Land Value Capture and Conflicting Public Goals

Land Value Capture (LVC) is often praised for funding public purposes in an era when traditional taxation faces political resistance. LVC tools are viewed as compromise solutions that help governments pursue public goals without direct taxation by leveraging market forces and private land ownership to deliver financing or in-kind supply for public services. However, the political economy of LVC can create unexpected tensions: What happens when government reliance on LVC conflicts with willingness to adopt new public-interest objectives? This paper examines such a conflict in Israel's housing policy, specifically regarding the legalization of Accessory Dwelling Units (ADUs) - small rental units within existing homes that offer market-based affordable housing. While ADU legalization in the United States has progressed as states and local governments revise zoning regulations, Israel presents a unique legal context, involving LVC. Israeli local governments are authorized to collect a substantial LVC levy - 50% of the value increment from new development rights. Prior to a recent legislative amendment, establishing an ADU legally required both a building permit and payment of this betterment levy. Given high housing prices and the significant levy amount, combined with lengthy permitting procedures, most existing ADUs were created illegally, through internal modifications that could be hidden from external view. The betterment levy was hardly ever collected. In 2017, responding to severe rental housing shortages, the national planning and building law was amended to encourage ADU creation. The new rules specified minimum requirements: 45 square meters, separate entrance, kitchen, and bathroom. As a supposed compromise between collecting revenue and encouraging ADU development, the legislation reduced the betterment levy to 34% for ADU permits. Our analysis of pre-parliamentary committee protocols and interviews with decision-makers revealed critical oversights. The legislation ignored the existence of potentially hundreds of thousands of illegal ADUs across Israel (with a population of less than 9 million). No amnesty was considered for existing units, likely because it would forego all levy revenue. Meanwhile, enforcement against illegal units faces both administrative and political barriers - authorities cannot feasibly undertake the costly process of fining or evicting thousands of households without providing alternative housing. The political repercussions are predictable. Most notably, policymakers failed to test whether the reduced 34% levy would actually incentivize compliance. Our scenario analysis examined construction costs and income flows for both existing and new ADUs, with and without the levy. For existing units, we included costs of adjusting to new specifications. The findings demonstrate that in most cases, even the reduced levy makes units financially unattractive. For existing units, meeting new specifications plus paying the levy would likely force many off the market, thus thwarting the very purpose of the legislation. This Israeli "natural experiment" illustrates what happens when a high-consensus public policy goal clashes with established LVC mechanisms. Path dependency – and income dependency - can complicate traditional government decision-making and budget priorities in ways not yet fully addressed by theoretical and empirical research.