh unemploymen, as i happened wih he effec of disposable income, his number was reduced in his 2003 paper o 8

10 16%. Similarly, Balmaseda, San Marín and Sebasián (2002) quanify he effec of youh and women unemploymen o explain 10% of he price increase. Even hough he youh unemploymen already caches some demographic effecs over he demand of houses and some auhors such as Bover (1993) have quesioned he sensiiveness of house prices o hem, i is worh menioning wo addiional demographic facors. Firsly we have he growh of he populaion which are in a favourable posiion o purchase a house and/or sar a household (hese are people over 25 years). Beween 1997 and 2007 his populaion grew from 27 million o 33.2 million, his is a 23% increase in 10 years. Secondly, he increased number of reired people in Europe, he creaion of he euro and he reducion in ranspor coss, combined wih he araciveness of he Spanish coas for many Europeans, increased he housing invesmen by non-residens in Spain. This invesmen grew a an average growh rae of 20% beween 1997 and 2003, poin a which i represened 10% of oal residenial invesmen and 0.9% of GDP. Since 2004 he increase in house prices, he overcrowding of he coas and he compeiion from oher counries such as Croaia could have conribued o he decrease in he non-residens invesmen (André, 2010). There are a series of financial facors which affec he demand for housing. A decline in real ineres raes and a deregulaion of he morgage marke leading o lax lending sandards are wo of he main financial facors driving house prices up (André, 2010). There is a srong link beween ineres raes ha are below Taylor-implied raes and housing bubbles. The impac of ineres raes on housing bubbles is especially srong when hey are oo low for oo long (Ho, 2012). The graph on he lef of figure 2.6 shows he decline in real morgage ineres rae from over 11% in 1993 o around 0% in This cheaper access o credi made buying a house more aracive o many homeowners, especially hose which had lower rens. The graph on he righ shows he oal morgage credi as a percenage of GDP. Prior o he boom, he raio credi-o-gdp grew a a CAGR of 7% beween 1991 and 1996, his number doubled o 13% for he period , meaning a 270% absolue growh rae. Figure % 10% 8% 6% 4% 2% 0% -2% Real morgage ineres rae % 80% 60% 40% 20% 0% Toal morgage credi (as a % of GDP) Source: Bank of Spain 9

11 Usually, he banking secor is highly exposed o he housing marke and his is why he burs of a housing bubble usually leads o a banking crisis (Ho, 2006) and hus, he effecs of crisis originaed by a housing bubble are deeper han he effecs of a crisis arising from a financial bubble. Helbling (2003) reviews he experience wih asse price buss in indusrial counries during he pos-war period, comparing he effecs afer equiy price buss and housing price buss. The conclusions were ha housing price buss were less frequen, lased nearly wice as long and were associaed wih oupu losses wice as large, reflecing greaer effecs on consumpion and banking sysems. The banking secor played a key role in he Spanish real esae boom. No only had he raio credi-o-gdp risen since he 90 s; he Loan-o-value (LTV) raio, which is also a good measure of he involvemen of banks in he housing marke, was well over 64% unil Since hen, i has fallen o jus over 50%. The increased role of he banking secor has many implicaions for he average household. The defaul (delinquency) rae was smaller han 2% in 1999; decreasing unil i reached is minimum of 0.74% by he end of However, since hen, i has skyrockeed, and in he firs quarer of 2014 i was well above 13% and increasing. Decreasing house prices probably explain grea par of he increasing defaul rae. In conclusion, he coninued growh in disposable income, he decline in unemploymen raes, he easier and cheaper access o credi, he increase in he populaion over 25 years and he increase in demand by non-residens have all conribued o he increase in prices. We should now deermine up o wha poin prices grew accordingly o hese fundamenals, and o wha poin hey grew exclusively due o expecaions of fuure growh. I is ineresing o poin ou ha many of hese fundamenals reached heir maximum (or minimum in hose cases for which i applies) in However, prices coninued growing even hough ineres raes didn fall any more or disposable income was no growing a he same pace Tax subsidies from a hisorical perspecive In previous secions we reviewed some reasons why he housing secor had so much imporance in he economy. As poined ou by García-Monalvo (2001), he access o adequae housing appears in he Spanish consiuion (Ar. 47) as a basic righ of all Spaniards. I is widely agreed ha home-ownership enjoys a favourable ax reamen in many counries, and Spain is one of hem. This favourable reamen is one of he reasons why he renal share is so low 3. We will now briefly explain he mos common feaures of he ax reamen of he housing marke, bearing in mind ha no all of he axes were applicable a he same ime. Some of axes appear during he consrucion process, like he Value Added Tax (VAT) of purchasing he land or he Corporae Income Tax (CIT) relaed o 3 In García-Monalvo, J. (2003). Burbujas Inmobiliarias he reader can find a se of fallacies very common in he Spanish sociey abou price expecaions which basically have lead many people o believe ha "house prices canno fall or ha buying a house is he safes invesmen. 10

12 consrucion companies benefis. Oher axes are paid by he homebuyer. Regarding he consumer here are 3 sages were axes appear: acquisiion, enure and selling. In he firs sage, when he consumer buys a house, he/she has o pay indirec axes depending on wheher i is a new house (VAT) or second hand (ITP Impueso Transmisiones Parimoniales ). Usually, a par of he house enry paymen could be deduced in he firs year, and in subsequen years, deducions could be applied in concep of principal amorizaion. During he second sage (enure sage) he home-owner will pay he propery ax (IBI - Impueso Bienes Inmuebles ), a fracion of which could be a imes deduced. Furhermore, deducions on morgage ineres paymens could be applied in he Personal Income Tax (PIT). The final sage occurs when he agen sells he house. Houses are considered an invesmen wih paricular feaures, one of which is he fac ha even if hey are used over many years heir value usually will increase. If his is he case, a capial gains ax is applied o he invesor. In real life however, capial gains from selling a house are basically unaxed. In his paper we concenrae on he axes suppored by poenial homebuyers, which affec he demand for housing hrough he user cos. Ever since he PIT was esablished in 1978, deducions of morgage ineres paymens have been allowed. Many changes have occurred in he PIT law since , ou of which, he mos imporan were he ones in 1992 and specially he 1999 one. The changes in hese wo years however wen in compleely opposie direcions. In 1992, changes were mean owards a housing marke where home-ownership did no benefi from so many privileges. Some of hese measures were o inroduce a 15% ax credi for ren paymens, o eliminae principal and morgage ineres paymens deducions of secondary homes or o reduce he maximum limi of MID in he usual residence (before 1992, MID limi was 4,800 in he single declaraion scenario and 9,600 in he join declaraion scenario, afer 1992, he laer limi was decreased o 6,000 ). The Spanish housing marke before and afer he 1998 reform is characerized by 6 main poins according o many auhors such as López García (2005), Sanz (2000) and J.M. Raya (2012). The able below summarizes his informaion: Elemen Before 1999 Afer Impued ren A percenage of he assessed value of propery axed Impued rens no longer axed 2. Propery ax 3. Morgage ineres deducion (MID) 4. Morgage principal repaymen A percenage of he assessed value of propery axed. Paymens of his ax were deducible. Tax deducible wih a limi of 800,000pas ( 4,800 ) 15% ax credi for principal repaymens 5. Capial gains Taxed a reduced rae wih many exempions 6. Ren paymen if enan was a rener Propery ax paymens no longer deducible Morgage ineres paymens and principal amorizaion joinly deducible (as a ax credi). The limis are increased o 1,500,000pas ( 9,015 ) Sill axed a reduced rae bu wih more exempions 15% ax credi o ren paymens Removal of ax credi 4 See García-Vaquero (2005) for a deailed explanaion of reforms in every year can be found 11

