Thursday, May 05, 2011

Solving the problem of black money in real estate

by Shubho Roy and Pratik Datta.

Manmohan Singh as finance minister killed off smuggling, by eliminating customs duties. Black money in the real estate sector recently attracted his attention. He suggested lowering of stamp duties to check the flow of black money in this sector. But will this solve the problem of black money? And how will the State compensate for the loss of revenue collected from stamp duty?

Stamp duty is a transaction tax; it is charged as a percentage of the transaction value of the property. Public economics teaches us that all transaction taxes are bad taxes, that the right level for the stamp duty is zero (as it is for all taxation of transactions).

The stamp duty distorts the behaviour of parties to the transaction. Stamp duty on property is usually paid by the buyer. Hence, the buyer tries to coax the seller to agree to undervalue the property on paper (the transaction value declared to the government) and accept the rest in black money. On the other hand, sellers have an incentive in accepting black money from the buyer in order to evade the taxation of capital gains. As long as real estate capital gains are taxed, eliminating the stamp duty will influence the behaviour of the buyer but not that of the seller.

Hence, modest changes in the stamp duty rate will not solve the problem of black money in real estate. When stamp duty is eliminated, the buyer will be comfortable with zero evasion, but the seller will still urge him to take some black money.

Bad taxes should be eliminated because they are bad taxes. There should be no attempt at finding a direct replacement. As an example, India largely phased out customs duties, because the economists said these are bad taxes, without specifically trying to find a replacement. The elimination of customs duties enabled high GDP growth, and the main pillars of taxation (income tax and the VAT) generated bountiful revenues. A similar story will hold for stamp duty.

The economists teach us that all taxation of transactions is wrong. The property tax suffers from no such problems. Much work is needed in India in building a sound property tax system. In some countries, property tax revenues can be as large as 1% of GDP, which is a very big number compared with the financing of local government in India. The key issue is that the average value of property in each micro neighbourhood (e.g. a 200 metre stretch of road) needs to be assessed correctly and revised every year. This should then be used as a preumptive property tax rate, per square foot, for that micro neighbourhood. Once this is done, property tax collections will be a powerful source of revenue for local government.

There is a link between these two issues. As long as there is a stamp duty and high taxation of real estate capital gains, the reported data will understate property values. This will hamper the revenues obtained through the property tax. To the extent that we solve the twin problems of stamp duty and capital gains taxation, the data in the hands of government about real estate prices will improve, and this will bring property tax to life as a significant revenue source.

12 comments:

  1. We need only 1 tax to eliminate all the black money. Support this movement. http://www.arthakranti.org/

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  2. This suggestion of revisions are fine on the way up. If my property value goes up from 100 to 150, I get taxed on 50 for the year. What if the property value goes down? If value goes down from 100 to 80, do I get a reimbursement? As real estate trends in many countries (especially US) have shown, people can get stuck in low valued property and if they are funded through debt it becomes even more burdensome.

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  3. So the idea is that
    a) Eliminating stamp duty will prevent the buyer from under-reporting the buying price
    b) Eliminating capital gains will prevent the seller from under-reporting the selling price

    But what if both parties decide the sale price is Rs 1 crore but report it as Re 1? This will certainly benefit the buyer if the property tax is based on the sale price. Looks like there needs to be an incentive to correctly report the sale price.

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  4. you are kidding us right?.property tax is a good tax? it violates all ideas of private property -it assumes that you are leasing your land from the sarkar.you never your own house completely.not to mention that the govt will surely/always see it as atm machine.as to property valuation,dont you even seen the moral hazard ? the govt has all the incentives to inflate a property bubble and keep it going.property tax must be the most regressive of all taxes.

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  5. Though I don't agree with dsylexic's idea of private property, I do think that property taxes are problematic in the Indian scenario. A lot of land in India is held as ancestral property that has been passed on for many generations that precede the current ruling establishment in India. Alienating people from those lands because they can no longer pay the tax on it will be seen as unfair and generate another revolt. Also, as Dsylexic pointed out, it will encourage governments to inflate the property bubble as it happened in the US.
    The easiest reform is to reduce the capital gains tax to zero without reducing the stamp duty. This will make it useless for the seller to take black money. A good property market is a sellers' market and everything will follow to plan.

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  6. This sounds pretty funny.

    IM(NS)HO, the transaction taxes would have little affect for the vast majority of cases. In most cases, the buyer doesn't have enough "white" money and the seller wouldn't prefer to take any more "white" money that what she would need to due to circle rates and all that.

    The incentives on real estate need to go away. Restrict the number of properties an individual can buy. One living in Mumbai doesn't need houses in Delhi and other parts of the country.

