Doug Ford has a policy idea, and it’s a bad one

For those who haven’t been following these things, our current Toronto mayor Rob Ford has dropped his bid for re-election and his brother Doug has taken over for him. How much of a difference this makes remains to be seen. One might be tempted to say that there’s no real difference between the two, just six of one, a half-dozen of the other. That’s not entirely accurate, it’s more like schlemiel, schlemazel.

Anyhow, Doug Ford (aka “schlemiel”) has been sticking fairly closely to the “post-truth” playbook, essentially saying whatever sounds best, in a way that shows total disregard for the norm of truth. Yesterday though he announced a genuine policy commitment, which is to reduce Toronto’s land transfer tax by 15% per year for 4 years. Reducing this tax is something that his brother Rob (aka “schlemazel”) campaigned on four years ago, and failed to gather enough support on council to implement. Doug, however, is certain that he can succeed where Rob failed, because he knows what makes councillors “tick” – or so he claims.

The policy is a terrible one, and I would like to explain why. My major reason for doing so, however, is actually just to harp on something that I love to harp on, which is the concept of tax incidence. This concept is one that interests me because it reveals the limitations of all “populist” approaches to taxation and tax policy. It’s not a difficult concept to explain – the idea is simply that, when it comes to taxation, the person who writes the cheque to the government is not necessarily the person who pays the tax. That’s because people often have the ability to pass along to cost of the tax to someone else. As a result, it sometimes takes a bit of investigation to figure out “where the buck stops,” and therefore, who is actually paying the tax.

The most obvious example of this is the GST/HST, which is technically paid by corporations – after all, they are the ones who actually have to remit GST payments to the government. But from the perspective of tax incidence, the GST/HST is obviously paid by consumers, because corporations just pass it along.

This point is often made whenever the NDP starts talking about wanting to increase taxes on corporations. Whenever they do (which, lately, has been always), the newspapers are full of columnists pointing out that the tax on corporate profits is typically not paid for out of profits, but is passed along to workers, consumers, etc. Again, the key concept is tax incidence – the person who writes the cheque to the government is not necessarily the person who pays the tax.

The thing about this concept is that it is relatively abstract, involving several steps in reasoning to explain, and so cannot be grasped through our “intuitive” or system 1 style of cognition. It depends upon an essentially rational insight. As a result, anyone who is campaigning in a “populist” style will be driven to ignore it. And to the extent that the needs of the campaign are dictating policy, this means that populism will almost inevitably generate bad tax policy (think of Harper’s decision to cancel a scheduled income tax cut, in order to lower the GST instead; or the NDP’s insistence on raising corporate taxes…)

Okay, so how does all this apply to the land transfer tax? The crucial point is that, even though this tax is paid by home buyers – and is therefore “hated” by home buyers – it is not really paid by home buyers. Right now, in the Toronto market, it is actually paid by the seller, which is to say, the incidence of the tax falls upon the seller. In order to see why, just remember that practically every home that is sold in Toronto has multiple bids.

How do prospective home-buyers decide how much to bid? First step is they talk to various people, to determine what their budget is (i.e. how much they are willing to spend). Most importantly, they sit down with a mortgage specialist at their bank, who will look at their income, look at all their expenses, determine how much of a monthly mortgage payment they can afford, then take interest rates and extrapolate out from this a total amount that the bank is willing to lend. This amount obviously includes the land transfer tax.

As a result, if a bank is willing to lend $800,000, and the land transfer tax on a transaction in that range is going to be, say $20,000, then the bank will tell the prospective buyers than they can spend a maximum of $780,000. (For simplicity, just ignore the fact that the buyers will also be putting up some of their own money, for a down payment.) What this means is that, when these buyers get into a bidding war, the most that they are able to bid is $780,000 – so assuming they really want the house, this is how much they will bid. The other prospective buyers will bid whatever it is that they have been told by their banks that they can bid. If the first buyers win, then the house will sell for $780,000. The bank will lend $800,000 to the buyers, $780,000 will go to the seller, $20,000 to the government.

Now suppose that the land transfer tax is eliminated entirely. What would be the effects? Everything is much simpler – the bank tells the prospective buyers that they can spend as much as $800,000. But of course, it isn’t just one bank doing this. Since no one is paying the tax any more, all the banks will be increasing the budgets of all the prospective home buyers. As a result, it will no longer be possible to win the bidding war on the house by offering only $780,000 – since the other buyers all have more money to spend now. Thus our prospective buyers will have to bid their maximum amount again, $800,000. And again, if they win, the bank will lend them $800,000. But this time, all of the money goes to the seller and none of it goes to the government.

