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The Allocation of Capital Between Residential and Nonresidential Uses: Taxes, Inflation and Capital Market Constraints


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  • Patric H. Hendershott
  • Sheng Cheng Hu


We have constructed a simple two-sector model of the demand for housing and corporate capital. An increase in the inflation rate, with and with- out an increase in the risk premium on equities, was then simulated with a number of model variants. The model and simulation experiments illustrate both the tax bias in favor of housing (its initial average real user cost was 3 percentage points less than that for corporate capital) and the manner in which inflation magnifies it (the difference rises to 5 percentage points without an exogenous increase in real house prices and 4 percentage points with an exogenous increase). The existence of a capital-market constraint offsets the increase in the bias against corporate capital, but it introduces a sharp, inefficient reallocation of housing from less wealthy, constrained households to wealthy households who do not have gains on mortgages and are not financially const rained. Widespread usage of innovative housing finance instruments would overcome this reallocation but at the expense of corporate capital. Only a reduction in inflation or in the taxation of income from business capital will solve the problem of inefficient allocation of capital. The simulation results are also able to provide an explanation for the failure of nominal interest rates to rise by a multiple of an increase in the inflation rate in a world with taxes. When the inflation rate alone was increased, the ratio of the increases in the risk-free and inflation rates was 1.32. An increase in the risk premium on equities, in conjunction with the increase in inflation, lowered the simulated ratio to 1.10, introduction of a supply price elasticity of 4 and an exogenous increase in the real house price reduced the ratio to 1.03, and incorporation of the credit-market. constraint reduced the ratio to 0.95.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0718.

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Date of creation: Jul 1981
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Publication status: published as Hendershott, Patric H. and Sheng Cheng Hu. "The Allocation of Capital Between Residential and Nonresidential Uses: Taxes, Inflattion and Capital Market Constraints." The Journal of Finance, Vol. 38, No. 3, (June 1983), pp. 7 95-812.
Handle: RePEc:nbr:nberwo:0718

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  1. Martin Feldstein & Lawrence Summers, 1978. "Inflation, Tax Rules, and the Long Term-Interest Rate," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 9(1), pages 61-110.
  2. Leo Grebler, 1979. "The Growth of Residential Capital Since World War II," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 7(4), pages 539-580.
  3. Smith, Barton A, 1976. "The Supply of Urban Housing," The Quarterly Journal of Economics, MIT Press, vol. 90(3), pages 389-405, August.
  4. Hendershott, Patric H. & Cheng Hu, Sheng, 1981. "Inflation and extraordinary returns on owner-occupied housing: Some implications for capital allocation and productivity growth," Journal of Macroeconomics, Elsevier, vol. 3(2), pages 177-203.
  5. Friend, Irwin & Blume, Marshall E, 1975. "The Demand for Risky Assets," American Economic Review, American Economic Association, vol. 65(5), pages 900-922, December.
  6. Malkiel, Burton G, 1979. "The Capital Formation Problem in the United States," Journal of Finance, American Finance Association, vol. 34(2), pages 291-306, May.
  7. Hanushek, Eric A & Quigley, John M, 1980. "What Is the Price Elasticity of Housing Demand?," The Review of Economics and Statistics, MIT Press, vol. 62(3), pages 449-54, August.
  8. Kearl, J R & Mishkin, Frederic S, 1977. "Illiquidity, the Demand for Residential Housing, and Monetary Policy," Journal of Finance, American Finance Association, vol. 32(5), pages 1571-86, December.
  9. Martin Feldstein, 1980. "The Distribution of the U.S. Capital Stock Between Residential and Industrial Uses," NBER Working Papers 0448, National Bureau of Economic Research, Inc.
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Cited by:
  1. Skinner, Jonathan, 1996. "The dynamic efficiency cost of not taxing housing," Journal of Public Economics, Elsevier, vol. 59(3), pages 397-417, March.
  2. Leung, Charles, 2004. "Macroeconomics and housing: a review of the literature," Journal of Housing Economics, Elsevier, vol. 13(4), pages 249-267, December.
  3. Berkovec, James & Fullerton, Don, 1992. "A General Equilibrium Model of Housing, Taxes, and Portfolio Choice," Journal of Political Economy, University of Chicago Press, vol. 100(2), pages 390-429, April.
  4. Berkovec, James & Fullerton, Don, 1989. "The General Equilibrium Effects of Inflation on Housing Consumption and Investment," American Economic Review, American Economic Association, vol. 79(2), pages 277-82, May.
  5. Gervais, Martin, 2002. "Housing taxation and capital accumulation," Journal of Monetary Economics, Elsevier, vol. 49(7), pages 1461-1489, October.


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