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China Goes Wrong Way on Property Taxes

December 18, 2009

China’s leaders are becoming increasingly alarmed that a bubble may be forming in the country’s booming real estate sector.  That’s why, late last week, they announced the reimposition of a nationwide property sales tax in an effort to rein in speculative buying.  But while their intentions are sound, the new tax takes China in entirely the wrong direction, and is more likely to make the problem worse rather than better.

To understand why, it’s important to realize what the new tax is and is not.  It is not a “property tax” as understood in most Western countries, i.e., an annual tax on the value of property holdings.  China’s government has often announced its intention to impose such a tax, but each time the move has been postponed due to the panicked opposition of real estate developers.

The policy announced last week is a transaction tax.  According to the Financial Times, it “requires anyone selling a secondhand apartment or house within five years of its purchase to pay a sales tax of 5.5 per cent.”  Previously, the same tax had been imposed only on owners selling within two years.  The idea, in both cases, is to discourage speculators from buying residences with the sole intention of selling (or “flipping”) them for a quick profit, rather than to live in.  Such practices were highly prevalent in the U.S. in the past couple of years and played a key role in contributing to the formation of the real estate bubble and sub-prime mortgage crisis there.

In China, however, “flipping” is not the problem.  Some people may be engaged in short-term “flipping,” but as I’ve described in my FEER article “China’s Real Estate Riddle,” a lot more are buying residences — in many cases multiple units — and holding them vacant indefinitely as an unproductive “store of value,” like gold.  As I mentioned in my article, the Financial Times estimates that there are 587 million meters of apartment space that buyers have purchased over the past five years only to leave lying empty (for a concrete notion of what this statistic means, take a look at Al Jazeera’s report on Ordos).  This puzzling phenomemon is due to the fact that Chinese citizens have relatively few investment options, and China’s real estate sector (unlike its stock market) has never experienced a sustained downturn since the country converted to private home ownership in the mid-1990s.  The fact that China has no annual holding tax on property means there is little penalty for letting property lie idle, in the hope that it will appreciate or at least retain its value.  The result is an inflated market where the demand for property as a pure investment vehicle far outstrips the demand for affordable, usable space.

If people were trying to “flip” their properties, that might actually be a good thing.  At the very least, it would mean those residences would have to be brought onto the secondary market and priced.  What we see in China, though, is an extremely weak secondary market.  In the U.S., the ratio of secondary to primary residential property transactions for the first half of 2009 was 13.45; in Hong Kong it was 7.25.  In China as a whole, that ratio was 0.26 (four times as many new home purchases as secondary sales).  Even in China’s most developed markets the ratios were just 1.30 for Beijing, 1.56 for Shanghai, and 1.35 for Shenzhen.  [Keep in mind that an immense quantity of existing housing stock was privatized in the 1990s, at nominal prices, so the explanation cannot be simply that China is a "new" market -- China actually has a higher rate of established home ownership (80%) than the U.S. (70%)].

The way I read these figures is that an immense amount of new housing is being purchased and accumulated (in a vacant condition) off-market.  Nobody has any idea what it is actually worth because there is little urgency to offer it, to end users, on the secondary market and actually see it priced based on their demand.  If investors were at least trying to “flip,” we might find out, but they’re not, and so prices for new residences (especially on the high-priced luxury end) continue to rise without anything to bring them back down to earth.

What China desperately needs is an annual property holding tax, like in the West, that imposes a hurdle rate of return — effectively, a penalty for allowing property to remain idle.  What it is getting is a sales tax that gives buyers an incentive to let their property lie idle even longer, and withhold it from being priced on the secondary market.  The fact that this tax is being adopted as a temporary measure — a bid to calm a momentarily overheated real estate sector — rather than a permanent change only gives investors a further incentive to hold onto their vacant properties longer to try to wait out the government’s mood.

