Are High Taxes and Restrictive Zoning a Package Deal?

by Reihan Salam

Josh Barro argues that home prices are driving people out of California, and I’m obviously very sympathetic to his conclusion that Texas’s openness to new housing construction is one of its main economic virtues

In Josh’s view, restrictive planning and zoning policies are one thing and tax policies are another:

Conservatives tend to resist the housing analysis of interstate competition. They have a strong emotional attachment to the idea that blue states are punished for high tax rates. But this is also a story of blue-state public-policy failure. People move from California to Texas because Texas has a freer market in real estate that serves people better by providing more affordable housing.

But what if there is a mutually reinforcing relationship between high tax rates and restrictive planning and zoning policies? Consider a recent working paper by Rebecca Diamond on housing supply elasticity and rent extraction by state and local governments:

It is possible government workers can extract rent from private sector workers by charging high tax rates and paying themselves high wages. Using a spatial equilibrium model where private sector workers are free to migrate across government jurisdictions, I show that private sector workers’ migration elasticity with respect to local taxes determines the magnitude of rent extraction by rent seeking state and local governments. Since private sector workers “vote with their feet” by migrating out of rent extractive areas, governments trade off the benefits of a higher tax rate with the cost of a smaller population to tax. Variation in areas’ housing supply elasticities differentially restrains governments’ abilities to extract rent from private sector workers. The incidence of a tax increase falls more on local housing prices in a less housing elastic area, leading to less out-migration. Thus, governments in less housing elastic areas can charge higher taxes without worry of shrinking their tax bases. I test the model’s predictions by using worker wage data from the CPS-MORG. I find the public-private sector wage gap is higher in areas with less elastic housing supplies. This fact holds both within states across metropolitan areas for local government workers and between states forstate government workers. [Emphasis added]

Diamond finds that “states with less elastic housing supplies have significantly better paid state government employees, as compared to private sector employees residing in the same state.” The same dynamic applies at the local level:

The plot shows high local government wages gaps in land unavailable cities including Los Angeles, New York, Cleveland, Chicago, and Portland and low government wage gaps in cities with lots of land to develop including Atlanta, Houston, Minneapolis, and Phoenix. Housing supply elasticity explains a significant amount of the cross-section variation in public-private wage gaps.

Diamond suggests that local governments in land unavailable cities have more market power than local governments in land available cities because the cost of housing is more salient in land unavailable cities:

A tax hike by a government in an area with inelastic housing supply leads to a small amount of out-migration because housing prices sharply fall due to the decrease in housing demand driven by the tax hike. The housing cost decline offsets the negative utility impact of a tax increase with a only small amount of out-migration in the housing inelastic area. Thus, governments in housing inelastic areas can charge higher taxes without shrinking their tax base since housing price changes limit the migration response.

In land available cities, in contrast, the housing price changes aren’t big enough to offset the negative utility impact of a tax increase, and so the out-migration response will be big enough to shrink the tax base. 

If anything, this is all the more reason for voters in capacity-constrained regions to agitate for less restrictive planning and zoning policies, as it will give them more leverage relative to their local governments.

I’m oversimplifying matters, of course: differences in tax and spending levels could reflect the fact that high tax jurisdictions are actually offering much better public services than low tax jurisdictions, and so something other than rent extraction is at work, at least some of the time. But Diamond’s model is an intriguing one. 

And it might shed light on recent findings by Daniel Shoag and Peter Ganong, which Virginia Postrel described in a July column:

The states with the highest incomes also used to have the fastest-growing populations, as Americans moved to the places where they could earn the most money. Over time, that movement narrowed geographic income differences. In 1940, per-capita income in Connecticut was more than four times that in Mississippi. By 1980, Connecticut was still much richer, but the difference was only 76 percent. In the two decades after World War II, Shoag and Ganong find, migration explains about a third of the convergence of average incomes across states.

But migration patterns changed after 1980. “Instead of moving to rich places, like San Francisco or New York or Boston, the population growth is happening in mid-range places like Phoenix or Florida,” Shoag says. Lower-skilled people, defined as those with less than 16 years of education, are actually moving away from high-income states.

Shoag and Ganong attribute this shift to local land-use regulation in affluent regions. Postrel offers her take on the underlying driver of this increase in local land-use regulation:

Making it hard to build new housing in a place people want to live drives up the price of the existing housing stock. Old-timers reap capital gains. Regulation, Shoag notes, “takes what should be the gain for the worker who wants to move in and turns it into the gain for the owner of the house.”

Finally, there’s the never-mentioned possibility: that the best-educated, most-affluent, most politically influential Americans like this result. They may wring their hands over inequality, but in everyday life they see segregation as a feature, not a bug.

This story interacts in complicated ways with Diamond’s: local land-use regulation tends to increase housing prices, yet tax increases tend to decrease housing prices. Local land-use regulation could be understood as a way for incumbents in affluent regions to protect their investment in local real estate in the face of periodic tax increases. If this is indeed the case, we’d expect that the higher the taxes, the more resistance we’d see to relaxing planning and zoning restrictions.

Or not. Who knows? But this story makes intuitive sense to me. I’d also want to throw William Fischel’s homevoter hypothesis into the stew pot of irresponsible speculation.

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.