The Capitalization of Interest Subsidies: Evidence from Sweden
Berger, Tommy, Englund, Peter, Hendershott, Patric H., Turner, Bengt, Journal of Money, Credit & Banking
OWING TO THE WIDESPREAD USAGE of assumable mortgages and the sharp rise in mortgage rates during the second half of the 1970s and early 1980s, numerous U.S. house sales in the early 1980s were accompanied by below-market financing. This triggered a barrage of empirical studies estimating the extent to which the value of the below-market financing was capitalized into house prices or, put more grandly, testing whether the housing market was efficient.(1) The studies used widely varying methodologies (for example, some capitalized the value of pretax interest saving and others after-tax) and obtained a similarly wide range of capitalization effects, from only a third capitalization of after-tax interest savings to over full capitalization of the larger pretax interest saving. In fact, the most consistent attribute of these studies was their small sample size. Only one of the eight studies had over 162 observations, and that had but 319.
In Europe below-market financing has been widely available through various government programs [see Turner, Jakobsson, and Whitehead (1996) and Boelhouwer (1997) for surveys of these programs]. In the 1990s there has been a trend toward reducing these subsidies as a contribution toward an overall reduction of government transfer programs. Sweden is a prime example. Loans at subsidized interest rates have been available to owners of most housing constructed after 1974, both owner-occupied homes and rental apartment buildings. In the early 1990s the present value of these interest-rate subsidies amounted to over a fifth of construction costs. Since then the subsidies have gradually been reduced, and the system is due to be phased out in the 2000s.
In order to understand the impact of these subsidy programs on the housing market--both as they were introduced and as they are now abandoned--it is important to know to what extent the interest subsidies have been capitalized into house prices. Thus, in this paper we revisit the capitalization issue, but using an ample data sample consisting of all arms length sales of single-family houses in Sweden during the period 1981-1993, 290,000 transactions nearly 10 percent of which had subsidies accompanying them. We focus on owner-occupied single-family houses, whereas a companion paper (Hendershott and Turner 1999) addressed similar issues for apartment buildings.
Swedish interest subsidies apply only to special loans collateralized by the building in question. When a property changes hands, the subsidized loan is routinely transferred to the new owner, subject to standard credit evaluation. Because the subsidy is tied to the building rather than the owner, one would expect the subsidy value to be fully capitalized in the purchase price in an efficient housing market. The home buyer effectively purchases a package of house cum subsidy, and, provided that equivalent housing services are available without subsidies, transaction prices of houses of identical quality should differ by exactly the value of the subsidy. Consequently, testing for full capitalization can be interpreted as testing for efficiency and rationality in the housing market.
Like other efficiency tests, however, testing for full capitalization is really a joint test of efficiency and a particular expectations assumption. The present value of subsidies--the difference between after-tax cash outlays with and without the subsidy--depends on the future course of subsidy and tax rules and market interest rates, so any subsidy measure embodies expected values of these components. Given that tax rates, subsidy rules, and monetary policy have been changed a number of times during the sample period, it is not clear how these expectations should be modeled. Purely static and perfect foresight are two possible forecasting rules that we employ.
A second group of problems relate to the difficulty of measuring the subsidy even conditional on expectations of tax rates, subsidy rules, and interest rates. …