Moderate impact fees won’t discourage housing development

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From a 2007 city consultant report

Should the city of Seattle tax housing developers to pay for neighborhood improvements?

This is the boiled-down version of the question facing the city council and the mayor in the current debate over development taxation (AKA impact fees, AKA linkage fees). The Seattle Times’ Danny Westneat has previously supported them; developers, for obvious reasons, oppose them. In this post, I claim that moderate impact fees developer taxes will do little or nothing to discourage housing development (and pursuant expansion of Seattle housing).

Non-empirical thought experiment about Seattle housing market dynamics

Suppose there are a hundred people who want housing in Seattle. Let’s assign them each a number, 1 through 100, and posit that someone’s number is equal to the maximum amount they can can afford to pay for rent (so #1 has $1, #25 has $25, and so on). Finally, let’s assume that there are 50 houses for rent: demand overwhelmingly exceeds supply.

What price will maximize revenues for developers/renters?

Suppose they charge the highest possible price: $100 per unit. Technically, this price is within the realm of the housing market, but only for one buyer. One unit will sell, forty nine will remain empty, and the developers will make $100.

Suppose they charge $1: the lowest possible price. The whole population of buyers can each afford to buy a house, and fifty houses are sold at $1 apiece to make a total of $50.

Suppose $26. Three-quarters of the buyer population (#26 through #100) qualify; fifty of them will actually get housing, to create a total revenue of $1250 for developers.

At this point you might guess how we can reckon the price which will maximize developer revenue: just take the number of available houses and start counting down from the top of the buyer list, matching a house to each buyer until there’s no more housing. In this case, that would mean buyers #100 through #51 each pay $51 for a house. 50 houses are sold at $51 dollars apiece to create a total revenue of $2550.

That’s the revenue-maximizing price for housing. Set the price at $50 and all 50 houses will sell but at a lower total revenue ($2500) than if the price was a dollar more. Set the price at $52, and supply will outstrip effective demand: only 49 people (#100 through #52) can afford to buy houses, for a total revenue of $2548. $51 is the equilibrium price for housing in our hypothetical market, in which the maximum amount of mutual benefit is achieved by both parties (maximum amount of housing is available to willing & able buyers, and developers get maximum revenues from their investment).

Notice that so far we’ve said nothing about development costs: they could be $1 per house or $50 per house: in either case, the developer would still set the price at $51 per house (for a profit of $50 per house in the former case and a profit of $1 per house in the latter). As long as there’s profit to be made in development (i.e. as long as the price of development is lower than the price of buying housing), developers will develop. In a market where producers can meet demand by producing more of the commodity (e.g. mobile phones), things would work out differently: producers undercut each other’s prices, driving the market price down until it equals the cost of production (or at least that’s what happens theoretically, if there’s perfect competition). But our developers can’t produce more housing: they’re limited by the amount of zoned land available. So instead of a buyer’s market where sellers bid against one another to drive down prices, the Seattle housing market is a seller’s market in which buyers bid against one another to drive up prices.

To summarize: because Seattle’s housing market has a limited supply which does not meet demand, the price of housing will be determined by the richest buyers out-bidding everyone else. This price does not change when the price of development is raised or lowered. As long as the price of developing housing is lower than the price of buying it, the price of development will not affect the price of buying housing.

Hence, modest impact fees developer taxes are good

This is where impact fees developer taxes come in: assuming that housing developers are making a profit (and it’s hard to imagine they’re not, given that Seattle is “the fastest-growing city in the United States,”), adding moderate impact fees developer taxes to their overall cost of development will not affect the price of housing. “Moderate” in this case means “not expensive enough to make the cost of developing housing become greater than the price of buying housing.” Think of it this way: with all the money to be made in renting and real estate right now, developers are chomping at the bit like horses transfixed by a carrot set in front of them. Making those horse-developers clean up some of their dung as a condition for getting that housing-market-carrot won’t be sufficient disincentive to stop them from developing/eating the carrot.

So that’s my argument in favor of impact fees developer taxes, and more broadly in favor of taxing capital: figure out how much taxation would make an investment no longer profitable to a developer (or any firm), and then tax just a little bit less than that. Call the tax(es) whatever you want, and tweak them to encourage or discourage whatever behavior you want: smoking, driving, college enrollment, building housing—whatever social engineering projects you’ve always wanted to play God with. Take the taxed money and invest it into infrastructure (as impact fees do), so that tomorrow’s Seattle remains attractive to renters, developers, and capital in general (and so that, incidentally, the city remains/becomes a nice place to live).

Brief foray into actual evidence from real world

What is a “moderate” impact fee developer tax in the actual Seattle housing market? According a city consultant’s report (p. 7) that’s extrapolating from another city consultant’s report (in which the phrase “nexus fee” appears to just mean impact fee, because Latin sounds smart, I guess), a 6% return on residential development and 10% return on commercial development are suggested as development “feasibility” benchmarks. Further research might be useful, but these statistics show how in principle the city can estimate the minimal return on investment developers need and use that to set developmental tax rates (AKA impact fees). A 2007 city report reviews four case studies of cities taxing development, including a linkage fee in Boston that generated over $80 million for the city over two decades. This doesn’t tell us what the specific effects of impact fees development taxes would be on Seattle housing development, but it does demonstrate that it’s possible for a large city to tax development without the sky falling.

Anti-racist bonus

Tangential to the rest of my argument but still cool: adopting the kind of impact linkage fees proposed by the city’s consultant would place higher impact fees (AKA development taxes) in richer areas and lower impact fees in poorer areas, effectively encouraging development in poor areas and thus doing the opposite of the infamous “redlining” which, as Ta-Nehisi Coates contends, institutionalized post-Jim-Crow racism.

Update: Oops

It turns out that while impact fees and linkage fees are both taxes on developers, they’re earmarked for different investment targets: linkage fees pay for affordable housing, while impact fees make the neighborhood nicer. This doesn’t affect my larger argument, which is about developer taxes in general, but it does make me look stupid. Oops.

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