If China’s real estate sector were experiencing a typical bubble, where assets are being rapidly flipped higher and higher until the music suddenly stops, China’s new property sales tax would make eminent sense.  But this new policy misdiagnoses the problem, which is that property is being accumulated and left idle, indefinitely, as a store of value.  As long as that property remains off-market, and is not compelled to be priced based on actual demand for affordable usable space, the asset price illusion will continue and the bubble will grow.  If China wants to bring it real estate market back to earth — and that’s a big “if” — it should be offering investors a reason to use, rent, or sell.  An annual property holding tax does this.  A higher property sales tax, while well intentioned, only makes things worse.

[FYI, for those who might be wondering if I've suddenly converted to advocating tax increases, I have not.  In my view, the imposition of an annual property holding tax should be revenue-neutral, i.e., should be offset by trimming or abolishing other taxes.  China's top personal income tax rate of 45%, for instance, is sorely at odds with its desire to develop Shanghai as a financial center, compared to Hong Kong with its tax rate of 16%.  And its 3% revenue tax on service firms (in addition to corporate taxes on profits) imposes yet another burden on a sector whose development China desperately needs to encourage.  What I advocate is not raising taxes, but revising the tax structure to reward productivity and discourage the wasteful accumulation of idle assets.]

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26 Comments leave one →
  1. BenjaminL permalink
    December 19, 2009 2:11 am

    Well thought out, the difference in Chinese vs. U.S. real estate markets means that many won’t understand the nuanced tax necessary to impact the situation the way Chinese officials wish. My concern is that a property holding tax would start a nasty chain of events, since in my mind going from zero resistance (no PHT) to some resistance (“hurdle rate of return” PHT) is a much bigger deal than going from some resistance to more resistance.

  2. Dean Jackson permalink
    December 19, 2009 3:57 am

    Interesting. What would be the typical financing arrangement on buying a home and does it vary with whether it is a primary residence versus an investment? Clearly this “store of value” psuychology seems like a misallocation of resources, but maybe that is just my cultural lens. Having said that, would seem to be more efficient to develope a market for future delivery of housing on a certain plot of dirt.

    • prchovanec permalink*
      December 19, 2009 12:32 pm

      From what I can tell, most first homes (for living in) are now being bought with mortgages, at least in major urban markets. But most additional units (for investment) are being bought with cash. The mortgage terms for buying a 2nd or 3rd unit are more demanding than those for buying a first home.

      You mention “future delivery” — in fact, most sales of new units are done on a pre-sale basis, before the apartment building is finished or even started. Most developments are sold out well in advance, but left largely vacant for years after completion.

      • Dean Jackson permalink
        December 21, 2009 10:41 am

        Ignorance is not bliss. I do not know the typical ratio of unit price to income, but I presume it at a multiple. Even with the relatively high Chinese savings rate, it challenges me to believe that many people have accumulated the cash to support the continuing supply plus the existing stock mentioned in your FEER article. I wonder if there is leverage seeping into this in a non-traditional way?

        Even if cash savings is supporting this and leverage is largely absent, it still supports the bubble characteristic of having no economic basis in fact to support the valuation. Thus, as you mention in the FEER article, if confidence is eroded, pricing could turn ugly. At a minimum, at some point the owners will want to access their savings to support a true economic need or opportunity. Seems like a tulip mania. And the lack of an established secondary market, in that case, then becomes an accelerant in the process.

        If I take the above at face value, it seems more likely the first bubble to pop will be found elsewhere such as commercial real estate or problems with provincial enterprises. Residential could end up being just another domino in the chain. Will be interesting to see whether it is the Chinese authorities or US authorities, most notably the Fed, that intentionally or inadvertently take the policy step that commences the next crisis.