13 Some aspecs of he reform mus be menioned. Firsly, he aim of axing he impued rens before 1999 was o ax he ren he home-owner saves or pays o himself. Secondly, regarding he changes in morgage ineres and principal repaymen deducions, we mus menion how he pos-reform ax credi works. For he firs wo years, here was a ax credi of 25% for he firs 4,500 and 15% on he excess up o 9,015, for subsequen years he former rae decreased o 20% while he laer sayed consan a 15%. Thirdly, one of he mos imporan exempions on capial gains occurs when he owner sells he usual residence wih he purpose of buying a new one. The eliminaion of he axaion of impued rens and he eliminaion of he ren paymen ax credi, ogeher wih he increase in he limis of ineres and principal paymens deducions are a clear ax advanage o home-ownership agains is counerpar of rening a house. The imporance of he non-axaion of impued rens mus be clearly saed: if ha house was o be occupied by someone else, he rens received by he owner would be axed; if he invesor insead of buying a house in order o ren i, invesed in an alernaive asse, hose dividends would also be axed. Two main argumens were used by he 1999 governmen o defend heir reform. The firs one is ha he reform ried o increase he progressiviy of he ax sysem. One feaure of MID is ha i is regressive as i is a ax deducibiliy and reduces axable income; herefore, people wih higher income enjoy greaer benefis from i. The second argumen hey used was ha he reform inended o increase access o home-ownership. Many people back hen graefully acceped his 1999 reform as he ex-ane price of a house was mean o decrease by means of promoing he favourable ax-reamen. Wha only few of hem could imagine is ha he huge increase in demand for houses would ineviably increase he ex-pos price, and more so in he case of he bubble. Several reforms were made since 1999 worh menioning. Some measures have been aken o deal wih insiuional facors which also il he owning-rening decision owards he former. The Sociedad pública de alquiler, creaed in 2005, promoes home renal wih maximum guaranee for landlords and beer condiions for enans. In 2009 a se of reforms were made wih he aim of increasing he proecion of he landlord and faciliaing he ejecion of he enan if necessary (Orega, Rubio, 2011). Regarding he favourable ax reamen o home-ownership, in 2006, he ax credi on ren paymens was reinroduced; i consised in a 10% deducion for rens smaller han 24,000, aimed a making renal more available and cheaper o lower rens. In January 2011, MID on he usual residence were eliminaed for rens greaer han 24,000 ; however, i was reinsaed in 2012 by he incoming governmen and once again removed in 2013 by command of European decision makers. Capozza e al. (1996) consider he posiive exernaliies aribued o home-ownership as he main raionalizaion for he favourable ax reamen. Green and Whie (1997) showed ha children of home-owners are more likely o finish high school, less likely o become young parens and less likely o be arresed; holding paren s income, educaion, race, age and marial saus consan. García-Monalvo (2003) gives 4 12

14 common argumens. Firs, he real esae marke generaes essenial housing services o which families dedicae grea par of heir budge. Secondly, he asymmery creaed by an inelasic supply (in he shor run) and a very sensiive demand in he case ha here was an economic downurn. Thirdly, he long lasing profile of houses implies ha any decision has considerable long-erm effecs. Finally, houses are an imporan real asse in people s porfolio considered an alernaive o financial asses. We should now have a leas a brief look a lieraure conribuions. Poerba (1984) opened he way wih he asse-marke model, which by means of he user cos approach, is able of measuring he effecs of fundamenals on prices and also allows measuring he effec of policy changes on hem. In his 1984 paper he concluded ha for an economy wih a 25% marginal ax rae, he effec of eliminaing MID was an increase in he user cos from 4% o 7%, leading o an immediae fall of 26% in real house prices and a long-run effec of -29% over he sock of housing capial. Capozza e al. (1996) esimaed he effec of eliminaing propery ax and morgage ineres deducions, and concluded ha changes in axaion affeced prices bu no so much quaniies. For an economy wih a 22% marginal ax rae hey esimaed a 13% decrease in house prices. They also poined ou ha removing hese deducions removes he preference for deb financing a house and, herefore, i would reduce he level of borrowing. Oher sudies make inernaional comparisons of ax sysems. Crowe e al. (2011) saed ha he evidence abou he relaionship beween business cycles and housing s ax reamen is inconclusive from counry-o-counry experience; here are counries wih relaively unfavourable ax reamens where prices increased a lo in he pas years and counries wih relaively favourable reamens where prices did no increase much. For he Spanish economy, López García (2000, 2008) sudied wha would be he effecs over he real esae marke if PIT deducions (principal and ineres paymens deducions) were permanenly eliminaed. A 26% decrease in house prices in he shorrun and a 16% decrease in he long-run were he main resuls. In López García (2005) he scenario before and afer he 1998 reform were compared, reaching he conclusion ha, in he long-run, he reform would barely have any effec over he price of houses or he sock, bu ha here will be a disribuional effec as he mos regressive elemens were eliminaed. Sanz (2000) focused he analysis on he user cos raher han on house prices. The uniqueness of his paper lies on how i includes all he feaures of he axreamen such as he limis of he differen deducions, he differen kinds of PIT declaraions or he level of deb financing of he house. The main findings were again ha he reform made ax subsidies more progressive, ha for low income levels deb financing became more profiable and finally ha here was an overall decrease in he user cos afer he reform. García-Vaquero (2005) used he concep of ax wedge as he difference beween he user cos afer axes and he user cos wihou axes and concluded ha he join effec of axes and subsidies lead o a decrease in he user cos and hence here was an effecive ax subsidy. Orega e al, (2011) use a differen approach: hey buil a small open economy DSGE model. Their main findings are ha removing MID has small effecs on he overall 13

