To downsize or not: the rising cost of the great Australian dream

One of my regular neighbourhood walks takes me past a fine example of Queen Anne architecture. The elegant family home has three sculptural red-brick chimney stacks towering from its multi-gabled roof, the horizontal ridge lines capped with decorative terracotta ornaments. Although the house is well maintained, its charms have begun to look slightly faded in recent years. The paint on the woodwork is no longer fresh and a front garden that was once cared for now looks as if it is simply maintained.

"Mary", who owns the house, is in her late 80s and has lived there alone since the death of her husband several years ago. In popular parlance, she is the archetypal little old lady rattling around in the old family home. In the language of public policy and economics, Mary is an "over-consumer" of housing and her choice of dwelling is "inefficient". Put another way, she is helping to reduce supply and inflate prices.

The number of older Australians who live alone in large homes is startling. An analysis of 2011 census data reveals that of homeowners aged 70 and over who live alone, 62 per cent have a house with three or more bedrooms. That adds up to 238,078 houses with at least three bedrooms occupied by just one person. Among houses owned by older couples (with at least one partner aged over 70), 82 per cent - or 332,752 houses - have at least three bedrooms.

The phenomenon appears certain to become much more pronounced. Treasury has projected that the share of the population aged over 65 will rise from 13 per cent to 23 per cent by 2050 (an increase from 3 million to more than 7 million people). Within that group, the number of "very old people" - people aged 85 or more - is expected to more than quadruple to 1.8 million. Since close to 80 per cent of Australians aged 65 or older own their own homes, that means legions of Marys are potentially "rattling around" in large houses.

In addition, Federal Parliament recently passed the final legislative elements of the Living Better, Living Longer package, which will see aged-care policy and funding focus even more on providing support to people in their homes, rather than in residential facilities. This welcome reform could have a downside if it encourages older people to stay in houses that are too big for them and that they can no longer keep in good condition. The costs of delivering aged care to the home would then rise rapidly as service providers, and by extension governments, are called on to provide more cleaning, repairs and modifications.

That trend will also exacerbate the shortages and cost pressures that already strain our housing system. And it will delay the redevelopment of the middle rings of Australian cities, where there is great potential to increase affordability and sustainability by replacing ageing houses on large blocks with more diverse, medium-density dwellings.

But it would be presumptuous, even draconian, to insist that someone like Mary should downsize. People of all ages live in houses that have many more rooms than occupants. Those spare bedrooms are often needed for visiting friends and family, as home offices, studios or music rooms, or to provide a refuge when sleep is impossible because a partner is snoring. The big backyard is needed for pets, for outdoor entertaining, for children to play in, or for growing vegies.

One other factor that we may fail to recognise, or at least admit to ourselves, is that an owner-occupied house in Australia is a highly tax-effective vehicle for accumulating, storing and passing on wealth. Under such conditions, it is hardly surprising that those of us who can afford to do so often buy houses that are larger than we might actually need.

The idea that it is inappropriate for older people to continue living in large houses is known as "the mismatch argument". Crudely put, it suggests older people don't know what is best for them and therefore become trapped in dwellings that are too large and too expensive to heat and cool, keep clean and maintain.

The argument takes no account of how older people might use and enjoy their extra rooms for hobbies, professional activities, accommodating guests, study, entertaining or hosting family gatherings - activities that often make a major contribution to their wellbeing. The argument also has a moralistic undertone, a suggestion that older people are denying others, especially young families, the chance to live in an ideal home.

On an individual level, Mary's choices are entirely a personal concern. At a societal level, however, the sum of our private choices can add up to a major problem.

The point is not to tell Mary or anyone else how to live their lives, but to recognise that our choices are framed by policies that create incentives and disincentives. If these policies deter older home owners from downsizing, then this acts as a brake on supply and keeps housing costs high.

If government policies deter older home owners like Mary from downsizing, then their choices are potentially being constrained rather than expanded. Someone who "over-consumes" housing is apt to "under-consume" other goods and services, particularly if he or she is on a fixed income, and could end up shivering frugally in a cold, rundown but spacious house, rather than turning on the heating or calling in a plumber.

A range of newer financial instruments - including reverse mortgages and partial sales - can enable older home owners to convert some of their equity into cash without moving house. But in a paper for the Australian Housing and Urban Research Institute, Rachel Ong and her co-authors note that retired home owners typically "appear to view housing wealth as precautionary savings that are only rolled out in extreme circumstances".

Yet there is evidence that many Australians are open to the idea of moving into a smaller residence as they grow older. A detailed survey carried out by the institute reveals that while the majority of us want to "age-in-place", this doesn't necessarily mean that we expect to stay in the same house. Most of us are attached less to a particular pile of bricks and mortar than to a local area - to a network of friends, services and familiar places.

So why don't more people downsize?

There are two answers to this question - the first is to do with the type of housing we build, the second with the way we tax it.

