Inclusionary zoning works in theory, but not in practice

Parcel-level calibration is not realistic

When zoning is a constraint on housing supply, upzoning can create a windfall gain for landowners by giving them valuable development rights. In theory, local governments can capture this surplus land value by requiring the landowner to provide subsidized housing. This is the idea behind inclusionary zoning (IZ) with density bonuses: we fund subsidized housing by allowing developers to build extra density. Essentially, the government is taxing the surplus land value created by upzoning.

But there’s a fine balance to be struck: the amount of the tax must be less than the amount of the surplus land value, i.e., the cost of the subsidized units must be small enough that project still pencils. If not, the tax falls on new housing, reducing supply and raising prices. Specifically, if the tax causes the developer’s willingness-to-pay for land to fall below the landowner’s reservation price, then the project fails and IZ reduces housing supply.

So IZ only works if the subsidized housing requirement is carefully calibrated on each parcel. But upzoning will increase land values differently across a city; a vacant parcel (cheap to redevelop) gains much more from upzoning than a parcel with a newly built house (expensive to redevelop). The IZ tax needs to be fine-tuned on a parcel-by-parcel basis to match this spatial variation. Similarly, since market conditions change over time, the IZ tax needs to be updated frequently to maintain calibration. Subsidized housing requirements need to be decreased when the surplus land value shrinks; waiting for higher rents to make a project pencil means reducing supply today.

Can governments maintain parcel-level calibration on a quarterly basis? No, in practice they impose a blanket IZ policy. But an area-wide IZ tax can easily fail the cost-benefit test: even if land value is captured from some developments, we have to weigh it against the cost of reduced housing supply elsewhere. And we shouldn’t be taking risks with net-negative policies. So unless governments become omniscient central planners, IZ will remain a nice idea in theory that doesn’t work in practice.

Our time would be better spent implementing a land value tax, which automatically captures surplus land value. It also applies to landowners who don’t redevelop; there is no loophole for landowners to keep land value for themselves by maintaining the low-density status quo. Most importantly, because it applies unconditionally, a land value tax doesn’t reduce housing supply; it actually promotes new supply, by incentivizing landowners to make the best use of their land.

Read more about IZ in my deep dive.