EVALUATING THE SOCIAL OPTIMALITY OF DURABLE PUBLIC GOOD PROVISION USING THE HOUSING PRICE RESPONSE TO PUBLIC INVESTMENT

• Published date: 01 February 2017
• DOI: http://doi.org/10.1111/iere.12207
• Author: Stephen Coate,Yanlei Ma
• Date: 01 February 2017

INTERNATIONAL

ECONOMIC

REVIEW

February 2017

Vol. 58, No. 1

EVALUATING THE SOCIAL OPTIMALITY OF DURABLE PUBLIC GOOD

PROVISION USING THE HOUSING PRICE RESPONSE TO PUBLIC INVESTMENT∗

BYSTEPHEN COATE AND YANLEI MA1

Cornell University, U.S.A.; Cornerstone Research, U.S.A.

Recent empirical work in public finance uses the housing price response to public investment to assess the efficiency

of local durable public good provision. This article explores the theoretical justification for this technique. It points out

that the logic justifying the technique for evaluating nondurable public good provision does not translate to the durable

case. A model in which investment is determined by the interaction between a budget-maximizing bureaucrat and a

community’s residents is used to demonstrate that the technique can falsely predict underprovision, falsely predict

overprovision, or perform without error.

1. INTRODUCTION

A sizable fraction of government spending is devoted to investment in durable public goods.

Such investment is undertaken by all levels of government—federal, state, and local. The goods

in question include physical infrastructure (roads, bridges, airports, etc.), basic research, de-

fense equipment, environmental cleanups, parks, and schools. A basic question of interest to

economists and policymakers is how the levels of durable public good provision emerging from

the political process compare with socially optimal levels. This question arises in many dif-

ferent policy areas. For example, there seems broad agreement that government substantially

underinvests in physical infrastructure and basic research. There is much less agreement con-

cerning defense, environmental, and educational investments, with conservatives and liberals

often coming down on opposing sides of the issue. Given the importance of the question, it

would be helpful if economic analysis provided convincing ways of answering it.

There is a long tradition in public finance of using housing prices to assess the social optimality

of local nondurable public good provision (see, e.g., Lind, 1973; Brueckner, 1979, 1982; Wildasin,

1979). The underlying idea is that the demand of potential residents to live in a community will be

influenced by the local public goods it provides and the taxes it levies to finance them (Tiebout,

1956; Oates, 1969). Accordingly, the net surplus generated by local public good provision will

be reflected in housing prices.2In a well-known and elegant theoretical formulation of the

∗Manuscript received August 2015; revised March 2016.

1An earlier version of this article was entitled “Evaluating Durable Public Good Provision Using Housing Prices.”

For helpful comments, we are grateful to two anonymous referees, Damon Clark, John Conley, Jesse Rothstein, and

Holger Sieg. For useful discussions, we thank Gregory Besharov, Nicolai Kuminoff, Ross Milton, and Chris Timmins.

The views expressed in this article are those of the authors and do not necessarily reflect those of Cornerstone Research.

Please address correspondence to: Stephen Coate, Department of Economics, Cornell University, Ithaca, NY 14853.

E-mail: sc163@cornell.edu.

2A vast literature investigates the relationship between housing prices and local public good provision empirically,

with particular focus on schooling. See Nguyen-Hoang and Yinger (2011) and Ross and Yinger (1999) for useful surveys.

3

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(2017) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association

4COATE AND MA

idea, Brueckner develops a model in which if housing prices rise following a small, permanent

increase in local nondurable public good provision, then it can be inferred that the good is

underprovided. Conversely, if housing prices fall, the good is overprovided (Brueckner, 1979,

1982). This model has been used as the basis for a number of empirical studies of the optimality

of local public good provision (see, e.g., Brueckner, 1982; Barrow and Rouse, 2004; Lang and

Jian, 2004).

Can housing prices be used to assess the social optimality of local durable public good

provision? In an ambitious and creative paper, Cellini et al. (2010) employ the approach to

detect whether local school districts are over- or underproviding public school facilities. Using a

static version of Brueckner’s model, they argue that if housing prices in a district rise following

an investment in public school facilities, then such facilities are underprovided. Conversely,

if housing prices fall, facilities are overprovided. To estimate what house prices would be in

the counterfactual situation in which an observed investment is not undertaken, Cellini et al.

exploit the fact that investments must be approved by residents in a referendum. Drawing on

the regression discontinuity literature, they then compare housing prices in school districts in

which referenda have just passed with those in which they have just failed. If prices are higher

in the just passing districts, they argue that school facilities are underprovided. This is indeed

what they find for California school districts.

The intuitive appeal of this approach notwithstanding, there are important conceptual differ-

ences between an investment in a durable public good and a permanent increase in a nondurable

public good. First, because of depreciation, the benefits from investment in the durable public

good will not be permanent. Rather, they will diminish over time. Second, again because of

depreciation, whether or not the investment in question is undertaken, future investments will

be made by the community. Moreover, the nature of these investments will depend on the stock

of the public good and hence on the fate of the investment in question. This creates a linkage

between the current investment and the future investment path in the community. These differ-

ences raise the question of whether the logic that underlies the nondurable case can be applied

to justify using the housing price response to public investment to evaluate durable public good

provision. The purpose of this article is to investigate this important question.

The article begins by developing a simple model to study the issue. This model is designed

to capture the recurring nature of investment in durable public goods and the linkages between

decision-making periods that durability creates. The model is a partial equilibrium model of

a single community whose government provides a durable public good. There is a pool of

households who, for exogenous reasons, are potential residents of the community. Households

move in and out of this pool, creating an active housing market in each period. Investment in the

public good is financed by a tax on the residents. The path of investment follows an exogenous

stochastic process, reflecting the machinations of an unmodeled political process. The supply

of houses in the community is perfectly inelastic, implying that the future surplus a resident is

expected to receive from public good provision is fully capitalized into housing prices.3

This model is used to investigate whether the housing price response to investment reveals

the efficiency of durable public good provision in the community. In particular, it investigates

the accuracy of the housing price test, which asserts that (i) a nonnegative housing price response

to an investment implies that the public good level without the investment is too low, and (ii) a

nonpositive housing price response implies that the public good level with the investment is too

high.4It shows that the housing price test works if the socially optimal level of the public good

maximizes the surplus residents are expected to receive from provision in equilibrium; that is,

3This article does not contribute to the important debate in the literature about the extent to which the property

capitalization effects offer reliable estimates of households’ willingness to pay for changes in local public goods and

amenities (see, for example, Klaiber and Smith, 2013; Kuminoff and Pope, 2014). Instead, the article is interested in

the narrower question of whether housing price changes reveal the social optimality of local public good provision in

an environment in which capitalization of future public good surplus occurs.

4By “too low” and “too high,” we mean relative to the socially optimal level of the public good. This should be

distinguished from the level of the public good that is optimal for the community in equilibrium. In our environment,