15 economy (0.1% decrease in GDP and 0.6% decrease in employmen), bu reallocaes resources from he consrucion secor o he consumpion goods secor. Addiionally, is removal implies a decline of 8% in real house prices, an increase of 5.6% in he renal share and a reducion in fiscal expendiure equal o 0.9% of GDP. We should bear in mind ha according o he daa provided by he Spanish ax auhoriies, MID implied a cos greaer han 4,000 million annually o he governmen since 2000 (Raya, 2012). 3. The Fundamenal Value of Houses 3.1. The model In his secion we develop he model which allows us o calculae he heoreical house value deermined by is fundamenals. The following model combines he asse and he marke view of house prices. Saring wih he asse view, he house price is defined as he presen value of fuure impued rens; he heoreical framework proposed by Poerba (1984) is he basis on which such works are based. In equilibrium, homeowners equalize he benefis obained from housing services wih he coss of owning a house. On he one hand, he impued ren, defined as wha i would have cos o ren an equivalen propery for a period (Himmelberg e al, 2005), is he benefi. On he oher hand, he cos of owning a house during one period is he user cos of home-ownership γ muliplied by he real price of he house ( P. This equilibrium is expressed by ( ) (1.1): R ) = γ P (1.1) There are several facors commonly used in lieraure o define he user cos. Firs of all, he owner has o pay a morgage ineres rae ( r ). Secondly, he house is subjec o depreciaion (a a rae δ ). Thirdly, he owner has o pay mainenance expenses ( m ) and will bear he risk of house price flucuaions for which he owner mus be compensaed by a risk premium ( ) π. e ρ.finally, he owner can profi from poenial capial gains ( ) For our analysis we need o accoun for he effec of ax subsidies. There exiss a ϕ is allowed o be proporional personal income ax a rae ( τ ) from which a fracion ( ) deduced in concep of principal and ineres paymens of he morgage. According o García-Monalvo (2003), afer he 1998 reform he user cos for he Spanish housing marke can be wrien in a simplified form as in equaion (1.2) 5 : e R = (1 ϕ) (1 τ ) r δ m ρ π P (1.2) Regarding capial gains, quie resricive assumpions are usually made. Himmelberg e al. (2005) for example use he average real growh rae of house prices o predic he 5 For a more deailed analysis of he expression of he user cos before and afer he ax reform of 1998 here are many working papers. Especially hose wrien by MA López-García (2000, 2005 and 2008), JF Sanz (2000) and of course he already menioned García-Monalvo (2003). 14

16 fuure growh rae. In order o relax his assumpion, we follow Ho and Monnin (2006) and derive expeced capial gains from he expeced fuure fundamenals. According o he raional expecaions hypohesis, he expeced housing revalorizaion is equal o he expeced value in period of he price in +1. Defining κ = δ + m + ρ we ge he expression: E[ P 1] + R = (1 ϕ) (1 τ ) r + κ 1 P P (1.3) Rearranging (1.3) for P i will now look as follows: P R + E[ P + 1] (1 ϕ) = [(1 τ ) r + κ + 1] (1.4) We define ω = (1 τ ) r + κ + 1. By forward ieraion of he value P + 1 we obain wha we will call he price equaion (1.5). This equaion ells us ha he fundamenal price of a house is deermined by he presen and fuure values of he impued rens ( R ) and he morgage ineres rae. 1 R R R 1 R P = E = E i... 1 ϕ ω ωω+ 1 ωω+ 1ω ϕ (1 τ ) j 0 + κ = + j (1.5) i i= 0 [ r ] There are wo main approaches o inerpre he evoluion of impued rens (Ho, 2006). The firs approach assumes a no-arbirage condiion by which in equilibrium, agens will be indifferen beween buying and rening a house and hence impued rens will be a equal o acual real rens ( ) R. The problem wih assuming rens as a deermining facor for fundamenal prices is ha rens do no have o be fundamenal hemselves. The Spanish ren marke is srongly influenced by governmen inervenion (in he form of regulaion) and subjec o imperfec informaion. Addiionally, he low renal share makes he acual ren no o be an appropriae proxy for he impued ren. The alernaive approach includes he marke view on house prices. This consiss on calculaing he fundamenal rens by assuming ha hey are he oucome of marke equilibrium beween demand and supply of housing services 6. The main advanage of his mehod is ha he ineracion beween demand and supply allows he GPD and he sock of houses o affec he fundamenal house price ( P ) via he fundamenal rens ( R ). In Ho (2006), boh approaches were compared for a se of counries and he marke approached yielded beer resuls. Due o his, i is he approach we will follow. 6 This is no he demand and supply of houses bu of housing services, he righ o occupy a house by buying or rening i. 15

17 We will now look a he demand and supply sides of he housing services marke. The demand side is influenced by he uiliy an individual derives from occupying a house and he budge resrain he faces. A represenaive consumer faces he following maximizaion problem: max U ( d, c ) = d c { d, c } α 1 α s.. yɶ = d R + c Where c is goods consumpion, d he occupaion of housing unis, α is he marginal rae of subsiuion and yɶ he disposable income. The disposable income of agens depends on he gross income and he effec of axes and subsidies on i. The uni price of consumpion goods is normalized o 1 and he cos of occupying a house for one period is equal o he real impued ren ( R ). The uiliy maximizing demand of housing per capia is: Muliplying he per capia erms (, ) d α yɶ = R d yɶ by he populaion ( ) will give us he aggregae demand for housing in he economy: (1.6) N of idenical individuals α N yɶ αyɶ D= N d= = R R (1.7) The housing marke is in equilibrium when he supply of housing equals he demand: D αyɶ R = = S (1.8) By rearranging for he impued ren we ge he expression which relaes he impued ren o he disposable income and he housing sock; his is he fundamenal value of impued rens: R αyɶ = S (1.9) In expression (1.9), he impued ren is a funcion of Y ɶ, which we said depended on axes. The income available for agens depends on he fracion of he price of he house which can be deduced from he personal income ax, hence, an increase in he proporion which is allowed o be deduced will increase disposable income and vice versa. We define Y ɶ as follows: Yɶ = Y (1 + qϕ) (1.10) 16

18 Where, q is he percenage of periods where deducions are allowed. For he ime being, we consider wo exreme cases for he disposable income and, hus, wo exreme cases for he impued ren (he real value of which will lie beween hose limis). Firs, he case were MID had never exised and, hence, Yɶ = Y ; his is he exogenous Y case. Second, a fracion ϕ has always been deduced and will be like ha in he fuure, herefore, Yɶ = Y(1 + ϕ) ; full deducion case. The final sep in he heoreical framework is o replace he fundamenal impued rens given by (1.9) in price equaion (1.5) and ge he Fundamenal House Price Equaion: P 1 = E 1 ϕ (1 τ ) + κ + 1 α Yɶ + i i i= 0 S [ r ] + i j= 0 + j (1.11) From (1.11) i follows ha house prices depend on presen and fuure aggregae income, morgage raes and consrucion aciviies. The wo fiscal parameers ( ϕ and τ ) also affec house prices. Furhermore, ϕ no only affecs he deerminaion of prices bu also he impued ren via Y ɶ. Boh fiscal parameers are assumed o be consan forever unless he policymaker decides o change hem; once hey are changed o a new rae hey will say consan forever again. In his paper we will deal wih ϕ, he fracion of PIT which is allowed o be deduced as principal and ineres paymens of he morgage. We will consider a governmen which eliminaes his deducion bu leaves he marginal τ unchanged, and hus, he new policy will se ϕ= 0. We should ask: Who PIT rae ( ) will be affeced by his policy change? We assume ha here is no reroaciviy. If his policy change was implemened in he year 2000, everybody who bough a house before hen will sill be able o deduce ϕ = 15% from PIT unil hey sele heir deb, 0 however, every new home-owner who deb-finances he new house will no be able o do so. For our purposes, he number of people owning a house and enjoying morgage ineres deducions does no affec house prices. In his model we have obained heoreical house prices which are deermined by fundamenal impued rens. These rens are he equilibrium resul of he ineracion beween demand and supply of housing services. Therefore, i is he marginal home-buyer ha deermines he demand for housing and, hus, he one who ses house prices Calibraion process In his secion we presen he seps used o esimae he fundamenal house price. Firs we esimae he fundamenal impued rens which we hen use o obain P. As he fundamenal price equaion depends on all he fuure values of impued rens and morgage ineres raes, we have o make some assumpions and calibrae he model in order o obain a consisen house price. For he ime being, we will assume ha agens 1 17

