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In the UK, a builder constructing a new home need not add tax to the price charged, but a builder undertaking repairs or renovations to an existing home must add value added tax (VAT, currently 20%). (There are some exceptions but that's the general rule - details can be found in HMRC Notice 708).

Question: Are there any economic reasons that could justify a higher tax rate on repairs and renovations than on new construction? I am interested in general economic arguments, whether applicable to the UK or not.

A possible argument for not taxing construction of new homes (even if most goods and services are subject to VAT) is that VAT should be regarded as a tax on consumption, and should instead be charged on the consumption of housing services (Barker K (2014) Housing: Where's the Plan? p 64). That presumably means that, for owner-occupiers, the tax authorities should determine the value of the housing services they consume each year and charge VAT on that. However, even this argument does not seem to justify the differential taxation of new construction, since the same argument could be applied to renovations and repairs, implying that what is taxed should be any resulting increase in the value of housing services.

Addendum 14/9/2017: I've slightly changed the wording so that it invites answers on either side, either yes there are reasons or no there are not.

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  • $\begingroup$ One possible reason is that land-bankers have been much more effective in their lobbying than the people who do the repairs. There may also be constraints within the EU VAT harmonisation rules - a check on whether a similar situation holds in other EU countries, might be informative. $\endgroup$ – EnergyNumbers Oct 28 '17 at 7:28
  • $\begingroup$ A 20% increase in the price of new homes will kill the construction market. Additionally, a 20% increase in the cost of a new home is not going to raise the new home's value by 20%. It is going to have a value about the same as an equivalent existing home. Thus, new home buyers will be starting off 20% in the hole or they'll simply buy existing homes further killing the construction industry. $\endgroup$ – Dunk Oct 30 '17 at 20:09
  • $\begingroup$ @Dunk Charging VAT on new construction would be only one way to remove the apparent anomaly. Another would be to exempt repairs from VAT. A Third would be to charge a common reduced rate on both new construction and repairs. $\endgroup$ – Adam Bailey Oct 31 '17 at 11:11
  • $\begingroup$ @AdamBailey - I'm not going to defend VAT but I was pointing out why there's an anomaly. As I thought I adequately pointed out, charging VAT on new construction is a no-go unless the government wants to put a lot of construction people and businesses out of work. Exempting repairs is that slippery slope to the government choosing winners and losers. If there are going to be exceptions they should be well-reasoned and not purely political to buy votes. A common reduced rate doesn't address the issue of the new home-buyer starting out in the hole by whatever that common VAT rate is. $\endgroup$ – Dunk Oct 31 '17 at 17:48
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If I'd have to summarize the proposed explanation that unfolds in the lines that follow in a few words, I would say that, the economic reasons behind a high tax rate on repairs are related to the effectiveness of revenue gathering and are also about providing the proper set of incentives to private economic agents.

Governments tax in order to finance spending, according to textbooks. It would seem rather trivial to assume that, like all rational agents that populate textbooks, it, too, pursues its ends in the most efficient way (in a traditional means-ends kind of calculation).

In the case of taxation, it also seems trivial to assume that the government will choose to impose only those taxes that are expected to produce the greater amount of revenue with the least push-back from the economy. It is common ground in neoclassical economics that taxes distort economic outcomes.

Therefore it follows naturally that taxing would be more productive (in terms of raising revenue) when applied on abundant (or relatively abundant-no free lunches, remember?) tax bases. Also, it seems that it would be more probable for a government, to target consumption spending rather than capital expenditures. In that way, it would avoid distorting incentives (by taxing capital income, for example).

Having set the stage thus, what needs to follow is an explanation of how exactly housing repairs and new houses construction fit in the so neatly constructed frame.

When a house owner-or a house tenant, for that matter-need to fix a leaky roof, they forgo a portion of their income-lets assume that it's 'income' and not 'wealth', for the sake of simplicity-for the purchase of repair services and relevant commodities. The amount of money that is extinguished, will provide the government coffers with 20% (as per example) revenue.

Consider now what will happen in the case where there are a lot of leaky roofs. It will come as no surprise that there will be a lot of repairing going on and as a consequence, there will be comparable a lot 20%'s of those expenditures going into the government's coffers.

Therefore, it seems plausible, that when the stock of houses is old and in need of repairs, taxing the amount spent on repairs seems like an effective way to pile up revenue.

On the other hand, the case is a bit different if we assume that instead of many house owners there are some real estate firms that own and distribute housing services in a country or a region.

In this case, under the assumption of "leaky roofs" it is not clear before-hand if it is in their interest to expend a considerable sum of money on repairs. Especially, when spending this much would also be burdened with the excessive tax rate. Perhaps, it is in their interest to build rather than renovate.

When the government chooses to incentivize private agents like that, it seems probable to assume it expects that, the expenditure on new buildings will create such a multiplier effect in the economy, that will-hopefully-overcompensate for the loss of revenue from the other options that got dis-incentivized ('repairs'). Also, opting for building new houses increases the stock of housing in the economy, which is another way of saying that the (residential) capital stock increases.

Therefore, it would appear that, when the government selects a high tax rate on housing repair services-as compared with the tax burden of new buildings-it is effectively 1. demonstrating its urgent need for cash and it is either acknowledging that 2. the residential housing capital stock is in dire need of repairs (derelict capital stock) or that it does not expect 3. the real estate developers to actually invest in new housing that would, in turn, invigorate the economy and create new sources of tax revenue.

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  • $\begingroup$ I'm not persuaded by the 'greater amount of revenue with least push back' argument. However much tax revenue existing arrangements raise, it would be possible to set an intermediate rate on both new construction and repairs that would raise the same revenue. It could I suppose work if supplemented by considerations of ease of collection or difficulty of evasion, although I suspect that would favour a higher tax on new construction, the sale of a new house being a large transaction and difficult to hide. $\endgroup$ – Adam Bailey Sep 14 '17 at 8:41

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