Putting property tax on solid footing

The increase in stamp duty of half a percentage point on houses worth £250,000 or more will do little to dampen the property boom in substantial areas of the UK.

In contrast, property tax reform could have been extremely effective against this and other economic problems. The table shows the evolution of the UK house prices/earnings ratio and the south-east minus UK difference in this ratio since 1970.

Many of the forces driving the market are comparable to those of the 1980s: higher incomes; easy loan conditions; relatively low interest rates; rises in financial asset prices; rises in house prices themselves which increase the equity cushion of owners; and the feeling of consumers that recent high rates of return in housing will continue.

Spectacular rates of return are being achieved, because mortgage borrowers are gearing up and so investing relatively little of their own cash. With the high returns believed to be available by many in London and the south-east, the rise in stamp duty will do little to dampen the market. Paradoxically, the impact of stamp duty will be felt more strongly in the next housing market downturn, when it will reduce mobility and have a larger effect on rates of return.

Property taxes are the most distorted part of the UK tax system. The current system is perverse: the largest houses in the most expensive locations, belonging to those with more than one home, attract the lowest tax rates. Moreover, small homes are proportionately the most highly taxed. Since almost half of those in the lowest tax band get council tax benefit, the tax also causes an unemployment trap.

If someone in a £40,000 house pays council tax of £500, the tax rate is 1.25%. The rate drops to 1.07% at £70,000, 0.47% at £320,000, and to 0.15% at £1m. Second or third houses attract only half the tax rate on first houses.

The New Policy Institute has suggested ways of making council tax less grossly unfair. Reforms that we have suggested go further.

They include allowing pensioners to defer council tax until the property is sold or it can be paid from their estate. This removes the biggest objection to a property tax, which is that pensioners in expensive houses often have little cash. We also propose regular revaluations and reducing the regional inequalities in council tax rates. A 35% income tax band could compensate the more affluent whose council tax bills would rise.

For the macro-economy, such a package would have helped to halt speculative fever in the property hot-spots and slowed the growth in spending in those areas, allowing interest rates and the exchange rate to fall.

Instead, sterling rose 1% against the euro after the Budget, in part reflecting the market view of what the monetary policy committee would have to do. The committee will surely push rates up only slowly, given the outcry over Rover and worries about other parts of manufacturing and agriculture which have to compete against continental Europe. And, with the public finances in good shape, gilt yields, against which fixed rate mortgages tend to be priced, will in any case remain low.

The high exchange rate will raise relative unemployment and cut relative earnings in the west midlands and other parts of the economy more exposed to European competition. Migration to the south-east will be supported by these trends, despite increasingly high housing costs, in turn tending to sustain higher house prices there.

A more level property tax playing field would have reduced many of these current and future problems - possibly saving Longbridge and Dagenham, and helping to rescue farmers from bankruptcy.

It would also prevent the waste of resources symbolized by empty homes in the north and overbuilding in the south-east.

• Gavin Cameron is a research fellow and John Muellbauer is professor of economics at Nuffield college, Oxford.