19 are raional and have perfec foresigh. These assumpions allow us o subsiue he expeced fuure fundamenals by heir acual values: [ ] [ ] E P E r = P = r We sill have hree main problems wih which we will have o deal. Firs we need o find adequae values for differen parameers. We also have o make some assumpions on how fundamenals evolve ou-of-sample. Finally, if we have a look a equaions (1.9) and (1.11), we see ha some variables are expressed as index numbers ( R, Y ) and ohers a heir levels ( S ). Hence, in order o be able o compare boh sides of he equaion, we need appropriae conversion facors. Calibraion of fundamenal rens: We follow Ho s (2009) proposiion, which says ha even if in he shor-run acual rens deviae from heir heoreical values, in he long-run he acual values do no oscillae much from heir fundamenal ones. In expression (1.9) we see ha α affecs he level of impued rens ( R ). We choose a parameer α 0 which minimises he Mean Square Difference (MSE) beween acual and impued rens. This α 0 includes he preference parameer α and he conversion facor. Overall, we have o solve he following minimizaion problem: min { α > 0} 0 T = 0 R a α 0Y ɶ S 2 (1.12) Fuure values of fundamenals: In order o calculae he fundamenal price of housing, i is required o have all fuure fundamenals up o infiniy. As we do no have such daa we make assumpions abou how fundamenals evolve afer he end of he sample (ime T). P depends on he fuure heoreical ren ( R ) and fuure morgage ineres rae ( ) We will assume ha impued rens evolve a a consan growh rae (g), equal o he average growh rae of he las 5 years. α Yɶ R g R g i = 0 (1 + i ) = i T i T (1 + + ), 0 S > Similarly, he morgage ineres rae will be assumed consan and equal o he average rae of he las 5 years ( ) r from period T+1 onwards. r = T i r, + i > 0 How o choose he period in which we compue he average growh rae of rens and average ineres rae is quie arbirary. For his reason, i is convenien a his poin o make a robusness es of his fundamenal model. To do so, we consider wo oher r. 18

20 periods, he las 10 years and he whole sample. The fundamenal price proofs no o be sensiive o which period is chosen. Calibraion of fundamenal house prices: Once we have he fundamenal impued rens and he morgage ineres raes up o infiniy, our remaining parameers in order o calibrae he fundamenal house price are m, ρ, δ, ϕ, τ and he conversion facor α 1. We assume κ = δ + m + ρ = Regarding he fiscal parameers, we iniially se τ= 20% and ϕ = 15%. Wheher he value chosen for is increased o 25% or no does no aler 0 our resuls very much, giving some addiional sense of robusness. Finally, regarding he conversion facor, we choose α 1 so ha he deviaion of he fundamenal house price ( ) a P from he acual house price ( ) P is minimal in a randomly chosen ime period. We assume ha in his poin prices are in heir long-run equilibrium and so variaions in he fundamenal prices explain acual prices. Firs we have o deermine in which period prices are in equilibrium. We ake wo scenarios. The firs one, following he research of Balmaseda, San Marín and Sebasián (2002) and García-Monalvo (2003) among ohers would assume prices in he period o be in equilibrium. The second opion is o ake he price in o be in equilibrium. The resuls differ a bi as in he second approach prices appear o be slighly undervalued from heir fundamenals in he period This resul lies in accordance wih Ayuso and Resoy (2006).The auhors aribue he overvaluaion in 2004 o be he consequence of an adjusmen process deriving from he undervaluaion of prices in he lae 1990 s afer he bubble bursed in They rejec he hypohesis of a bubble in he early 2000 s. We follow he firs scenario aking he prices in as reference. The reason for his is ha prices were sable for 6 years beween 1993 and 1998 wih a real appreciaion of jus 1%. Bu also, i is ineresing for us o assume prices o be in equilibrium in 1999, so ha when we check he effec of removing he MID in 2000 and in 2004 we sar from a long-run price equilibrium. Overall, we have o solve he following minimizaion problem: min { α > } 1 R + P + 1 ϕ (1.13) (1 τ ) r + κ IV a 1 P α I 2 7 In he lieraure, κ as such is no defined. However, he se of values aken by δ + m + ρ usually ranges beween 4-12%. Poerba (1992) for example uses 8%, and he average value in Ho (2009) for 6 differen counries is 8% oo. We ake his approximaion, however, we also allowed for some changes in order o es he robusness of he model and resuls did no change significanly. 19

21 3.3. Daa In his secion he daa used for he calibraion and esimaion of he fundamenal house value is presened. All daa mus be quarerly and he ime horizon aken ino accoun includes from 1997-I o 2013-III. Daa is deseasonalized and nominal values deflaed by he domesic Consumer Price Index (CPI). The lack of daa and he doubful qualiy regarding house prices has been repeaedly commened. Many roubles come from he heerogeneiy of houses boh in ime and in space. Bover (1993), who was he firs analys o face his problem, poined ou ha no daa is available before 1976 nor complee series a a naional level before Since hen, daa is provided by he differen appraisal agencies, and all of hem aggregaed by he Miniserio de Vivienda. In 1995, he Miniserio de Fomeno ook over using he same mehodology 8. García-Monalvo (2012) argued ha financial eniies involvemen in appraisal agencies capial lead he laer o overesimae he value of houses during he boom period. According o him, house price daa is subjec o a possible overvaluaion close o 30% during his period. Since 2007, INE offers a hedonic price index. The hedonic price model consiss on explaining he price of a good in erms of is characerisics, which for he housing marke could be nº of bedrooms, nº of bahrooms, square fee, wheher or no he house has a garage, ec. However, due o is shor ime span we have o choose anoher source. In his paper we consider house prices since 1997, we follow daa provided by he Miniserio de Fomeno. The housing sock; measured as he number of houses, and he morgage ineres rae; approximaed by he Tipo de los présamos libres para adquisición de vivienda de hogares are obained from he Boleín Esadísico from he Bank of Spain. Disposable income, inflaion and acual rens are all obained from INE. The GDP is obained from he Conabilidad Nacional Trimesral and Vivienda en alquiler componen in he CPI. R are approximaed by he 3.4. Removing morgage ineres deducions: he fundamenal price In his secion we analyse he effec on he fundamenal house price of removing MID. On a nushell, is eliminaion would have mean an increase in he user cos of owning a house and, hence, a decrease in he demand for housing, followed by a decrease in he fundamenal house price. We are also ineresed in comparing he effecs of he policy had i been aken in he year 2000 or in 2004, his is; a he beginning of each legislaion period prior o he crisis. Before discussing he effecs of removing MID we shall review he overvaluaion of house prices. There are wo main approaches for deecing bubbles: he macroeconomic one and he financial one. a 8 See Bover (1993) and García-Monalvo (2001) for a more deailed analysis of he differen sources of daa and how hey are gahered. 20