  3. bill permalink
    December 21, 2009 5:07 pm

    Thanks for this very informative post. I think that a property tax would certainly not encourage more real estate speculation, and would have some (at least to “socialists”) appealing potential wealth redistribution effects, but I don’t think an annual property tax would have a material impact on the growing real estate bubble here, for the following reasons:

    1. Owners in China already pay property management fees on those vacant properties, at an annual rate of somewhere between 0.1 and 0.5% what they paid. So they are already bearing annual, cash carrying costs for these vacant properties, and an additional 0.5-1.0% in property tax (the numbers I have heard bandied about but I am not sure anyone knows what the likely number really might be) is unlikely to be meaningful to many of the owners;

    2. My assumption is that most of the places that are vacant, with no real attempts to rent them, were either purchased in cash and/or the owner is rich enough that they can handle an incremental 25-75k rmb a year in property taxes, on top of the property management fees they are already paying. It would be helpful if you have any data on the composition of ownership, from net worth to mortgage size to percentage that paid in cash; I have not been able to find that data, but based on my personal experiences in Beijing a property tax for most of the owners of these vacant properties would be a nuisance but not much more;

    3. The Chinese I know in Beijing and Shanghai with multiple properties bought them either because they had too much cash and no good place to invest it other than real estate, they assume that even if prices are high now in 10 years in world class cities like Beijing and Shanghai they will be even higher, and/or they are buying as an inflation hedge. I think Chinese people culturally have been conditioned to see real estate as an inflation hedge and a savings vehicle, much more so than in the US (our houses were seen as consumption vehicles for the most part);

    4. I think that reintroducing limits on buying by foreigners, especially Hong Kongers, could have a meaningful impact on at least the high end of the market. There has been a Hong Kong buying frenzy in Beijing (and I assume Shanghai) fueled by cheap and easy money in Hong Kong (thanks to the peg and the Fed) and real concern about a dollar collapse and inflation, coupled with the fact that Beijing and Shanghai still look pretty cheap compared to Hong Kong. One anecdote, the Beijing Four Seasons residences (soon to open next to the Lufthansa Center) were only sold in Hong Kong. Day 1 they were priced at 70,000 RMB/sq m; demand was so high that in a matter of days the price was raised to 100k, and they are now all sold out. They were never marketed in China, other than to insiders (friends of the developer could buy for 35,000 RMB sq m in May). Curbing this kind of speculation from overseas, much of trying to play a long RMB/ short USD (you can get very cheap USD mortgages in HK and through Bank of East Asia in Beijing) as well as hedging against inflation and playing the long term geopolitical and urbanization trends, would probably much more popular than a property tax, and for good reason. So long as the currency is not convertible, there is an argument to be made that if you are not a PRC citizen and you want to buy a property in the PRC you should have to live in it;

    5. Whatever effect a property tax might have on speculation, I think it would be at the margins at best and would not address the core, structural factors that have been driving price appreciation. In this interview posted today on 21st Century Herald with economist Lang Xianping http://www.21cbh.com/HTML/2009-12-21/158680.html he points out that the real causes of the growing real estate are extremely loose monetary policy/excess liquidity, overcapacity and structural problems that lead to misallocation of capital with massive corporate/SOE participation in real estate and equity markets using borrowed money [how many of these vacant apartments may actually be owned by companies? How many SOEs bidding on urban with basically free government money?]

    6. I have had several Beijing friends who have started buying the US. They don’t see the property tax as a reason not to buy, they just see it as one of the costs associated with the transaction and factor for it accordingly

    I think a property tax can’t hurt, but much deeper, more structural efforts are needed to really try to reign in some of the excessive speculation.

    • October 1, 2010 12:29 pm

      On your point #1 and 2. Management fees are typically on the lowest end of what you suggest. They are typicaly 2 to 5 rmb per square meter per month. So on a 130 sq m (~1300 sq ft) apartment, that would cost about 5-6 million rmb to buy now (prices in downtown shanghai are 40-50k per sq m), the annual mangement fee would be about 5000-6000 rmb per year. Thats about .1 %. So an annual property tax of 1% would be 10x the management fee and would be significant at 4 to 5k rmb per month for a decent percentage of people that own these apartments.

      Also, the psychological affect of the tax on the market can not be underestimated. The mere mention of a new tax in china on stock or property usually causes prices to decline.

