The precise mechanisms by which beta-catenin controls morphogenesis and cell differentiation remain largely unknown. Using embryonic lung development as a model, we deleted exon 3 of beta-catenin via Nkx2.1-cre in the Catnb[+/lox(ex3)] mice and studied its impact on epithelial morphogenesis. Robust selective accumulation of truncated, stabilized beta-catenin was found in Nkx2.1-cre;Catnb[+/lox(ex3)] lungs that were associated with the formation of polyp-like structures in the trachea and main-stem bronchi. Characterization of polyps suggests that accumulated beta-catenin impacts epithelial morphogenesis in at least two ways. "Intracellular" accumulation of beta-catenin blocked differentiation of spatially-appropriate airway epithelial cell types, Clara cells, ciliated cells and basal cells, and activated UCHL1, a marker for pulmonary neuroendocrine cells. There was also evidence for a "paracrine" impact of beta-catenin accumulation, potentially mediated via activation of Bmp4 that inhibited Clara and ciliated, but not basal cell differentiation. Thus, excess beta-catenin can alter cell fate determination by both direct and paracrine mechanisms.