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  7. All these measures look good when the revenue from tax generated is put to good use. The primary concern of 'aam janta' while evading tax is that their hard earned money goes into the hands of corrupt politicians to be stacked away in numbered swiss bank accounts. There is a lot of justified scepticism when it comes to paying tax for this good old reason. So before even getting into eliminating loopholes in the tax collection system there should be trust building efforts shown by government to gain the confidence of the public or else one way or the other people will find ways of milking the system to earn their own hard earned money.

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  8. @anon on May 10th 12:29.
    its bizzare that you want to solve things by abolishing people's freedom to buy property anywhere in india.lets also have price controls and limit the prices of homes,airplane tickets -people dont need to travel that much,plus it is not so good for the environment..
    welcome to cuba or north korea

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  9. IMHO black money in real estate is less to do with the stamp duty, than as a conduit for illicitly obtained black money. With the increased KYC and computerisation in financial sector with risk based analytics coming in, Property provides a safe haven to park the black money, and to generate even more of black money. There is no transparency in the way real estate market operates in India, an exchange could be developed and a brokerage/service charge could be levied instead of the stamp duty- however for this to happen the land ownership needs to be defined. The government does try to do this using circle rates concept, but even that is circumvented by paying stamp duty at the circle rate and conduct transaction at lower rates.
    A workaround could be to set floor prices as the mandatory least price for any propoerty to be bought or sold, and link these circle rates with the "real estate indexes(something similar to NHB developed real estate index)" on a real time basis. Also, the need is to make the circle rates as close to the actuals as possible. The stamp duty rates could then be lowered to offset the increase in collections due to increase in base.
    what this would essentially do is to
    1. bring in more transparency in the dealings, and provide some benchmark for property transactions
    2. keep the stamp duty collections more or less at the same level while reducing the outgo on every individual transaction as a percentage
    3. check the flow of "black money" in the property system
    4. ensure that the black money which is accumulated in the system would be taxed on exit - all black money transactions invested in real estate using a unrealistic/underreported transaction value would be
    a) taxed on sale, as the transaction takes place on circle rates, and capital gains tax is collected - thus reducing the total size of parallel economy
    b) make the black money investement as a sunk investment as you could not sell the propoerty is you decide not to pay taxes

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  10. The easiest way to fight black money is to make it advantageous to have all the money above the table. I have seen independent professionals declare higher incomes to the tax authorities when they realize that they need to show a higher income to obtain a bank loan etc.

    Of course, there is no way to encourage revelation of money made through corrupt deals and crime. That is a wholly different problem. With lax enforcement and files going missing in even the most high-profile investigations, there is not much hope in this regard.

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  11. How about this folks! I hate taxes. I do not have to pay anyone in addition to what I pay the buyer. I do not care how intelligent and innovative the govt is and how it is earning its revenue. However, I'd like to contribute. Lets do this. Percentage of sale is telling you to be truthful and declare an amount and then put a percentage of it into the mouth of corrupt govt. So, lets do a constant thing. My experience - In chennai, we have something called Guideline value. This guideline value is decided by the govt for a location, differs even by street and is basis for lending by banks. Now, this is price per square feet.
    In some other cities it may be square meters or cents, don't know. Here is my formula on the knowledge based on chennai, assuming 2% govt tax:
    [Guideline value of 1 square feet] * 2% * Total number of square feet property involved in the transaction.
    Thats it. If I buy 2000 sqft property, guideline value 1000Rs per sq ft, then I pay 2% of [2000 *
    1000] = 2% of 20 lakhs which is what: 40k. This is something I need to pay no matter what the heck the transaction amount is, between buyer and seller. Its clean and neat and transparent.

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  12. Real estate prices are infalting far beyond the reach of common man, because of high expectations, artificially created for the value of property in future. People don't even know to evaluate the cost for property and on what basis they are charged, such huge price for the purchase.

    Two beneficieries of this game are, Real estate developers (thats why n number of companies are getting populated like mushrooms in this business - HUGE profits in SHORT time) & BANKS (they cant keep thier money ideal without financing, as they too have high targets for loan disbursement every year. Sales pressure again on them too!!)

    Poor victims are people who have fat salary packages, and doesnt even know whether the money they spend (even several lakhs to a crore) are worth buying it. Mainly for tax saving purpose, & for investment they are ready to spare huge amount of EMI's to be paid almost through out their life. Anytime, if recession hits and their fat salary job will be under problem, then they will feel the real heat on them and the stress on their economics. Guys! particularly salaried ppl, pls think twice or thrice and plan for your investments, so that your hard earned money need not get trapped into hands of real estate inflation!!

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