22 The financial approach uses he price-o-earnings and price-o-income raios, as in he financial asse pricing lieraure. Many auhors, such as Case, Shiller (1989, 2004), have exended hose raios o he real esae marke. The firs raio is equivalen o he housing price-o-ren raio and reflecs he relaive cos of owning versus rening; if house prices are high, poenial home buyers would end o ren and, hus, he demand for houses would decrease and prices would fall. The second one, he price-o-income raio, describes he affordabiliy of a house. Commonly, i is agreed ha if he price-oren raio is high, prices are susained by unrealisic expecaions of capial gains raher han by fundamenals and, hence, a bubble may exis. The financial approach, which is more sraighforward han he macroeconomic one as i does no require he calculaion of he fundamenal price, has been criicized as inadequae in order o explain house price bubbles (Himmelberg e al, 2005). These indicaors only consider one fundamenal facor a a ime, bu even if hey considered several of hem, hey only consider he curren fundamenal and no heir fuure developmen (Ho, 2006). Ayuso e al. (2006) presen a summary of he research on housing bubble deecion for he Spanish case. The following able summarizes he findings in he recen lieraure: Work Approach Overvaluaion in (%) 9 Balmaseda, San Marín and Sebasián (2002) Macro 28 Ayuso and Resoy (2003) Financial 20 Marínez-Pagés and Maza (2003) Macro 43 García-Monalvo (2003) Financial 28 Abad (2013) Macro As described in secions 3.1 and 3.2, in his paper we follow he macro approach for he fundamenal price and he overvaluaion. There are wo reasons for choosing his approach. The firs one is he inadequacy of he price-o-ren raio menioned above. The second reason is ha he macroeconomic approach as described in secion 3.1 allows us o inroduce fiscal policy changes and measure heir impac over he fundamenal price. The fundamenal price is represened in figure 3.1. This graph shows he wo exreme cases: he exogenous Y case fundamenal price, and he full deducions case price. These are he upper and lower limis o he fundamenal price. We assume prices o be in equilibrium during he period Fundamenals are able o explain he acual price for wo addiional years (unil 2001), and from hen onwards, he heoreical price coninued o grow slowly while he acual price boosed. According o our esimaes, house prices were overvalued by 30-34% in he year This figure is a bi higher han he resuls obained by García-Monalvo (2003), Ayuso (2003) and Balmaseda e al. (2002) bu lower han he one obained by Marínez-Pagés (2003). This paper basically follows he same approach as in Abad (2013), 10 however, including 9 Difference beween acual price and long-run equilibrium (%) 10 I wish o hank J. Abad for helpful discussion and advice in he elaboraion of his paper. Furhermore, his esimaion of he impued ren is used in his paper as he exogenous Y case ren, where income is no affeced by axes. 21

23 fiscal policy parameers; his may be he reason for he discrepancy beween he wo figures. The fundamenal price reached is maximum by The impued rens coninued growing during 2006 and 2007, however, recall from secion 2.2 ha, morgage ineres raes were close o 0% in 2006 and grew o 3% by he hird quarer of The increase in he ineres rae raised he user cos and offse he growh of impued rens. For his reason, he fundamenal price sayed fairly consan during ; however, he acual price kep rising. The 2008 recession ranslaed ino an increase in he unemploymen rae and a fall in disposable income, hese, ogeher wih an accumulaed housing sock which had ripled following he boom in residenial consrucion, lead o an excess supply and he bursing of he bubble in he second quarer of 2007, period in which he house price overvaluaion peaked, exceeding 80%. The fundamenal price experienced he greaes fall in Beween he end of 2009 and he beginning of 2011 disposable s income growh rae seemed o recover, and his, ogeher wih he sagnaion of he housing supply, is why he fundamenal price recovered oo. However, since 2011 disposable income again was decreasing and, hus, he fundamenal price has been falling unil he las daa is available (hird quarer of 2013). The fundamenal price has fallen by 12% beween he end of 2007 and he end of The acual price has plummeed wihou sop ever since he adjusmen process began in mid By 2013, real house prices had fallen by 36% bu hey were sill 29% overvalued. Presumably, wih daa from he beginning of 2014 we would see an increasing fundamenal price. 130 Figure Fundamenal house price Exogenous Y Full deducion Figure 3.2 shows how he fundamenal price would have behaved in case MID had been eliminaed a differen poins in ime. This fiscal policy change has wo effecs over he fundamenal price. The firs effec occurs via disposable income and impued rens. In equaion (1.10) we defined disposable income as a funcion of aggregae income and he Yɶ = f Y, q,ϕ. Removing MID number of periods in which deducions were allowed ( ) will reduce disposable income, reducing he impued ren and, hence, reducing also he fundamenal price. The sooner he policy change occurs, he greaer he effec will be over income. The following able summarizes he differen expressions for Y ɶ. 22

24 Case Nº years q = (,, ) Exogenous Y 11 0 Yɶ = Y Full deducion % Yɶ = Y(1 + ϕ) Removing MID in /11 = 64% Yɶ = Y(1 + 64% ϕ) Removing MID in /11 = 27% Yɶ = Y(1 + 27% ϕ) The second way by which his policy affecs he fundamenal price is he direc effec of removing ϕ on he fundamenal price equaion (1.11). This is a 16% decrease in he fundamenal price. This resul maches hose sudies reviewed in secion 2.3; Poerba (1984), Capozza (1996) and MA López García (2000, 2008). I migh srike he reader ha his second effec on he fundamenal price is independen of wheher he reform akes place in 2000 or in We should ake wo hings ino accoun. Firs, fundamenal house prices are defined as he presen value of all fuure impued rens, hey are he seady sae equilibrium owards which acual prices should move and herefore, his equilibrium is no sensiive o wheher he policy is aken wih jus 4 years of difference. Secondly, mos papers which evaluae he effecs of such a fiscal policy change only measure he effecs on he fundamenal price or he seady sae equilibrium. Wha hey do no ake ino consideraion is he speculaive componen of house prices. The complee removal of MID has been criicized o be a policy which has a limied effec as i can only be done once. Furhermore, he effecs of his policy change are said o be a one-ime decrease in prices which leaves no room for fuure acion (Crowe e al, 2011). In his paper however, we wan o measure he effec of he policy change no only on he fundamenal price bu on he bubble as well. To do so, we canno only focus on he effec porrayed in figure 3.2 bu we also have o model how he acual price would have behaved given he expecaions bubble. Our resul will show ha carrying he reform in 2000 or in 2004 will no significanly maer for he fundamenal price in he long-run, bu will be crucial for he bubble componen and, hence, he acual price. In he nex secion we will see he role played by expecaions and how hey have conribued o explain he evoluion of prices Figure Fundamenal house price and fiscal policy Full deducion Removing MID in 2004 Removing MID in

