I'm talking about general public finance, not the what happens at the point of development. Property taxes typically make up the bulk of local government receipts, so they are incentivized to prevent market corrections to high real estate prices.

I'm not arguing that there would be no issues on a perfectly free housing market, just that we aren't currently operating in one and artificial scarcity is enforced by the state so we can't even observe what the market is trying to do. You can get a glimpse, though, by comparing the expensive highly regulated markets to the cheaper less regulated ones.