Following this chain of reasoning, it’s easy to see that in the first scenario, where there is a land transfer tax, that tax is actually being paid by the seller, in the form of a reduced selling price on the home. And when you cut the land transfer tax, all of the benefit goes to existing home owners – they get the full benefit in the form of increased sale prices on their home (the tax is “capitalized,” as they say). Home buyers get no benefit at all (except insofar as they are selling their old house).

So the real question is, do existing home owners deserve to get a big tax break – since this is, in effect, what Doug Ford is proposing. My inclination is to say “no,” for the simple reason that people who own Toronto real estate have already been reaping windfall gains. Many have seen the value of their homes double or triple in the past decade. Do they really need a tax break? Furthermore, thanks to various forms of regulation, including caps on density, there are significant economic rents associated with residential property ownership in Toronto. A tax on rents (in the technical sense of the term) is the best form of tax, from an efficiency perspective, since it is non-distortionary. Thus the land transfer tax is both efficient and fair, making it something close to an ideal tax.

Or consider the question from a Piketty perspective. Many people, myself included, were pretty skeptical about his proposal for a “wealth tax” on all assets, including such things as bank deposits. But if one agrees with the general sentiment, a fairly decent approximation to a wealth tax is a tax on property. (Municipal property taxes are, in general, the most progressive type of taxes we have – with an important exception, having to do with incidence again, in the case of rental housing.) So to the extent that a land transfer tax is a partial wealth tax, it is to be supported on egalitarian grounds.

Anyhow, undoubtedly no one in the Ford camp has thought any of this through. The policy is just a knee-jerk response to something that people are upset about. The people who think they will benefit from such tax cuts (home buyers) are simply confused, while the people who are actually paying it don’t realize they are paying it, and so don’t even care. There is only one group out there with a clear, steely-eyed, rational understanding of where its economic interests lie. That’s real estate agents. First, because they charge commissions based on sale price, exclusive of taxes. Since lowering that tax would lead to a commensurate increase in prices, they stand to benefit. Second, since they make their money off transactions, they benefit from churning and turn-over in the market. So they want to maximize the number of transactions, which can be achieved, they think, by reducing all other transaction costs.

This is why the Toronto Real Estate Board (essentially the lobby group for real estate agents) has been really active on this file, starting up an astroturf campaign for repeal of the tax, and producing a laughable study claiming that the tax has done enormous damage to our real estate market. (Meanwhile, everyone else in the world, including the federal government, is worried by obvious signs that the Toronto real estate market is dangerously overvalued.) Their interests are so obviously orthogonal to the interests of both home owners and home buyers that not many people take them seriously. With Doug Ford though, they seem to have found someone simple enough to believe their claims.

Anyhow, I know this is asking a bit much, but I think it would be great if all the columnists who are always lined up to denounce NDP plans to increase corporate taxes, on the grounds that these taxes are not ultimately paid by corporations, would hit the presses again, this time to criticize Doug Ford, and to explain why the land transfer tax is ultimately not paid by home buyers.


Doug Ford has a policy idea, and it’s a bad one — 3 Comments

  1. On the Toronto Real Estate Board study … for what it’s worth, the City of Pittsburgh has a 4% tax on land transfer, paid by the buyer. This is a city where houses stay on the market for weeks and months, and the concept of a bidding war is absurd. Rather, buyers strategize about just how far below asking price their opening bid should be. Under these conditions, the tax actually does serve as a disincentive. People will look for houses outside city lines to avoid paying the 4% tax. Or they will negotiate the price down even further to factor in the tax.

    All that to say, the concept that a land transfer tax is punitive on individuals is not crazy. In Toronto, the evidence is pretty overwhelming that Ford’s claim is not applicable though.

  2. Excellent. I would add that most sellers are also buyers and that real estate is a positional good in the sense that your ability to get it is dependent on your relative rather than absolute income level meaning that the net effect of the land transfer tax is not to diminish your ability to buy real estate. You get the same house it’s just that you are able to spend some of your money on collective goods as well via the tax. The exceptions are those who are downsizing – potentially seniors. Yet there is likely a more rational and tailored way to subsidize that demographic.

  3. If the land transfer tax is reduced by 15%/year x 4 years = 60%, and if the reduction is completely transferred into an increase in selling prices, this means that a house selling for 800,000$ would sell for 812,000$ (or less, the tax is lower if the buyer is a first time buyer).

    Correct me if I am wrong, but the average commission of real estate agents in Toronto is around 5%, which means that they will only make 5% x $12,000 = $600. This is a marginal gain given what they are making with the house already (5% x $800,000 = $40,000), especially since this gain needs to be split in two. This makes it even more surprising that the Toronto Real Estate board is so proactive about the land transfer tax reduction. They don’t have a lot to gain.

    But Torontonians have a lot to loose if lower taxes translate into higher prices and more speculation.