25 4. The inrinsic bubble in he real esae marke 4.1. Calibraion process In he fundamenal model i is no only assumed ha agens are raional, bu also ha hey have perfec foresigh. These indeed are wo very srong assumpions regarding invesor s forecasing abiliies. We accep ha, in he long-run, prices will reflec heir fundamenals and hey will rever o hem. However, in he shor-run bubbles may exis. In his secion we ry o explain he deviaion of acual and fundamenal prices by means of a speculaive bubble model. Shiller (1981) aribues excessive flucuaions in he sock marke o he irraional behaviour of invesors. Raional bubbles, however, rely on he self-fulfilling expecaions of invesors and, hus, prices could increase only because invesors believe ha he price will increase in he nex period. The inrinsic bubble model proposed by Froo and Obsfeld (1991) 11 for he sock marke can be easily applied o he real esae marke. In order o do so, we simply consider he impued rens ( R ) calculaed in secion 3 as he dividends paid in he sock marke model. Bearing his in mind, he real price of a house according o he b inrinsic bubble model ( ) b pv erm P = P + B as in (2.1): P will be he sum of he presen-value erm and a bubble b P = ar + cr λ (2.1) + 1 where a and c are arbirary consans and λ> 1 gives he bubble erm is explosive characer. I should be saed ha he bubble erm in his paper is a funcion of periods + 1 ren which is a modificaion of he original proposiion, see appendix A for a furher discussion of his maer. Firs we calculae he presen-value erm in (2.1). The consan a can be calibraed in he same way as in secion 3.2; we se a so ha a equal o he acual price ( ) P in The second par of (2.1) corresponds o he bubble erm. The exponen λ = log (1 + κ + rɶ ) is he key elemen for he model; i is wha allows prices o 1+ gɶ overreac o changes in fundamenals. We assume gɶ o be he average growh rae of impued rens and rɶ o be he average real morgage ineres rae, boh of hem for he 5 firs periods of he sample ( ). Jus as in he fundamenal model, choosing his period is quie arbirary. Similarly, in order o es he robusness of he model we allow for anoher period, in his case, he firs 10 years ( ). The model is again robus o hese changes in parameers. The arbirary consan c is calibraed so ha i reduces he Mean Square Error (MSE) during he whole sample. Therefore, c solves he following minimizaion problem: T ( ) 2 a P ar cr λ 1 { c} + + min = 0 pv P is 11 See Appendix A for a review of he inrinsic bubble model as developed by Froo and Obsfeld (1991). 24

26 In figure 4.1 we display he resuls obained boh for he fundamenal and he esimaed price, and we compare hem o he acual price. The bubble erm explains mos of he acual house price flucuaions and he model fis bes in he upward rend of house prices bu no so well when prices sar o decline. Once he bubble burss, he model predics a much more pronounced fall in prices. However, his should no be hough as a drawback of his model. The model is derived from a financial asse valuaion framework and hence, i ignores some characerisics of he real esae marke. In paricular, as menioned in secion 2.2, he banking secor is highly exposed o he housing marke. Hence, house prices are no allowed o decline as fas as he model predics since i would have a subsanial impac on he financial secor s soundness. Moreover, here are supply rigidiies since owners may no wan o sell heir houses even hough prices migh be plummeing if hey expec his fall o be ransiory Figure House Prices Acual House Price Esimaed House Price Fundamenal In any case, main purpose of his paper is o simulae how he housing price bubble would have evolved had ax subsidies, such as MID, been removed in he early 2000 s. Thus, for our purposes, we are jus ineresed in he upward rend of house prices raher han on he adjusmen process which ook place following he bubble burs. For his reason, even hough his model migh presen several drawbacks and deficiencies, i is very useful for wha we wan o analyse. We use he esimaed house price as a proxy of he acual house price in he upward cycle of prices Removing morgage ineres deducions: he bubble Jus as we did in he fundamenal model case, we now consider he effecs of a complee removal of MID. Tha is, changing ϕ from ϕ = 15% o ϕ= 0. We use he calibraed 0 model presened in secion 4.1 o measure he effecs of such a removal of MID on he bubble. We se parameers a and c from he real economy daa. However, in his simulaion exercise, we will no longer have real daa wih which o calibrae i. For his reason, we keep he same parameers a and c and we approximae how he acual price 1 25

27 would have evolved by changing he bubble componen of house prices R λ. We will consider hree scenarios; he base case is he acual siuaion, in which MID were no eliminaed prior o he bursing of he bubble. The second scenario is he case ha MID would have been removed in The hird scenario is removing MID in he Each scenario will have an associaed esimaed house price. Figure 4.2 shows he bubble erm according o he model in secion 4.1, and how his componen would have changed once MID were been removed. Conrary o he fundamenal price case, here here is a clear difference in he bubble componen depending on wheher MID were removed in 2000 or Removing MID in 2004 would have mean ha he peak of he bubble erm would have been 26% below ha he one wih no fiscal policy change a all. Had his policy acion been aken in 2000, he effec would have been as wice as big and he bubble erm would have been 51% smaller han he acual one. Consumers expecaions on house prices play a key role in he evoluion of hese prices. As MID are removed, and hence, home-ownership become less aracive, he demand for houses falls and hus, prices would no have risen so much. The sooner his policy was implemened, he slower (and smaller) he upward expecaions would have evolved. 120 Figure The bubble componen and fiscal policy Bubble erm Removing MID in 2004 Removing MID in In figure 4.3 we presen he acual house price and he esimaed effecs of hose fiscal policy acions. In his graph we do no only focus on he bubble erm ( B ), as in he b previous graph, bu we look a he esimaed house price ( P ). The green and ligh blue lines represen how he acual house price would have evolved if MID had been removed in he 2000 and 2004, respecively. We sar from a siuaion where esimaed prices are higher han he acual price. This iniial overesimaion could be aribued o he euro effec menioned in secion 2.1. If MID had been removed in 2004, prices would have been 14% smaller han he acual prices reached a he peak, jus before he bubble burs. In he scenario where MID were removed in 2000, prices behave more smoohly and a heir maximum would have been 27% smaller han acual prices. 26

28 Figure Acual price and esimaed price Acual House Price Removing MID in 2004 Removing MID in 2000 Measuring how prices would have peaked is of grea imporance; however, hey do no reflec he whole effec of he policy change on he housing bubble. Recall we defined he bubble as he difference beween acual and fundamenal prices. We have already obained he esimaed effec of removing MID boh on he fundamenal price and he acual price. In order o measure he overvaluaion in each scenario, we have o compue he difference beween he esimaed house price in each of he hree cases (depiced by figure 4.3) and he fundamenal house price in each scenario (as shown in figure 3.2). Figure 4.4 shows he overvaluaion in each scenario. There are several ways o assess he effec of he ax policy over he bubble. The firs one is o measure he overvaluaion a he maximum poin. The acual overvaluaion was around 80% a he 2007 peak. We can compare he overvaluaion in he wo alernaive scenarios wih his one. Our resuls indicae ha, in 2007, had MID been removed in 2004; he maximum overvaluaion would have been 5 percen smaller, bu sill close o 80%. In his case, he decrease in he esimaed price is mosly offse by he decrease in he fundamenal price. However, if MID would have been removed in 2000, he fall in he esimaed price would have been greaer, as here were 4 more years in which expecaions would have curbed, and hus, he overvaluaion in 2007 would have been 30% smaller in his case. 100% 80% Figure Overvaluaions 60% 40% 20% Acual overvaluaion Remove MID in 2004 Remove MID in % The second way o assess he effec over he bubble is o measure he accumulaed overvaluaion which would have been avoided. When he bubble is a is early sages, he relaive impac of removing MID on he bubble componen is small compared o he 27

