Zoning and market externalities.

• Author: Lehavi, Amnon
• Position: Special Issue on Affordable Housing

ABSTRACT

The centennial of the 1916 New York City Ordinance and creation of zoning in the United States provides an exceptional opportunity to reconsider the regulatory and legal basis upon which the key governmental power of zoning is founded. The motive to control the various market externalities embedded in land use regulation, from effects on commercial activity to housing prices and job-related housing needs, has practically guided local governments from the very first days of zoning. Yet, at the same time, such considerations of market externalities remain in the shadows of explicit zoning law and policy, as the discussion is re-routed to the allegedly more stable foundations of zoning, such as control of environmental, fiscal, or social externalities.

This Article is the first to specifically explore the legitimacy of local governments regulating private economic activities that have an aggregate effect on the real estate market--defined here as "market externalities." May a local government limit the scope of new commercial uses, such as shopping malls, if it believes that there is already an excess supply of them; or constrain the entry of big-box retailers to preserve the economic viability of existing retailers in a downtown business district? Can a land use ordinance limit, or entirely prohibit, the renting out of housing units in a certain neighborhood, to keep out investors who might drive up real estate prices? Is government entitled to require a developer of market-rate properties to pay a mitigation fee to finance affordable housing units--under a theory that the project would generate new demand for local services provided by modest-income workers who are in need of housing solutions?

This Article develops an innovative theory of zoning and market externalities. It argues that zoning power should extend to regulate market externalities--provided that such decisions are based on a general land use policy that can be clearly identified and are not tailored to intentionally block, or legitimize, specific projects.

TABLE OF CONTENTS Introduction 362 I. Externalities and Theories of Zoning 365 A. The Zoning Power 365 B. Technological or Environmental Externalities 370 C. Fiscal Externalities 373 D. Social Externalities 376 E. Pecuniary and Market Externalities 380 II. The Regulation of Market Externalities 384 A. Entry of Commercial Uses 384 B. Renting Out Investment Property 389 C. Inclusionary Zoning and Market Nexus 393 III. Judicial Review of Market-Based Zoning 399 A. Consistency with Overall Land Use Policy 399 B. Intergovernmental Market Externalities 404 Conclusion 409 INTRODUCTION

The New York Times recently portrayed the growing economic distress of many enclosed shopping malls across the United States. (1) The potential reasons for this hardship are numerous, and not all malls share the same fate. While high-end "A-rated" malls are performing well, middle- and working-class malls are seeing increasing vacancy rates. The fundamental problem of the latter malls is arguably one of over-abundance, the result of a "long boom in building retail space of all kinds." (2) Moreover, once such a massive space becomes vacant or entirely "dead," its resurrection might prove a daunting task. (3)

This turn of events may reinvigorate a long-standing debate about the proper role of government in the real estate market. The current downturn of multiple shopping malls could be seen as a sign of healthy competition among retailers and an inevitable result of changing consumer preferences. Alternatively, however, this decline might be an indication of some kind of market- or government-failure. If the latter proposition is embraced, government might legitimately avoid this failure by intervening early and explicitly considering, within its land use regulation powers, the potential effect of excess demand or other pecuniary impacts that a planned project might entail.

As this Article shows, the economic effect of real estate developments is a matter of crucial importance for private and public stakeholders, and such considerations play a key role in land use decisions. The issue of pecuniary externalities and other types of economic activities that have an aggregate effect on the real estate market--defined here as "market externalities"--may even be seen as going back to the days of establishing the institution of zoning in the United States. (4)

However, the jurisprudence on the legitimacy of the government explicitly addressing market externalities and on the standard of review that should apply has been sporadic. (5) In many cases, both policymakers and courts avoid these questions by rerouting the analysis to the allegedly more stable foundations of the zoning power, such as regulation of environmental externalities caused by conflicting land uses, or fiscal externalities that address developments' impact on public infrastructure. (6)

Therefore, while economists have long addressed the welfare and distributive effects of pecuniary externalities and have applied such insights to the spatial-urban context, the legal profession has done neither. (7) This Article sets out to close this gap by developing a legal framework for zoning and market externalities.

This Article asserts that the power of zoning and other types of land use regulation should extend explicitly to regulate market externalities. Regulatory decisions addressing pecuniary externalities should be considered legitimate when such regulation establishes a general land use policy and is not tailored to intentionally block or legitimize a specific project. Every zoning decision must obviously account also for the specific features of the project and the cost/benefit analysis it entails, and government should be entitled to deviate from its general policy under extraordinary circumstances. At the same time, judicial review should examine the government's ability to explicitly anchor its individual decisions within a broader land use policy.

Although the dilemma of specific versus general decision making is present for the more established justifications for zoning power, this tradeoff is of particular importance in the context of regulating market externalities. (8) Accordingly, courts should defer to governments by lowering their standard of review only for actions made within a broader decision making framework--not actions made outside of it.

Moreover, a local government's zoning decision that regulates potential market externalities may generate other types of market externalities, positive or negative, across municipal borders. Judicial review of such zoning decisions should also hold the local government accountable for the potential threat of "regulatory opportunism," in which a certain municipality simply seeks to shoulder a specific negative market externality on the residents of adjacent localities. (9) The legal criteria for holding a municipality responsible for an inter-local market externality, generated by its zoning decision, should be based chiefly on the consistency of this effect with the broad-based policy adopted by the municipality to regulate its own intra-local externalities.

The Article is structured as follows. Part I starts by concisely portraying the power of zoning, and land use regulation in general, as it has emerged over the past century. It discusses the gradual, often implicit expansion of zoning's legitimate goals as identified by courts and the corresponding standards of judicial review applied to such measures. This Part analyzes the different treatment of technological and environmental externalities, fiscal externalities, and "social externalities" versus the treatment of market externalities. While the former types of effects are viewed as operating 'outside the market' and, thus, liable to generate welfare inefficiencies, economists have tended to view market externalities as operating 'within the market' by solely affecting prices, thus producing no inefficiencies. (10) From a legal perspective, however, pecuniary or market externalities, whether positive or negative, receive almost no explicit attention and remain in the shadows of zoning law. (11)

Part II explores, in detail, market externalities. It discusses three different settings. First, this Part asks whether government can limit the scope of new commercial uses, such as shopping malls or big box retailers, if the city believes that there is already excess supply of commerce or if the city otherwise wishes to preserve the viability of its Central Business District ("CBD"). (12) Second, it examines various limits imposed on renting out housing units in a certain jurisdiction, or parts thereof, in order to keep out investors who might drive up real estate prices. Third, it asks whether a local government is entitled to require a developer of market-rate properties to pay a mitigation fee to finance affordable housing units--under the theory that the project would generate demand for services, which would be provided by low- and modest-income workers in need of housing.

Part III outlines the standards of judicial review that should apply to such cases. It argues that land use decisions that regulate potential market externalities should be granted a high degree of deference, as falling within government's police power, if the regulation is anchored in a general policy that deals with the relevant features of the real estate market. The municipality would thus have to establish a "substantial relation" (13) between its broad policy on market activities and measures taken to control adverse market externalities. At the same time, such a local policy should be held accountable for potential market externalities that this strategy may generate for neighboring localities. This is required in order to prevent opportunism among local governments in regulating market externalities.

1. EXTERNALITIES AND THEORIES OF ZONING

   1. The Zoning Power

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