  4. December 22, 2009 8:02 pm

    OK so why don’t they rent them out? Or do laws make renting to tenants problematic?

    • Daniel permalink
      December 25, 2009 5:08 pm

      I’d like to know this too!
      Surely even a low rent is better than no rent! Rentals also give you some means of assessing the value of properties (for which this article sites it being difficult to price at the moment). If there is such excess supply that it only makes sense to buy, then it’s difficult to see it as a bubble.

    • Vincent911 permalink
      December 26, 2009 2:39 am

      David,
      This might help you to know why we don’t rent them out :
      1) Apartments in China are sold unfurnished, bared wall, no toilet, unhabitable.
      2) To rent out you need to invest at least $10,000 USD for the interior decoration to be habitable.
      3) Rent income is very very low. If you are lucky you can get around $60 to $350 USD per month for an apartment that costed you $200,000 USD to buy.
      4) If you buy an apartment for investment it is better to let it unfurnished so it is always “NEW” to your future buyer rather than “USED”
      5) What is my cost of letting it empty ?
      *) $30 USD per month property management fee (100 square meter apartment).
      *) $200,000 x 2.52% / 12 = $420.00 per month lost earned interest.
      *) total cost to let it empty per year ($30 x 12) + ($420 x 12) = $5,400
      *) $5,400 / $200,000 = 2.7%
      6) If house price increases over 2.7% per year then I make more money than put it in saving account.
      7) In China the buyer pay “ALL”. All taxes, all fees, etc. 100% of the transaction fees & taxes.

    • January 2, 2010 8:09 pm

      David, in Chinese culture new has a lot more value than used. Renting an apartment will bring you some cash, but you’ll lose a lot in capital value. Not good if you plan to resell your property after a few years.

  5. David Oliver permalink
    December 22, 2009 8:45 pm

    I think a property tax would help curb speculation. I suspect that many people with empty apartments don’t bother paying the property management fee, but the government would be much more effective at collecting any property tax owed. It doesn’t really matter if the wuye block you getting access to your apartment for not paying your management fee. It may only be a concrete shell and can probably be sold sight unseen.

    When I helped a friend sell their apartment in Shenzhen during the last bubble the real estate agent even negotiated that the buyer paid the 5.5% tax payable if selling within XX years. A property tax would mean people having to fork out real cash every year while other bills payable can be deferred until after a sale.

    • October 1, 2010 12:33 pm

      The property developers are not that stupid. When you buy the house from the developer or secondhand, the property management company requires a deposit for the fee or you wont get the title/deed to the house. Yes its probably only enough for 1 to 2 years of the fee, but I guarantee you they get their money when the owner trys sells the house again.

  6. mrsmartypants permalink
    December 22, 2009 11:54 pm

    Lemme guess… You missed the run up.

    Better luck next time, sucka! Beijing luxury property, to the moon!!!

    • prchovanec permalink*
      December 24, 2009 1:35 am

      Actually, my wife and I have been property owners in Beijing for the past two years, and my impression is that it has appreciated significantly in that time. So no “sour grapes” here. But we actually live in our place and intend to hold onto it for the foreseeable future, so I’m not preoccupied with marking it to market.

  7. Nick Dranias permalink
    December 24, 2009 12:10 am

    Patrick,

    Great observations! Maybe you should contact our resident “Georgist” senior fellow, Prof. Fred Foldvary (perhaps the only living Georgist), for his thoughts on property taxes and see if he can contribute something to making your observations actionable. Fred is the sort of libertarian that Leftists love because of his theories regarding taxing away the surplus value of real estate which amounts to a public subsidy deriving from public infrastructure. The only problem I have with his arguments is his assumption that real estate is uniquely scarce–one obvious rebuttal to this assertion is Dubai’s island construction. Nevertheless, I think his argument that real estate is subsidized by public infrastructure is true and that among the evils of taxation, attempting to tax away that subsidy seems among the least evil. Might get you somewhere with the locals. Or it might get you killed by developers. Anyway, his info is here http://www.goldwaterinstitute.org/seniorfellows