29 impac on fundamenals. Therefore, in hose cases we can find some periods in which he ne impac of removing ax incenives on overvaluaion is even posiive. We ignore hose periods in calculaing he accumulaed impac of he ax reform. Our resuls indicae ha removing MID in 2004 would have mean ha he housing bubble would have been jus 15% smaller during his period. Bu if MID had been removed in 2000, he bubble would have been 36% smaller. The following able summarizes he resuls. The firs row corresponds o figure 4.2. I jus reflecs he impac on he bubble erm. The second row gahers he informaion from figure 4.3: how (smaller) would have he esimaed house price been wih he ax reform. The hird row measures how smaller he overvaluaion would have been a he peak (2007), as shown in figure 4.4. The fourh row shows he amoun of accumulaed overvaluaion ha would have been avoided wih he policy change. Elemen Removing MID in 2000 (%) Removing MID in 2004 (%) Effec on he bubble erm Effec on he house price peak Effec on peak overvaluaion Accumulaed overvaluaion avoided Overall, we can conclude ha removing he implici ax subsidy o home-ownership would have had a subsanial bu no complee effec on he housing bubble. By removing MID, buying a house would have become less aracive and he demand for houses would have decreased, hence, curbing prices. This effec is paricularly srong if we ake ino consideraion he speculaive componen of house prices. A bubble occurs when house prices increase uniquely due o expecaions of fuure capial gains. Therefore, should prices have iniially been lower; expecaions would have buil up o a lower exen. The fundamenal house value seems no o be very sensiive o he dae in which MID are removed. On he conrary, he esimaed house price according o he inrinsic bubble model changes considerably depending on he policy iming; he sooner he fiscal reform would have been aken, he smaller he house price increase. 28

30 5. Conclusions In he descripion of he Spanish recession i is common o find an appeal o he housing bubble as one of he main drivers of he economic disaser. Moreover, mos analyss and poliical acors claim ha policy inacion on he bubble is highly responsible for he severiy of our recession. However, nobody has esimaed so far o wha exen ax deducions are really responsible for he bubble build-up. In his paper we ry o quanify i. All in, we could have avoided a hird of he bubble if he ax reform had been implemened in 2000 and around a 10% if acions were aken in 2004, a dae ha was oo close o he end of he boom period. We assess he effec of a fiscal policy change eliminaing morgage ineres deducions (MID) - on he Spanish housing bubble. The firs sep is o calculae he fundamenal (or heoreical) house value. Following he asse-marke approach originally proposed by Poerba (1984), we develop a model based on he user cos of home-ownership. Once his model is calibraed, we obain a fundamenal house value, and define deviaions of acual prices from his fundamenal price as bubbles. As he fundamenal model canno explain he house price flucuaions, we follow he inrinsic bubble model proposed by Froo and Obsfeld (1991) o jusify excessive price flucuaions. In a raional bubble model, prices deviae from fundamenals as he consequence of he selffulfilling expecaions of agens, however, in he inrinsic bubble model, agens overreac o changes in he fundamenals of he model, hough in a nonlinear fashion. The price of a house according o his model is he addiion of a presen-value erm and a bubble erm. This model is capable of explaining house price flucuaions accuraely unil he bursing of he bubble. However, i has wo main drawbacks. The firs one is ha he model does no consider a very imporan acor of he housing marke: banks. Banks play a key role in he price adjusmen process, given is implicaions on heir financial soundness. The second one is ha he model is derived from a financial asse pricing model and, hus, i ignores some characerisics of he housing marke such as supply rigidiies. Bu, for he purpose of his paper, which is o simulae how he housing bubble would have evolved if ax subsidies had been eliminaed in he early 2000 s, he model does no suffer from hese drawbacks. We quanify he effec on he esimaed 80% buil-up bubble if MID had been removed in 2000 or in 2004, ha is, a he beginning of each legislaion period prior o he crisis. The main resul of he paper is ha removing MID in 2004 would have mean a bubble reducion of jus 5-15% smaller. Tha year is oo close o he end of he boom and he following burs, and hus, he effecs are limied. However, had MID been removed in 2000, we could have avoided beween 27-36% of he price bubble. In he model we define disposable income as a funcion of aggregae income and ax incenives; he longer an individual can make deducions from he personal ax income, and he greaer he amoun ha can be deduced is, he higher he disposable income of 29

31 his individual will be. Thus, we obain wo exreme cases for he disposable income in he economy; he exogenous income case is he one wih no deducions. The full deducion income case is he one where deducions could be applied in every period. These wo exreme cases for disposable income yield wo exreme cases for impued rens and, herefore, wo exreme cases for he fundamenal price. Removing MID a some poin will lead o an inermediae scenario where individuals will experience a decrease in heir disposable income as hey have o pay more axes. These wo exreme cases define he boundaries of he effec of such a fiscal policy change. Furhermore, as menioned above, in his model we ake he housing supply as exogenous. This is a quie srong assumpion in he simulaion exercise. I is rue ha removing MID would shif he demand for houses curve o he lef, while leaving he supply curve unchanged (Lopéz-García, 2000 and 2008). However, even if he supply curve remains consan, a shif in he demand curve would have decreased he quaniy supplied. By considering he housing sock as exogenous we do no ake ino accoun his effec. Therefore, he resuls are again an upper band on he fiscal policy change impac. Given he poliical implicaions of he resuls, we asked ourselves how dependan resuls are o changes in he parameers of he model. Several robusness ess have been made hroughou he paper. Resuls proved o be consisen wih differen parameers. In secions 3.2 and 4.2 we chose ime periods in which o measure he average growh rae of impued res and he average impued rens. Which period o choose could be quie an arbirary decision. Again, he model proved o be robus wheher we chose 5 years, 10 years or even he whole sample. In summary, as far as we know his paper is he firs o quanify he effec of fiscal policy decision on he housing bubble. Previous works had deal wih he effec on he seady sae equilibrium house price. However, none of hem considered he overall effec on he bubble. From here, several exensions could be done. One of hem is he impac on he bubble had a differen moneary policy been implemened. Anoher exension is relaed o loan supply under differen ax incenives schemes. 30

