Above All Else Stop Digging: Local Government Law as a (Partial) Cause of (and Solution to) the Current Housing Crisis

Abstract:     
So many things have gone wrong with our housing market that it is hard to know where to start. One simple diagnosis is that we invested too much in houses that were not worth as much as we thought. Looked at in this way, it is relatively easy to see how innovations like interest-only loans contributed to an over-valuation of housing. Certain actions of the federal government were and are also clearly problematic, such as the longstanding tax breaks for home ownership.

This article looks at state and local government law, and particularly at financing mechanisms created by state law and used by local governments to subsidize new development. In essence, local governments issued bonds to build key infrastructure for new developments, and interest on those bonds were exempt from state and federal income taxes. This article maintains that these mechanisms served as yet another subsidy to the very same kinds of value-destroying housing developments that were already being over-encouraged in other ways. Just as the current crisis has rightly led policymakers to reconsider government actions at the federal level, this crisis should also lead to a similar reevaluation of state and local government law, particularly as it intersects with the federal tax exemption for state and local bonds.

However, there is an ideological obstacle to this straightforward solution. Making money available for sprawl-pattern development has been perceived as a market-friendly solution; directing money to infill development is perceived as heavy-handed interventionism. And, because of these perceptions, some very modest reforms to the current system have already been defeated. These perceptions arise from the central normative justification for the current local government landscape. This justification is economic and consists of the argument that competition among a multitude of local government entities is efficient. This vision of jurisdictional competition is generally known as the Tiebout model.

This article makes a series of specific contributions to this rethinking. First, despite arguments by proponents of the Tiebout model to the contrary, it is demonstrated that a full-blown Tiebout model does not release governments at various levels, nor citizens, from making political choices about a just (versus merely efficient) distribution of resources. This is primarily because the legal background rules that set the terms of the competition also select for different equally efficient sets of jurisdictions. From this result it follows that these legal background rules ought to be interrogated as making political choices. A particular type of rule is described in this article as a "bundling rule." A bundling rule operates, for instance, by making a certain method of financing schools readily available only to new subdivisions, thus bundling new schools with new development. By opting to make such a method available, state governments are in effect choosing to encourage certain patterns of development. Once this is realized, then there should be no barrier standing in the way of scrapping bundling rules that encourage sprawl.

Keywords: Tiebout, property tax, Mello-Roos tax, assessment districts, residential segregation, housing crisis

Working Paper Series