    Nick

  8. Bob_in_MA permalink
    December 24, 2009 1:47 am

    Ironically, Calculated Risk has a post up on the ratio of existing to new home sales in the U.S. and it just hit an all time high of 18+! But it’s expected to fall from this tax-policy-induced peak.

    http://www.calculatedriskblog.com/2009/12/ratio-of-existing-to-new-home-sales-at.html

  9. Dean Jackson permalink
    December 27, 2009 8:43 am

    This from the FT seems pertinent:

    China’s bubbling housing market: Private chat points to government action
    December 23, 2009 10:47am
    By Geoff Dyer, China bureau chief

    A couple of years before the US housing market really collapsed, the journalist Michael Kinsley came up with the idea of a Dinner Party Index to work out when the bubble was about to pop. The theory was that if your dinner guests are already bored by anecdotes about quick profits from flipping properties, then the game will soon be up.

    In China, the clever money listens less to middle-class chatter and more to the private conversations of senior officials – the Communist Party Index, if you like. Which is why the following interview on Chinese central television with He Keng, a leading member of the National People’s Congress, has gone viral on the Chinese internet over the past week.

    CCTV: “Tell me, can an official like you afford property in Beijing?”

    He Keng: “No, I simply can’t. What about you?”

    CCTV:”At my current salary level, I don’t think I can afford it either.”

    HK: “Well, if a famous host on CCTV or even a vice minister-level official like me can’t afford a decent home, it must be a huge problem for most ordinary people.”

    CCTV: “Are property prices realistic at the moment?”

    HK: “There are two main problems in the market right now. First, there is bubble. Then there is speculation. It means that ordinary people cannot afford their own property.”

    The index’s rule is simple: when the grumbling among senior cadres reaches boiling point, expect government measures to slow down the market. Which is exactly what is beginning to happen.

    Link:http://blogs.ft.com/rachmanblog/2009/12/chinas-bubbling-housing-market-private-chat-points-to-government-action/

  10. billbishop permalink
    January 6, 2010 3:43 pm

    highly recommend this on when and how property tax might happen

    http://www.21cbh.com/HTML/2010-1-6/160693.html

  11. January 11, 2010 9:12 am

    Hi Patrick,

    Enjoyed your article very much. I’m not an expert in China, but I’m very curious about this country.

    It is interesting to observe that China’s secondary market for real estate is only 0.26 of the primary market. The implication is, as you say, that it is impossible to ascertain the value of real estate.

    So, if the secondary market grows and develops in China and the value becomes realisable, do you think it will exert a downward pressure on real estate prices (given that there’s so much over-supply of homes in China)?

    I know of someone in Shanghai who had to sell in a hurry because of the new sales transaction tax. If the Chinese authorities manage to engineer an increased liquidation of hoarded real estate (e.g. that someone I know in Shanghai), then the secondary market will increase in size. Assuming that the opening of the secondary market will result in downward pressure in prices, wouldn’t that cause many Chinese to question the store-of-value function of real estate? That will in turn beget more selling, resulting in a bigger secondary market?

  12. January 13, 2010 8:52 pm

    While they are new to capitalism and the needs behind it I am sure it won’t be long before they master this issue!

  13. October 20, 2010 5:24 pm

    According to me property rates are not realistic … For example renting a public housing can fetch you some money nevertheless you’ll lose a lot in asset rate. And it’s not fair if you plan to resell your property after some years. May be some work out but not all….

Trackbacks

  1. More Evidence of Froth in China’s Housing Market « naked capitalism
  2. Leverage and China’s Property Market « Patrick Chovanec
  3. More On China’s Frothy-Looking Housing Market « naked capitalism
  4. China Special (5-6): Final thoughts on Chinese property market « U.Pro.Fish
  5. China Special (5-6): Final thoughts on Chinese property market « U.Pro.Fish

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