32 6. Bibliography Abad, J. (2013). Precios de la vivienda: sobrevaloración y burbuja, Universidad Compluense de Madrid André, C. (2010). A Bird's Eye View of OECD Housing Markes, OECD Economics Deparmen Working Papers, No. 746, OECD Publishing. Ayuso, J and Resoy, F. (2006). El precio de la vivienda en España: Es robusa la evidencia de la sobrevaloración?, Boleín Económico Banco de España, Junio 2006, pp Ayuso, J., and Resoy, F. (2003). House prices and rens: an equilibrium asse pricing approach, Documenos de Trabajo, Nº0304, Banco de España Balmaseda, M., San Marín, I. and Sebasián, M. (2002). Una aproximación cuaniaiva a la burbuja inmobiliaria, Siuación Inmobiliaria BBVA, diciembre 2002, pp Bover, O. (1993). Un modelo empírico de la evolución de los precios de la vivienda en España ( ), Invesigaciones Económicas, Vol. XVIII, Nº1, pp Bover, O. (2005). Wealh effecs on consumpion: microeconomeric esimaes from he Spanish survey of household finances, Documenos de rabajo - Banco de España, Nº0522 Capozza, D., Green, R. and Hendersho, P. (1996). Taxes, Morgage Borrowing,and House Prices, Wisconsin-Madison CULER working papers 97-05, Universiy of Winsconsin Cener for Urban Land Economic Research Case, K. and Shiller, R. (1989). The Efficiency of he Marke for Single-Family Homes, American Economic Review, Nº 79(1), pp Case, K. and Shiller, R. (2004). Is here a bubble in he housing marke?, Cowles foundaion paper, Nº 1089, pp Crowe, C., Dell Ariccia, G., Igan, D. and Rabanal, P. (2011). How o Deal wih Real Esae Booms: Lessons from Counry Experiences, IMF working paper, WP/11/91 Froo, K., and Obsfeld, M. (1991). Inrinsic Bubbles: The Case of Sock Prices, American Economic Review, Vol. 81, Nº5, pp García-Monalvo, J. (2001). Un análisis empírico del crecimieno del precio de la vivienda en las Comunidades Auónomas Españolas, Revisa Valencia de Economía y Hacienda, Nº 2, pp García-Monalvo, J. (2003). La Vivienda en España: desgravaciones, burbujas y oras hisorias, Perspecivas del Sisema Financiero, Nº78, pp.1-43 García-Monalvo, J. (2012). Perspecivas del precio de la vivienda en España, Cuadernos de Información Económica, Nº227, pp

33 García-Vaquero, V. and Marínez-Pagés, J. (2005). Fiscalidad de la vivienda en España, Documenos Ocasionales Banco de España, Nº0506 Green, R. and Whie, M. (1997). Measuring he Benefis of Homeowning: Effecs on Children, Journal of Urban Economics, Nº41, pp Helbling, T., and Terrones, M. (2003). When Bubbles Burs-Chaper II, World Economic Oulook - Inernaional Moneary Fund, April 2003, pp Himmelberg, C., Mayer, C. and Sinai, T. (2005). Assessing High House Prices: Bubbles, Fundamenals and Mispercepions, NBER working papers, WP11643 Ho, C. (2009). Explaining House Price Flucuaions, Swiss Naional Bank Working Papers, Ho, C. and Jokipii, T. (2012). Housing Bubbles and Ineres Raes, Swiss Naional Bank Working Papers, Ho, C. and Monnin, P. (2006). Fundamenal Real Esae Prices: An Empirical Esimaion wih Inernaional Daa, Naional Cenre of Compeence in Research Financial Valuaion and Risk Managemen, Nº356 López García, MA. (2000). Un marco para la discusión de los efecos de la políica imposiiva sobre los precios y el sock de vivienda, Papeles de rabajo del Insiuo de Esudios fiscales, Nº 8, pp.1-36 López García, MA. (2005). La vivienda y la reforma fiscal de 1998: un ejercicio de simulación, Hacienda Pública Española, IEF, Vol. 175 (4), pp López García, MA. (2008). Políica imposiiva y políica de vivienda, Clm. Economía, Nº 11, pp Marínez-Pagés, J. and Maza, L. (2003). Análisis del precio de la vivienda en España, Documenos de rabajo, Nº0307, Banco de España Orega, E., Rubio, M. and Thomas, C. (2011). House purchase versus renal in Spain, Documenos de rabajo-banco de España, Nº1108 Poerba, J. (1984). Tax Subsidies o Owner-Occupied Housing: An Asse-Marke Approach, The Quarerly Journal of Economics, Vol. 99, Nº4, pp Poerba, J. (1992). Taxaion and Housing: Old Quesions, New answers, The American Economic Review, Vol. 82, Nº2, pp Raya, JM. (2012). Una aproximación al impaco económico de la recuperación de la deducción por la compra de vivienda habiual en el IRPF, Observaorio de Divulgación Financiera, Documeno de Trabajo Nº6 Sanz, J.F. (2000). Las ayudas fiscales a la adquisición de inmuebles residenciales en la nueva Ley del IRPF: un análisis comparado a ravés del concepo de cose de uso, Hacienda Pública Española, Nº 155, pp Shiller, R. (1981). Do Sock Prices Move Too Much o be Jusified by Subsequen Changes in Dividends?, The American Economic Review, Vol. 71, Nº 3, pp

34 7. Appendix A 7.1. Inrinsic bubbles in a presen-value model The financial asses valuaion model proposed by Froo and Obsfeld (1991) sars from he sandard no arbirage condiion where real sock prices in period ( P ) are equal o he expeced dividends paid in period ( D ) plus he expeced real price of he sock in he nex period ( P + 1) discouned a rae r : [ ] P = (1 + r) E D + P (3.1) By successive forward subsiuion of he expeced price in +1 we obain ha he sock price is equal o he presen discouned value of expeced dividend paymens: pv ( s + 1) = (1 + ) ( s ) s= P r E D (3.2) Equaion (3.2) is a paricular soluion o he difference equaion (3.1), however, i is no he only possible soluion. Le { B } = 0 Then, pv be any sequence of random numbers such ha: B = + r E B (3.3) 1 (1 ) ( + 1) P = P + B is a soluion o (3.1) which can be hough of as he sum of he presen-value soluion and a bubble erm. Assuming ha he dividends of period are known when seing P, we have ha he presen-value sock price is direcly proporional o dividends: P pv = κ D (3.4) We now define B ( D + 1) 12 as: B ( D ) = cd λ (3.5) where λ and c are consans. In his case, he bubble erm in period depends on he expeced dividend in This is a modificaion of he original proposiion. According o he auhor s model he bubble erm is a funcion of curren dividends and no of expeced dividends. We consider ha his sligh modificaion suis beer he Spanish real esae marke while leaving he model pracically unalered. Furhermore, in (3.6) we proof ha (3.5) saisfies (3.3). 33

35 Defining g as he growh rae of dividends we can verify ha (3.5) saisfies (3.3): ( ) B = (1 + r) E B = (1 + r) B( D ) = B ( D ) + 1 [ ] 1 = (1 + r) B (1 + g) D 1 = (1 + r) (1 + g) cd λ (3.6) as long as λ = log 1+ g (1 + r). By summing he presen-value erm and he bubble in (3.5) we obain he model s basic sock-price equaion: pv P = P + cd λ (3.7) + 1 Whenever c 0, equaion (3.7) will conain a bubble. I migh be he case ha c< 0 and herefore, here is he possibiliy of a negaive bubble. However, he expeced posiive pah of he presen-value erm could overcompensae he negaive developmen of he bubble erm and we could have a siuaion of a negaive bubble where prices are no expeced o ge negaive (Ho, 2006). Like all raional bubbles, inrinsic bubbles rely on self-fulfilling expecaions. However, insead of being driven by exraneous variables, hese expecaions are driven by he nonlinear form of he price soluion. λ> 1 is he explosive nonlineariy which allows us o expec ha agens will overreac o changes in fundamenals. 34