With almost three-quarters of occupied private dwellings in Australia having three bedrooms or more, people who want to move to a smaller house have limited options, especially if they want to stay in the same locality. Zoning and planning rules often exacerbate this situation by inhibiting the construction of more diverse housing stock. And those rules could tighten up in many areas under Victoria's new zoning system, which gives local governments extensive powers to determine what kinds of development can take place in different locations.

The City of Glen Eira, the first local government to implement the new system, has classified almost 80 per cent of the municipality as a Neighbourhood Residential Zone. This places a two-storey height limit on all buildings and a limit of two dwellings per lot. The aim is to protect the amenity and character of quiet residential streets and concentrate higher-density development along major transport routes and shopping strips. But any residents who want to move from a free-standing family sized home to something smaller will almost certainly find that they have to leave Glen Eira's leafy streets behind.

A lack of housing choice is not the biggest barrier to downsizing for older Australians, though. More important is the way we tax property and the way this interacts with pension payments. Let's return to the example of Mary. She has no economic incentive to move into a smaller residence. Quite the opposite: were she to downsize, Mary would be financially penalised.

First, there is the transaction cost of any move - particularly stamp duty, which would amount to tens of thousands of dollars. Second, because her home is her primary residence, it is exempt from the assets test for the age pension; if Mary sells the house, though, the proceeds from its sale would not be exempt.

Given its location in a quiet, tree-lined street close to a park, shops and transport, Mary's home would be worth more than a million dollars. If she swapped it for a $500,000 unit and saved the difference then she might well find herself ineligible for the age pension. For a single home owner with assets worth up to $196,750, the basic pension is currently $733.70 per fortnight. For every $1000 in assets beyond that threshold, the pension reduces by $1.50. If Mary downsizes, then every $100,000 she puts in the bank reduces her pension by $150 a fortnight.

The Productivity Commission recognised this problem in its report, Caring for Older Australians. Its "first best option" was that the means test for the age pension should treat income and assets "in a consistent manner". In other words, certain types of wealth such as a family home should not be excluded from the assets test or treated differently from other types of wealth, like bank deposits or shares. Recognising that this was unlikely to be adopted, the commission recommended a more politically palatable Australian age pensioners savings account scheme. Older Australians would be able to sell their homes and deposit the proceeds in the account without affecting their government entitlements.

In the 2013 federal budget, the government announced a three-year trial of a similar but much more limited scheme, beginning in July 2014. Under the trial, pensioners will be able to put up to $200,000 from the sale of their home into a special account that is exempt from the assets test. To be eligible, pensioners must have lived in their own home for at least 25 years, and funds are only exempt from the pension test if they remain in the account. This rather undermines the thrust of the Productivity Commission's recommendations, which were designed not only to encourage retirees to downsize but also to free up the capital in their homes for other purposes, including making a greater contribution to the cost of their own care.

But schemes like this will only benefit those who already have substantial housing wealth, and will exacerbate rather than redress inequality. They offer nothing to older Australians who live in rented accommodation or to those who own poorly located property that is not worth much money.

And this brings us to the nub of the issue. In Australia, the family home is exempt from any form of taxation, except the stamp duty paid on purchase. It is exempt from capital gains tax and land tax and is not included in the assets test for the age pension. As a result, we use the family home as the primary store of personal wealth to be passed on to the next generation.

Economist Judy Yates has calculated that owner-occupiers benefited from government tax expenditures (that is, revenue forgone) totalling $45 billion in 2005-06. In a background paper for the Henry tax review in 2010, researcher Gavin Wood and his colleagues showed how these substantial benefits to home owners increase with age and wealth, adding up to an average annual subsidy of more than $5000 to home owners aged over 65.

The exemption of the primary residence from the pension assets test increased the subsidy, on average, by another $2500. Once benefits like these have been granted, it is very hard to take it away. In fact, to suggest that the family home should be taxed, or included in the pension assets test, is to risk being labelled unAustralian. There is no sign that either side of politics would be brave enough to canvas such radical ideas.

The one reform a government might conceivably adopt with bipartisan support would be to abolish stamp duty and replace it with a broad-based tax on the value of land. The ACT is the only jurisdiction in Australia currently moving in this direction.

By reducing the costs of moving house, the abolition of stamp duty would remove one significant impediment to downsizing with age.

A land tax would also capture some of the windfall gains that accrue to home owners from a well-located property, and from government investments in civic improvements and better infrastructure.

I don't know why Mary has chosen to stay in a house that is much larger than her apparent needs. Whatever her reasons, Mary has every right to stay put. The question is whether it is time to change the policy mix in a way that might prompt her to consider other options and also help to make Australia's housing more affordable and more equitable.

■ Close to 80 per cent of Australians aged sixty five or older own their own homes

■ Almost threequarters of occupied private dwellings in Australia have three bedrooms or more.

■ 62 per cent of homeowners aged seventy and over who live alone do so

in a house with three or more bedrooms.

■ 82 per cent of houses owned by older couples have a minimum of three

bedrooms.

■ The ACT has the highest level of housing “overconsumption” with 93 per cent of

older couples living in a house with three or more bedrooms.

■ Under current rules, an older person who downsize risks losing part or all of

their pension.