I would rather say the problem is in the very low cost of settling cities, not in the bad returns of vertical growth. I think vertical growth is ok, even though some buildings could use a buff and the gold/hammer ratio of purchasing things be changed, but the real culprit is that there is virtually no cost to founding new cities, except for a happiness cost that you can offset with fairly little trouble. Just adding any kind of city maintenance that doesn't use the happiness system will do the trick if it's high enough, and optimally a faster increase than linear. If you make settlers more expensive, REX becomes increasingly difficult to pull off and growing your cities becomes much more attractive.
Nerfing happiness, I agree, is not the way to balance ICS vs large cities. I also dislike the hard cap feeling you get out of the happiness balancing, but with just happiness there simply is no other way to do it. And the devs seem set on that approach.
