International Housing Finance Program Wharton Real Estate Center International Housing Finance...

International Housing Finance Program

Wharton Real Estate CenterInternational Housing Finance Program

Wharton Real Estate Center

Subsidizing HousingWhy, When and How

Marja C. Hoek-SmitThe Wharton School

University of Pennsylvania

World Bank Seminar on Housing FinanceMarch 10-13, 2003

Copyright 2003Trustees of the University of Pennsylvania/International housing Finance Program




Presentation Outline

Subsidizing Housing Marja Hoek-Smit Why Subsidize Housing? Types of Housing Subsidies Who Should be Subsidized? Criteria for the Design and Evaluation of Subsidies

Housing Finance Subsidies Douglas Diamond

A Roadmap to Subsidy Marja Hoek-Smit Reform and Design



Subsidizing Housing



Why Subsidize Housing?Rationales

Improving public health Improving fairness and justice Influencing economic and political stability Overcoming market inefficiencies that yield

monopoly profits or poor housing quality or insufficient volume of new and/or low-income construction, and that cannot be solved through regulations

Stimulating economic growth



Why Subsidize Housing? The Political Reality

The political system influences subsidy design Subsidies are initiated in response to specific

macro-economic or social situations But remain long after conditions have changed Existing subsidies are seldom evaluated New subsidies are added to address new

frontiers The subsidy scene in each country is a tapestry



Subsidy Defined

“A subsidy is an incentive provided by government to enable and persuade a certain class of producers or consumers to do something they would not otherwise do, by lowering their opportunity cost or otherwise increase the potential benefit of doing so” (adapted from US Congress, 1969).



Subsidies and Opportunity Cost

Opportunity Cost for Consumers or Producers of Housing: Current costs, net present value of future costs, uncertainty of future profits or costs because of lack of information e.g. for lender going down-market; cost reduction on servicing, compensation for lower yield (funding support) or insurance against risks (default risk)

Opportunity Costs for Government to Provide a Subsidy: Need to be taken into account in the same comprehensive way



Demand or Supply-Oriented Subsidies?

Supply side: subsidize housing directly needed when input markets do not work well the downside is that they often distort markets

Demand side: subsidize consumer considered more efficient (consumer choice) can only be applied in segments of the housing market

that work reasonably well (i.e., when markets respond to an increase in demand by producing more housing in the desired category)

if supply markets are non-responsive, demand-side subsidies benefit lenders or developers -- turn into supply-side subsidies



Location-based or Scatter-site Subsidies?

Location specific subsidies tend to be capitalized into real estate values and taxes and will in the longer term be less efficient from an equity perspective, but are often critical in the short term

Location-based subsidies can positively impact collateral value and encourage investment/lending in a particular area

Location-based subsidies can leverage community inputs which individual subsidies can not do



Entitlements or Rationed/Allocated Subsidies?

Who Should Be Subsidized? (1)

Should every household falling below a defined income/wealth threshold receive housing assistance?

What should be that threshold?

Should assistance ever be given to households above the threshold?



Who Should Be Subsidized? (2)

If not every qualified household is to receive a housing subsidy, who is to be preferred? the neediest? those who will be helped the most by the assistance? those for whom assistance will do the most for the housing

system as a whole? the most deserving (e.g. the working poor)? groups with special problems (e.g. the handicapped)? no one? Distribute housing assistance through a lottery

How should this question be approached? better housing, somehow defined, is an intermediate goal who is to be favored with a subsidy depends on the higher

level objective; that is, why, precisely is a housing subsidy being considered?



Entitlements or Rationed/Allocated Subsidies? (3)

Budgetary constraints limit entitlement subsidies (provided to all qualifying households)

If objective is public health or redistributive or focused on facilitating first-time home-ownership, entitlement subsidies are most effective

If objective is facilitating down-market expansion, rationed / allocated subsidies are often more efficient



Types of Housing Subsidies (1) Production/Rehabilitation

land grant or “write down”infrastructure / services assistancelabor, materials, management below costcapital grant to purchaser/ownercross subsidy

Financesubsidized construction loansubsidized permanent loan

– at or below govt. borrowing rate– buy-down– foreclosure relief/mortgage insurance

subsidized investor instruments– System default insurance/cashflow insurance



Types of Subsidies (2)

Operating expensespublic housing or employee housinghousing allowanceheat and utilities provided free or at reduced

price

Real estate tax deductionstax abatementtax cap for the elderly, the poor, etc.income tax credits/deductions for homeowners

and certain investors

Rent control



Finance is critical to extend supply of housing Finance extends affordability and hence demand for

housing Finance subsidies are relatively easy to design/

implement Finance subsidies can often be hidden from the budget

(irresistible for politicians)

But many disastrous examples of finance-linked subsidies

Why are Housing Finance-linked Subsidies Amongst the Most Prevalent

Housing Subsidies ?



