Stamp duty, house prices and irrational buyers

Despite recent reforms to stamp duty land tax in the UK, buyer and seller psychology continues to distort the efficient pricing of housing.

7th October 2016

London’s housing market has been characterised by abundant liquidity and a large stock of buyers and sellers.  Transaction volumes have averaged 50,000 units per annum since 1995. Despite this, market pricing has not been completely efficient.

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This article summarises how Stamp Duty Land Tax (SDLT) has influenced pricing in the Inner London residential property market.  Using Land Registry data we demonstrate that under the old SDLT regime tactical pricing was rife, and that despite recent reforms buyer and seller psychology continues to distort the efficient pricing of housing.

A brief history of SDLT

Stamp duty has existed in some form since the 1690s, when it was initially designed to fund the war against France. Payment of the tax was confirmed with a physical stamp on the instruments to which it applied - and it has kept the name ever since.  In 2003, Stamp Duty Land Tax was introduced as an ad valorem tax on land transactions, which consisted of various tax bands charged against the entire property value. 

However, persistent house price inflation has steadily increased the proportion of transactions falling into the higher SDLT bands (Chart 1) despite several adjustments to the thresholds. While 62% of transactions paid the minimum SDLT threshold in 2003, by 2015, this had fallen to just 12%. Over the same period, the proportion of transactions paying the 3% SDLT grew from 28% to around 43%. The proportion of transactions paying the top rates (4%+) of SDLT increased more than fourfold. The overall effect of this “boundary creep” was to increase the average rate paid from 1.9% to 3.4% between 2003 and 2014.

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The need for SDLT reform

The old SDLT regime created inefficiencies in the market, particularly for properties priced around the SDLT band thresholds.  For example, a home purchased at a price just below £1m would have attracted an effective SDLT rate of 4% on the total value of the property, whereas at just over £1m the rate would jump to 5%.  Similarly disjointed increases in the marginal rate of SDLT existed at all other thresholds, and boundary creep was exposing an increasing number of buyers to much higher SDLT charges.

These anomalies were largely corrected through the SDLT reforms in December 2014, which moved from the previous threshold “slab” system to a marginal system, whereby each element of the purchase price is taxed at a specific rate which applies to that band. This has resulted in a smoother profile to effective SDLT rates paid for various property prices (Chart 2). Under this new regime, effective SDLT has increased for most properties with purchase prices over £937k, while it has fallen for most properties below that level.

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Impact of SDLT on pricing

Because the old SDLT regime resulted in significant marginal increases in SDLT paid by the buyer, it encouraged tactical pricing especially at the thresholds where SDLT stepped up most markedly (1%-3% and 5%-7%).  Sellers of properties valued around the old SDLT thresholds would typically achieve prices slightly below those thresholds.  Whether or not these transactions were originally pitched above or below the threshold is difficult to determine, but it follows that tactical pricing was a good way of increasing buyer interest.

Interestingly, tactical pricing is also evident at the £3m level, despite there never being an SDLT threshold at that point.  This suggests that there remains a wider pricing inefficiency in the market, whereby properties tend to be sold just below major round-number prices. Prices just above major round-numbers might better reflect the value to the seller, but the sharp fall-off in transaction volumes suggest achieving these prices is much harder.

SDLT reform has improved pricing efficiency

Land Registry transaction data suggests the SDLT regime change has removed some of the tactical pricing that was so prevalent under the old regime. For instance, in 2015 17% fewer homes were sold for just under £1m than in 2014, whereas 10% more homes were sold for just over £1m (Chart 3). Similarly, an increasing number of homes were sold for just over £500,000, while transaction volumes fell just below this level. This is in the context of an overall 15% decline in transactions between 2014 and 2015.  But the effect of reform has not been uniform across price bands.

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The number of properties priced either side of £250,000 declined, arguably because of the “rising tide” effect whereby there are simply very few homes valued around the £250,000 level now. We note that the decline was less marked for transactions priced just above £250,000 which perhaps illustrates the lower incentive to price around the threshold.

The picture is also less clear for properties priced around the £2m mark, where a similar threshold had previously disincentivised pricing a property just above £2m. Transaction volumes fell sharply throughout the higher price bands, although the decline was again more gradual for properties just over the £2m threshold. This might indicate the reduced importance of marginal tax rates on higher value properties.

The irrationality of buyers

So, while it seems that the new SDLT regime has removed some of the pricing anomalies that characterised the market before 2015, we think that other ‘psychological’ anomalies remain in force.  These have been examined in great detail across other goods categories, particularly fast-moving goods such as food and clothing. Here, we see pricing strategies that seem to be linked to the perceived irrationality of buyers.

One example of this relates to the fact that we process data from left-to-right, thus when we read a price we focus on the major price unit first.  So the trivial act of reducing a £10 price by one penny results in a reduction of the major price unit to £9, thereby creating the illusion of a more significant discount.  Could a similar effect be at work in the housing market?

Another pricing strategy which we are accustomed to in other goods categories is the concept of discounted goods pricing, or the “99p effect”.  For example, if £10 represents a “full price” then £9.99 would represent the “special discounted price” and generate a disproportionately large increase in demand.  Does a similar effect come into being when the price of a home is reduced from £250,000 to £249,990?

Finally, economic theory recognises that pricing anomalies arise for certain goods.  For instance, so-called “Veblen” goods do not follow the normal laws of demand, and benefit from a strong positive relationship between demand and price.  Could certain elements of the housing market such as the super prime segment align more closely with the pricing characteristics normally associated with luxury goods that infer status?

The prime residential property market is well-understood to behave differently to the mainstream market.  Persistent tactical pricing – even after being disincentivised through SDLT reform – is just one way in which this occurs.

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