Since real estate tax in China has people buzzing let me explain why virtually everything you're reading is thimble deep & missing the enormity of the importance and risks it is exacerbating. This may be a long thread. I will try and include links and will use simple examples 1/n
Let's start by positing that as a method of financing government revenue a yearly tax based upon some pre-defined measure say assessed value of the property is a much better method than land sales. So I have no disagreement with others who say it is. It is. But..... 2/n
People are saying this should be done have really given no thought to a variety of the problems, complications, and risks. This is why they stand around looking puzzled why this wasn't done years ago. So let's try to lay out as many of these secondary issues as possible 3/n
First, when the primary real estate transaction occurs (developer to first purchaser) the implied tax rate (from land sales which the government collects) is typically upwards of 50% and can exceed 70%. Chinese citizens know this and are very resistant to further taxes on 4/n
Assets that are already so heavily taxed. To take a parallel comparison, they will grumble when toll roads pay back their initial investment but maintain the tolls. There is significant resistance to additional taxation. 5/n
Second, the government method of generating revenue from land sales has a lot of secondary implications. I will try and remember all the important ones. A) Land sales are finite vs. real estate taxes which are effectively infinite. Put another way, there is a fixed amount 6/n
of land but there are effectively infinite years that taxes can be collected on buildings where people live. B) Land sales front load revenue realization compared to tax revenues which extend and reduce volatility over time. C) Land sales vs. real estate taxes are 7/n
the difference between a stock and a flow. Put another way, it is like a stock vs. the dividend of that stock. When the government keeps "selling" that stock it eventually exhausts the "trust fund". D) Governments prefer asset sales to taxes because they get all the money 8/n
Up front vs. having to wait E) Even after amortizing the implied tax rate at time of initial sale, the discounted tax rate I would guess compared to risk free rates of return is probably about on par with many real estate taxes in other countries 9/n
F) A major drawback with land sales is governments do not benefit from revaluation appreciation (asset price increases). In most countries this is not a major issue. In China it is significant. Let's say a government sold land in 2005, the subsequent asset price increase 10/n
Has left a lot of money on the table for governments as real estate prices exploded because of the one time nature of of land sales. G) Who benefits from buying land early? Real estate owner because that implied tax rate drops significantly. That means that the implied 11/n
Money the government left on the table by not taking a real estate "annuity" flows to secondary sellers. I think those are all the key issues about land sales vs. yearly assessed taxes. So why is there so much risk and push back on imposing a real estate tax? 12/n
Moving into the risks I am going to start renumbering the risks about imposing a real estate tax beginning again at #1. First, real estate taxes impose a "carry" cost on previous costless assets. Assume I own an apartment for simplicity sake free and clear. 13/n
Imposing a yearly real estate tax will require me to pay a material amount yearly to hold the asset. That is an ENORMOUS deterrent for most holders. Remember that there are upwards of say 80 million empty apartments in China so it isn't like there is large demand in most 14/n
Places to move into those apartments. Any level of tax will provide an enormous incentive to sell. With the level of overhang, that is enormous selling pressure from a yearly tax. Second, the numbers being presented on how to tax real estate or that you may be familiar with 15/n
From wherever you live, let's assume 1% of a property's assessed value is FAR FAR FAR in excess of anything remotely realistic in China. I just did some back of the envelope for math for Shenzhen. A 1% real estate tax on the "market" value of an apartment in Shenzhen 16/n
based upon average take home after tax income with a single wage earner would amount to roughly 50% of a post tax income. Just scribbling some math, you would have to levy the tax rate at single digit basis points of the assessed market value before you start getting 17/n
To something remotely realistic. Even then this would generate a material tax increase on individuals throughout China even in the low single digit basis points. (Basis point is 0.01%). This leads to a number of additional implications about the reality of a real estate tax 18/n
Second, this would be a broad broad tax increase. Everyone in China needs a place to live. Even if only rolled out in a few cities. That tax would be broadly dispersed in China. Now keep in mind Chinese household debt to income tops 130% 19/n businessinsider.com/china-housing-…
Not only would this tax be enormously unpopular but it is going to strain an already very strained cash flow base upon which it would be taxing. Throw in the weakness of the Chinese consumer and you have the very real risks. Third, this will place material and significant 20/n
pressure on real estate prices which already dropped by my back of the envelope math over the last three months an amount equal to about 7% of GDP. Why? We have already gone over the carry cost. Who wants to pay money every month for an investment? 21/n
However, more fundamentally it totally changes the payoff value, as a potentially cash flowing asset or as an appreciating asset. Here is the important part: it changes the expected value of the asset in a NON-LINEAR way. It changes the expected value of the asset similarly 22/n
to how changes in mortgage rates change home values. A drop in interest rates from 10% to 9% doesn't change the value of homes by 1% or even 10% but by significantly more. (If you are a finance professor don't bust my chops here I'm on Twitter trying to explain and simplify) 23/n
Third, why should we expect the Chinese real estate market to be VERY elastic with respect to cost imposition driving downward pressure on the broader real estate sector? Over the past few years, most buying of property has been done by individuals already owning property 24/n
That implies these individuals will be very responsive to changes in costs and will look to sell. Couple that with already significant drops in resales in many major markets upwards of 60%, this tells us how responsive Chinese buyers are to changes in expected value 25/n
Fourth, fundamentally this is about the Chinese government needing revenue. Remember they have been running real public deficits of about 15% for the past 5-10 years. Land sales are just another example of Chinese government profligacy. My sources tell me Chinese governments 26/n
Are changing contract terms and seizing assets. Chinese citizens are killing investments for fear it will be noticed and assets seized. Because land sales are so heavily debt driven (in one form or another) transitioning to cash flow taxation is needed but incredibly risky 27/n
The absolute best they can hope for is to create a plan over say 10 years to transition to real estate cash flow taxation as they wind down land sales but the idea that any material amount of public revenue can be generated from annual real estate taxes in the near term 28/n
Without generating nothing more than a mushroom cloud is fantasy thinking. Does it need to happen and is it a more efficient means of public revenue generation? Absolutely. Are there very valid reasons and ENORMOUS risks? You betcha. Remember this is a financial system 29/n
from governments to households to banks to firms that are pretty extreme financial (debt, rental yields, price to income) metric outliers in everyway. Something like a real estate presents ENORMOUS risks to upsetting everything. Thanks for listening to me and here are 30/n
A couple of key citations that deal either with a topical issue to a China type issue:
voxeu.org/article/can-ch…
voxeu.org/article/can-ch…
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