The New York Times

October 20, 2005
Economic Scene

Is Affordable Housing Becoming an Oxymoron?


TO paraphrase Yogi Berra, it seems that houses are now so expensive that no one can afford to own one.

Of course, economists know better. In the short run, the supply of housing in most areas is more or less fixed. Hence the price of housing is determined primarily by the demand side of the market - by how much people are willing to pay for housing.

In the last few years, we have seen historically low mortgage rates, which feed directly into housing demand. In several locations, particularly on the East and West Coasts, where land-use restrictions make it difficult to increase the supply of housing, prices have been pushed up to unprecedented levels.

Whether these low mortgage rates have created a housing price bubble has been a matter of debate. There is no universally accepted definition of a "bubble" in economics, but the idea is that a significant part of the demand for housing is based on an expectation of future appreciation. The more prices go up, the more people want to buy so as to reap the gains from expected future price appreciation, pushing prices up even more.

It is quite possible that there is some "froth" in the market, to use Alan Greenspan's term, particularly on the coasts. But even when the froth subsides, housing will remain quite expensive in those areas. Can anything be done?

Some municipalities have started subsidized housing programs that provide various types of assistance to new homeowners. Unfortunately, such programs just increase demand even more, pushing prices up. In fact, in an ideal market with a constant supply of housing, a 10 percent subsidy offered to a broad segment of the market would simply push housing prices up by 10 percent. The out-of-pocket, after-subsidy price would end up right where it started.

If you really wanted to push housing prices down, you would increase taxes on housing. Analogous to the imposition of a subsidy, the imposition of a property tax would push housing prices down by the present value of the tax. Of course, the total cost of the housing (purchase price plus the present value of the taxes) would be unchanged, so this really does not solve the housing cost problem either.

In California, tax policy has played a significant role in housing price dynamics. Proposition 13, passed in 1978, limited property tax increases to 2 percent a year for owner-occupied homes. But when the house is sold, the property tax assessment is based on the sale price. This means the new owner typically faces a significantly higher property tax bill than the old owner.

Proposition 13 has been called a "tax on moving." Indeed it is, since a homeowner in California is much better off remodeling than moving. It is a lot cheaper to add a bedroom to a three-bedroom house than to buy a similar four-bedroom house because of the tax treatment of renovations as compared with new sales. For the same reason, empty-nesters have strong tax incentives to keep their houses, regardless of whether they need all that space.

The result is that fewer houses come on the market than would otherwise be the case, pushing prices up even more for the limited stock of housing that is available.

Of course, if you intend to move out of state, these considerations are not so relevant. In California, the best thing for empty-nesters to do is to sell their nests and migrate to Oregon. This seems to have become a pretty common practice, at least in some demographic groups.

So what is the answer to high home prices? Basic economics tells us that for housing prices to fall we have to see a reduction in demand or an increase in the supply of housing.

There is some hope on the demand side. As interest rates rise, we should see some moderation in demand; indeed, it appears that housing prices are flattening out in some areas.

Ultimately, the only reliable way to make housing more affordable is to increase the supply. But a new house requires land zoned for housing. We cannot make more land, so we either have to use the land we have more intensively or we have to build houses farther from jobs. Both of these options are unattractive.

In urban California, traffic has become increasingly congested, putting a limit on how far away from their jobs people can live. Land use restrictions are tight in many desirable residential areas, and political forces are aligned against relaxing these restrictions.

Imagine someone who scrimps and saves to buy his dream house in an area zoned for one-acre lots. The last thing he wants to see is his neighbor's lot being subdivided to build two or three new houses. Not only would it affect his quality of life, but, even more important, it would also affect the value of his house.

Zoning laws and land use restrictions are unpopular among those seeking less-costly housing since they push up the price. But by the same token, once a searcher becomes an owner, he often becomes a fervent supporter of such restrictions. As Pogo put it, "We have met the enemy and he is us."

Hal R. Varian is a professor of business, economics and information management at the University of California, Berkeley.

Note: I have corrected the sentence that originally read "Analogous to the imposition of a subsidy, a 10 percent increase in property taxes would push housing prices down by 10 percent."