Established in 1948 by the Declaration of the Establishment of the State of Israel, the Israeli multi-level governance systems is unitary, based on two levels of governments, the central level and the local level. The recognition of local governments is enshrined in different basic laws as Israel has no formal written constitution but thirteen “Basic Laws”. Local governments are governed by British colonial Municipal Ordinances of 1934 and 1941 that are still in place.

No major or comprehensive decentralisation reform or devolution of powers has officially taken place since. The central government retains most of the powers and strict oversight of local government activities and finances. Bylaws and ordinances adopted by councils, as well as their budgets, are subject to approval by the Ministry of the Interior. Looking at fiscal indicators in an international comparative way, Israel belongs to the group of OECD centralised countries, together with countries such as Chile, Hungary, Portugal, New Zealand or Ireland, where local governments have a limited role in terms of spending responsibilities (OECD, 2018[1]). In 2016, Israeli local governments accounted for 14.0% of public expenditure and 5.5% of GDP (vs 28.7% of public expenditure and 9.2% of GDP in OECD unitary countries on average), 15% of public staff expenditure (vs 43%), 9% of public tax revenue (vs 20%) and 3% of public debt (vs 12%).

Some de-facto decentralisation of political power however occurred in Israel since the 1970s , starting with the direct election of mayors and chairpersons by universal suffrage. This change was ushered in following the 1975 Law on Direct Elections Local Authorities, which went into effect in 1978. Since then, the country has aimed to improve public administration and enhance accountability, transparency and financial responsibility of local governments. The central government has also gradually withdrawn from delivering and overseeing local services. Some additional responsibilities have been transferred to local governments, for example, in the area of planning and building in 2014.

Today, local governments play an important role in providing primary and secondary education and social services. These are both delegated national services operated through local governments. Local governments also have compulsory responsibilities in several areas and they can also carry out voluntary tasks.

On the revenue side, local governments derive their income from two main sources: taxation and intergovernmental transfers in the form of grants and subsidies. Compared to OECD average, the share of taxation in local government revenues is high for a country having a centralised system of governance. Tax revenues accounted for 44% of local government revenues in 2016 (OECD, 2018[1]), which is above the average of OECD unitary countries (38.7%). However, tax revenues amounted to only 2.5% of GDP in 2016 (vs 4.7% in OECD unitary countries on average) and 9.5% of public tax revenues (vs 19.8%). In addition, while tax revenues include both shared and own-source taxes in most OECD countries, in Israel, all local taxes are own-source. Moreover, another characteristic of Israel is the high concentration of local tax on one tax, the property tax (Arnona), raised both on residential and non-residential land and buildings. In the OECD, only Australia, the United Kingdom, Ireland and New Zealand – all countries having strong Anglo-Saxon traditions - are in the same situation, where the property tax is the main, if not the only, local tax. Finally, Israel also stands out from other OECD countries concerning the method of calculating the value of the property tax bases. Israel is among the few OECD countries that still use area-based assessment (e.g. Czech Republic, Poland, Slovak republic) while the vast majority of OECD countries now take into consideration the property value (rental or market value) as shown in Annex1.

In this context, any project to reform the Arnona is both sensitive and challenging. Reforming the Arnona may have a strong impact not only on the local taxation system but beyond, on the whole municipal finance system, as Arnona is a crucial source of total local income.

This is one of the reasons why the system has not evolved much since the creation of the modern Arnona in 1948. There have been however some discussions and proposals for reform. In 1981, a National Committee for Local Authorities Affairs, set up by the Knesset and the ministry of finance, proposed to create a business tax, replacing the non-residential Arnona, and which would be based on a local value-added tax - VAT (Zanbar report). In 1995, an Inquiry Committee on the Structure of the Arnona established by Tel Aviv City Council also proposed to create a local VAT to replace the Arnona raised on businesses (Daran, 1999[2]). Finally, in 2007, the “Barzilai Commission”, appointed by the Ministry of Interior in 2007, confirmed the need for structural changes. The unpublished report contains two alternative proposals (replace the Arnona by a share of the VAT; or, move towards a calculation method based on property value) but none of these proposals were implemented.