:

Limitations of Most Finance-linked Subsidies (1)

Focus on formal mortgage finance excludes large section of population, i.e., households with low-income, income/employment instability, or collateral problems (negative impact on income distribution if mortgage-linked subsidy is main national subsidy)

Often regressive when tied to size of loan

Inefficiencies in the real sector not addressed, e.g., land markets, infrastructure provision, community services, building standards (subsidy capture by lenders or developers)



:

Limitations of Most Finance-linked Subsidies (2)

The way in which subsidies are mixed with finance has negative impact on the efficient development of national housing finance systems: Prevents private finance sector from developing

systems to address lending risks in middle and lower-middle income market

Subsidies offered exclusively by public housing banks or trusts which are typically less efficient than private institutions

High, often uncertain and “hidden” cost to government



Linking Housing Subsidies to Finance or Not?

Many countries drew lessons from poorly designed finance-linked subsidy systems and have, or are considering to move to more transparent and less distorting subsidies, e.g.,

Upfront grant subsidy system linked to savings or credit (but allocated through private lenders). Several Latin American countries; examples Costa Rica, Suriname, Mexico

On-budget interest rate subsidy / buy-down; Indonesia

Support to private, non-profit mortgage insurance, for short term and limited exposure; South Africa



Criteria for Designing and Evaluating Housing Subsidies (1)

Efficiency (with respect to a specific purpose) productive (lowest cost per subsidy/cost of provision by

government versus private sector) allocative (does expenditures reflect opportunity costs) transfer

welfare loss to individual (market value of assistance minus recipient’s valuation)

“buying out the base”/fungability of funds/ (recipient’s reduction of own spending on housing because of assistance)

% of recipients on the “margin”

Equity horizontal vertical / “cliff-effect”

Transparency (fiscal costs and allocation)



Criteria for Designing and Evaluating Housing Subsidies (2)

Effects on Public Investment Portfolio (present and future)

Effect on housing market as a whole production (housing allowance vs. production subsidies) prices quality

Political Feasibility or Imperative

Effect on Class Structure

Effects on Labor Mobility (an oft problem with subsidized rental housing)

Administrative simplicity



Given these Criteria, Is It Possible to Design an Optimal Subsidy?

Multiple conflicting goals and values make achievement of optimality impossible

Subsidies that seem appropriate in one country may not be appropriate in another, because of differing values, institutions, conditions and already existing subsidy arrangements throughout the economy

Nevertheless, some subsidy arrangements are better than others in any particular situation



Road Map to Subsidy Reform and Design




1. Determine the Housing Issues or Goals to be Addressed

Why is housing consumption below desired levels?

Are house prices too high Are finance cost too high Are incomes of some are too low and

redistribution through housing is desired

What are the specific constraints to improve the housing sector?

Refine the objectives for subsidies




2. Which constraints can be corrected without a subsidy?

What policy, regulatory, institutional measures other than subsidies are required to achieve the policy goals?

Which constraints can only be corrected at the macro-economic level?

i.e., high and volatile inflation, institutional distortions of special housing tax funds/banks




3. What specific household or societal problems, or market constraints, should be addressed by subsidy

programs?

And what type of subsidy instrument or approach is best suited to address each specific objective?




Option 1. Concern about low-income housing conditions?

Response: Promote housing consumption at low income level

Pay a portion of the cost of renting or owning to household through allowances or buy-down interest subsidies (when finance and real markets works); US, Northern European countries

Supply rental housing (US), serviced sites or core houses, improve slums; most developing nations




Option 2. A general housing subsidy to address general high cost of housing ?

Response:

General VAT exemption for housing Non-distorting subsidy on interest rates or

housing loans (rentals, owner-occupied, resale and new)

Tax credit (not deduction on income tax)




Option 3. Housing Finance System Improvement? Beyond regulatory and

policy reforms.What specific lender/borrower constraints need to be addressed through the subsidy program? Which risks and costs?

State involvement in default insurance for primary markets (short term/limited liability) (plus measures to decrease neighborhood risk)

State involvement in cash-flow insurance for funder market

Short-term support to alleviate servicing cost for down-market lending




Option 4. Support first time home-ownership?

When home-ownership is policy priority and life-cycle cross-over from from rental

to owning is difficult: Lump-sum cash grant (preferably not

eliminating down-payment if applied to loan) Transparent interest subsidy for initial

period of the loan Mortgage default insurance




4. Costing and Detailed Design

Macro-economic conditions inflation rate expected economic growth and its distribution

Expectations concerning house value movements

Expected real growth in household income Requirements for capital market transactions

Potential to stimulate beneficiary/community contributions (incl.self-help) to increase equity

Budgetary requirements On- or off-budget subsidies (transparency) Financial accountability (option to budget full cost in the

year the subsidy is provided; multi year allocations)



5. Implementation, Monitoring and Evaluation

Use private sector entities that are “best in class” for each activity and that will respond to program incentives

Minimize administrative requirements for implementing institutions (govt. and non-govt.) Minimize need for rationing (no windfalls) Do not unduly complicate financial management Minimize need for ex post monitoring

Regularly monitor, adjust size and conditions, and evaluate outcomes against goals




So…..

It Takes “Three” to Tango

Subsidy package/instrument for different groups of under-served households

Incentives and institutional innovations to induce lenders, investors, NGOs to make market-rate loans to targeted middle/lower-middle income households/investors in rental housing

Real sector reforms to facilitate participation by private developers/builders.

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