Review of Economic Dynamics 11 (2008) 584–613
On the user cost and homeownership
, María José Luengo-Prado
Universidad Carlos III, Spain
Northeastern University, 301 Lake Hall, Boston, MA, USA
Received 24 April 2006; revised 5 December 2007
Available online 23 December 2007
This paper studies the differences in the cost of housing services for renters and homeowners and calculates the bias that results
when we value owner-occupied housing services using a rental equivalence approach. Our framework is a life-cycle model with
endogenous tenure choice with households facing idiosyncratic uninsurable earnings risk and housing price risk. We model houses
as illiquid assets that provide collateral for loans. To analyze the impact of preferential housing taxation on the tenure choice and
the bias, we consider a tax system that mimics that of the US economy. Namely, owner-occupied housing services are not taxed
and mortgage interest payments are deductible. Through simulations, we show that a rental equivalence approach (relative to a user
cost approach) overestimates the cost of housing services. The magnitude of the bias is very sensitive to both the income tax rate
and the size of adjustment costs in the housing market.
2007 Elsevier Inc. All rights reserved.
JEL classiﬁcation: E21; C80; E39
Keywords: Consumption; Durables; Down payments; Housing; User cost
Housing services are an important component of aggregate consumption expenditure. In the 2006 National Income
and Product Accounts (NIPA), housing services represent approximately 15 percent of aggregate consumption expen-
ditures. A signiﬁcant fraction of these services (about 80 percent) is acquired through homeownership (the remainder
is obtained in the rental market). Therefore, it is important to pay attention to the valuation of owner-occupied housing
services. The current practice by the Bureau of Labor Statistics is to use a rental equivalence method (see Verbrugge,
2003 and Poole et al., 2005 for a detailed description of this approach). Simply put, the Consumer Price Index is
constructed assuming that the value of the services yielded by owner-occupied housing is the rental market value for
the home. This approach is also used in constructing NIPA. As Prescott (1997) argues, this procedure is inconsistent
with the principle that the effective price of a commodity should be its cost to the household consuming it (a user
cost method). In the absence of frictions, both procedures—by asset pricing theory—should yield the same value for
owner-occupied housing services. However, there are important frictions in the housing market. First, owner-occupied
E-mail address: email@example.com (M.J. Luengo-Prado).
1094-2025/$ – see front matter © 2007 Elsevier Inc. All rights reserved.