Budget 2007:Stamp duty is in dire need of reform, but minor changes would leave many core inequities intact, writes Marc Coleman

Reforming stamp duty, if it happens, will require all the skills of a bomb-disposal expert. The risk of an explosion in the property market, not to mention the election, is considerable. Mere speculation about reform has scared buyers away from the market pending the Budget and caused the prices of some categories of house to start falling.

However, this might cause some to leave well alone. Without reform the stamp duty bomb will keep on ticking until the election, threatening far bigger explosions next year.

The source of the danger comes from the rapid growth of the tax itself. Stamp duty now accounts for 9 per cent of total tax revenue and rising, up from 3 per cent in 1998, when revenues began escalating at the start of the housing boom.

Stamp duty's odd rate structure significantly magnifies the relationship between the rate of house price growth on the one hand and the rate of revenue growth on the other. In the first 10 months of this year, house prices rose by 10 per cent on average. By contrast, stamp duty revenues rose by 39 per cent over the same period, which strongly suggests that even a modest fall in house prices could significantly dent revenues from this source.

Despite this, both the Minister for Finance and his department have been reluctant reformers. A cash cow for the exchequer, stamp duty could rake in up to €4 billion in revenue next year. Coincidentally, this is also the amount by which the Government intends to increase State spending next year.

A modest reform of stamp duty might take some of the heat out of political debate. But if too modest, reforms will leave many of the tax's problems intact.

If the stamp duty "bomb" is to be defused once and for all, its component parts and wires need close and careful examination.

The first question is who should pay stamp duty and why. The unspoken truth is that stamp duty is tolerated by our political classes as an alternative to property tax. Not having any initial property to begin with, a policy of exempting first-time buyers seems immediately justified. In a strongly rising market, owner-occupiers trading up have not only property but equity from what they have sold.

But stamp duty taxes them not on the basis of that equity gain, but rather on the price of the property they are purchasing. If the duty exceeds the equity, then the incidence of stamp duty in that particular case will violate a core principle of good taxation by exceeding 100 per cent of the taxable value or gain.

Another problem with levying stamp duty on owner-occupiers is the way it penalises growing families and mobile workers. Requiring owner-occupiers to pay a tax simply because their family has grown and they need a bigger residence seems perverse. Similarly, for those who have to sell their old home and buy a new one in another part of the country in order to take up employment there, stamp duty discriminates against those who lose their jobs. It also contradicts the Government's policy of encouraging labour mobility.

For those owner-occupiers wishing to trade down, stamp duty acts as a disincentive to sell. A five-bedroom house where all the birds have flown the nest may stay occupied by one or two elderly relatives, while large families desperately seek accommodation.

Even assuming the tax is a valid one, it is hard to see that stamp duty - an alternative to property tax - should apply to houses with average prices. In this respect, stamp duty thresholds have lost all credibility.

Even after the 2005 budget, first-time buyers were still subject to a rate of 3 per cent on the purchase of a house worth €317,501 or more. But average house prices had already risen above this level eight months before that rate was set. Average house prices have risen to the point where an ever larger number of buyers will be pushed into higher brackets of stamp duty.

Another issue is whether owner-occupiers deserve to pay the same rate as applied to property investors.

After differentiating the rates in 2001, the Government brought rates applying to investors back down to rates paid by owner-occupiers.

Ostensibly done to prop up the rental market, the move denied owner-occupiers one of the few things working in their favour in a market where investors held most of the cards. In the United Kingdom, a rate of 1 per cent applies to all property purchases. In the Republic, three rates apply - 3 per cent, 6 per cent and 9 per cent.

Adopting a UK-style approach for owner-occupiers but retaining higher bands for property investors is one approach that the Government might consider this week. One caveat here is that such a policy should be rolled out over several years, in the same manner as the unwinding of tax reliefs for non-residential investments.

But perhaps the two most important issues relate to what impact reform would have on budgetary stability and on the housing market. The most unusual feature of stamp duty is also the reason why this tax has produced a relatively much stronger increase in revenues (and why the reverse may be true if things go wrong): once pushed into a higher rate threshold, the purchaser ends up paying the higher rate on the entire rate of the house.

Reforming the tax so that higher rates would only apply to that portion of the house price above the threshold would stabilise the relationship between prices and revenues, not to mention make the tax more equitable.

Finally, all eyes are on what impact any reform will have on the market. All other things being equal, an increase in the threshold will tend to increase the price paid to the seller, probably by less than but close to the amount of reduction in stamp duty.

In net terms, the Government would be the loser and the house seller the gainer.

While remaining a passive and neutral conduit in that transfer at the time of purchase, the house buyer would nonetheless gain in two respects. Firstly, the amount previously surrendered in stamp duty - but now paid to the buyer in the form of a higher price - would at least be retained in the form of housing equity. Secondly, whereas stamp duty forces many to eat into their personal savings, the higher price resulting from its abolition or reduction can be financed using mortgage finance, at a far lower opportunity cost and over a longer time span.