Community development with externalities and corrective taxation

This paper studies the impact of granting a community the authority to tax development when growth imposes negative externalities on existing residents. Taxes are chosen in each period by the residents who are fully forward-looking. Residents' policy choices reflect not only the desire to counter negative externalities but also their wish to raise tax revenues and the value of their homes. There exists an equilibrium in which taxes are gradually lowered to close to optimal levels, resulting in falling housing prices and increasing community size. In addition, there exist equilibria in which taxes are set much too high and development is permanently stalled. In these equilibria, residents anticipate that lowering taxes will cause a sharp fall in the value of their homes. This multiplicity of equilibrium means that, for a broad range of initial conditions, allowing residents to tax development can increase or decrease social welfare. Regulating growth with zoning generates even worse outcomes, but allowing the community to charge developers impact fees does better.