In the meantime, several measures have been adopted over the years which, actually resulted in “hardening” the Arnona system while reducing municipal taxing power over the tax. First, while until 1960 the Arnona was based on the rental value of the property, this was changed in 1960 to take into consideration the number of rooms (residential area) and the area (non-residential area). Ten years later, the system changed again, and since 1970 Arnona rates are based on the measured surface area of all properties. Second, through the mid-1980s, local councils had the authority to set their own Arnona rates. However all Arnona rates have been frozen in 1985 by the Knesset that enacted the Economic Stabilization Law (5745-1985). Current rates are still those of 1985, with two exceptions: changes in rates must be requested by a municipality and authorised by the Ministers of Finance and Interior; and, since 1998, inflation is taken into account into Arnona rates.

This situation has created or exacerbated several deficiencies of the property tax system. It has increased fiscal disparities among municipalities and has several negative consequences on the capacity of municipalities to provide adequate and equitable access to economic and social infrastructure and services across the country as well on local economic development.

There are two main deficiencies to the current Arnona system. The first one is the assessment and valuation method based on area and not on value. This area-based system introduces distortions between different types of business and among households, resulting in inequities both across households and between areas. Efforts to reduce these inequities have resulted in a local tax system that lacks transparency and is highly complex.

The second major deficiency is the significant unbalance in the level of tax rates between the Arnona on residential and non-residential Arnona. High rates of the business Arnona generally provide significant tax revenue while businesses do not consume lot of municipal services. By contrast, low rates of the residential Arnona provide low returns while inhabitants, who need more local public services, are more costly for the municipal budget. The marginal inhabitant is deficit-creating for the municipality. For many municipalities, receipts from the residential tax are insufficient to cover the costs of local public services provisions (education and welfare), to finance and maintain the adequate infrastructure required by residents as well as to develop new housing programmes (OECD, 2018[3]; OECD, 2017[4]). This adds to the severe housing shortage that they face.

This represents a big challenge in municipalities that do not have companies on their territory able to compensate for this low level of residential tax receipts, or which are not enough attractive for businesses.

In addition to being regressive and increasing fiscal disparities between poor and richer municipalities, this situation has also some other adverse effects. For example, municipalities tend to build business areas to attract more business taxpayers, instead of providing access to basic services and developing housing and other infrastructures for citizens. It results in the multiplication of business areas and in a lack of housing supply, whose costs increase substantially.

Some reforms have already been taken by the Israeli government to improve the situation, in particular reduce fiscal disparities between municipalities. For example, in 2017 the government created an equalisation fund, the Arnona fund, to redistribute resources across municipalities more equally. In local Arab municipalities in which this issue is particularly sensitive, a special five-year plan, including special budgetary allocations in many sectors, also aims at reducing disparities among municipalities (OECD, 2018[3]).

Nevertheless, these reforms remain insufficient to reduce distortions and it seems necessary to go further by reviewing the Arnona system it-self and not only compensating the negative effects of the system by punctual measures. The time for more substantial reform seems to come, both to reduce adverse effects but also to help municipalities carry out more effectively their tasks.

In this perspective, the Ministry of Finance of Israel has requested the support of the OECD to provide an in-depth diagnosis of the situation of Arnona’ system in an international comparative perspective, and develop recommendations to improve the efficiency and equity of the system. To carry out the work, the OECD has conducted a mission in Israel in February 2019 with two international experts on subnational public finance and taxation to meet key stakeholders. Deskwork, data analysis and review of international practices have also been carried out to produce the following synthesis report. The report includes three main chapters: the first chapter provides a review of the system of local government finance in Israel, with a focus on the Arnona. The second chapter presents a diagnosis of the major problems with the Arnona and, beyond the financing of local governments in Israel. Chapter 3 suggests a set of 13 policy recommendations.

On the whole, the recommendations are motivated by a desire to improve local government finance in Israel along a number of important dimensions:

  • Increasing economic efficiency by reducing distortions created by the Arnona system,

  • Increasing the horizontal and vertical equity of the Arnona both within and among local governments,

  • Simplifying and increasing the transparency of the system of local government finance

  • Enhancing the effectiveness of the public services provided by local governments

  • Providing local governments with increased autonomy over their fiscal affairs while also making progress on national goals of improving education, reducing poverty, increasing social welfare, and enhancing environmental quality throughout Israel.

The 13 OECD policy recommendations that follow are divided into two distinct sections. The first eight policy recommendations are designed to improve the existing Arnona system. Priority is given to changes in the Arnona system that are actionable and could be adopted and implemented relatively quickly. Once they are implemented, they should begin to produce results in terms of the criteria of an effective system of local public finance.

The final five policy recommendations represent a blueprint for reforming more substantially the system of local government finance in Israel. The centre piece of this reform is the establishment of a value-based system of local property taxation applied to both residential and non-residential property.

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