a1 University of New South Wales
a2 Indira Gandhi Institute of Development Research
Although several targeted welfare programs across the world have made owner-occupied housing exempt from the means test, relatively little is known about the impact of such exemption on portfolio choice and consumption. We study the Australian age pension scheme and argue that current uncapped exemption may lead to distortionary incentives for high levels of housing wealth to be sheltered from the means test. We set up a life-cycle model with explicit housing choice and borrowing constraints to match some key features of the Australian economy. We find that abolishing the exemption of owner-occupied housing in the assets test increases aggregate output, capital accumulation, and welfare, but decreases housing investment and homeownership. However, removing such distortions does not necessarily imply that all households would be better off. Lowering taxes to maintain fiscal balance would result in wealthy households experiencing a large welfare loss, whereas the majority of the population would benefit.
We thank participants at the Workshop for Dynamic Macroeconomics 2010 organized by Benoît Julien and Pere Gomis-Porqueras, as well as anonymous referees, for providing very useful suggestions. This work was partially supported by UNSW Special Research Grant 2009–2010. All remaining errors are our responsibility.