The real estate crisis will devastate state finances – time to prick the price bubble

By Manish Bhandari, Managing Partner & CEO, Vallum Capital Advisors

Even as everyone rejoices over the Herculean efforts of the Finance Minister in taming the central government’s fiscal deficit to 4.6 percent of GDP in the last budget, few people focus on the fiscal deficits of state governments and the underlying revenue drivers of income from real estate-related activities.

The decade-long housing price boom is coming to an end in India due to a multitude of factors. These include the reversal of the expansionary monetary policy by the Reserve Bank of India (RBI), the sub-five percent GDP growth rate, the deteriorating affordability quotient and low consumer confidence due to high and persistent inflation, not to speak of the impending central elections. These conditions are converging at the same time and setting the stage for a deep correction in real estate sector.

Let’s look at top 13 states in India which account for more than 75 percent of total state revenues and have land revenues in excess of 5 percent of total revenues. The contribution of real estate revenue to total revenue has increased in most states over the last decade. This is a direct function of increasing property prices and the number of transactions during the period.

Table: Revenue from Property & Capital transactions as % of Total Revenue

Table: Revenue from Property & Capital transactions as % of Total Revenue

States used this revenue to increase social expenditure or reduce deficits. However, the tide is turning and real estate prices are either sliding or struggling to hold. The states will face revenue constraints and struggle to meet their budgetary commitments.

There are five main channels through which the real estate market affects state and local tax revenues: property taxes payable by owners annually, transfer tax from stamp duty and registration paid on inheritance, sale or lease, sales tax from construction materials used in new builds or maintenance, sales tax from the purchase of equipment and goods by occupiers and income tax from people and companies active in the related sectors. The first two channels, the property tax and the transfer tax, are a direct function of the value of real estate and the volume of transactions, thereby making a strong case for budgetary constraint for state finances, going ahead.

There is an indirect effect on sales tax revenues related to general household expenditures. A drop in real estate values can reduce sales tax revenues from a range of goods and services. Housing wealth is the most important component for many households. Booms and busts in the housing market can induce increases and decreases in personal consumption in two ways.

Firstly, as per the conventional wealth effect, increases in house values raise the confidence of households, resulting in increased consumption. Secondly, households can borrow against the collateral and lenders are more winning to lend in a rising price environment. A downturn in the housing market will reduce consumption through these two channels, resulting in reduced sales tax revenues of state and local governments.

As we discussed earlier, making dividends compulsory is the only way to bring corporate governance and attracting long term investments in equity markets. Similarly, India needs serious introspection on its approach towards affordability in housing. The measures taken by the Chinese and Singapore governments to restrict price expansion in the housing sector should serve as a guiding indicator for all the other nations. The time has come to deflate the bubble in order to save financial institutions and individuals and channelize public resources for better productive purposes.


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