A Review of Local Government Finance in Israel

Executive summary

Israel’s local governments play an important role in the provision of public services. The central government has delegated to local governments the responsibility for providing elementary and secondary education and social welfare. In addition local governments provide a range of other services including sanitation, water and sewer, parks and recreation, and road maintenance.

Local governments are financed through a combination of revenue, primarily from the Arnona (the Israeli property tax) and grants from the central government. Over three-quarters of total government grants directly finance public education and welfare.

The Arnona accounts for a higher share of local tax revenue (around 81% compared to the OECD average of above 41%) and total local government revenue than in all other OECD countries except for Australia and New Zealand.

Unlike most countries that use property taxes, the Arnona is calculated on the basis of the size of property (in square meters) rather than its value, and levied on the users of both residential and non-residential property. Thus, local governments have very limited discretion over their Arnona rates and annual rate increases in rates are tied to inflation. Rates are generally higher for non-residential than residential property and vary substantially by type of non-residential property. Discounts are available for certain groups of households, such as low-income families, the elderly, or students that may have difficulty in paying their Arnona charges.

Key findings

• Although data are limited, it appears that the Arnona is a regressive tax and that Arnona payments differ substantially among households in similar economic conditions. As the size (area) of housing units is not closely related to household income, many households with low and moderate revenues face high Arnona payments. Moreover, identically sized housing units in any given area may vary greatly in value, while all face identical Arnona liabilities. This different treatment of taxpayers may generate public opposition to the tax, especially if the Arnona becomes a more transparent tax.

• The Arnona creates an incentive for local governments to discourage new housing development in favour of, in some cases, excessive non-residential development. The costs of providing public services to new residents often exceed the Arnona revenue, associated with these new residents. In contrast, non-residential development tends to create fiscal surpluses. As a result, many local governments may underinvest in new housing, while focusing on non-residential development even under the risks of an oversupply and not economic viability.

• Disparities in Arnona revenue generation across local governments play a prominent role in the disparities in the provision of local public services, especially education and social services. Arnona revenue per student is lowest for local governments with high shares of citizens with low socio-economic clusters. This pattern contributes to lower per pupil spending and poorer educational performance in those clusters. While social welfare needs are generally higher in communities with low socio-economic status, available resources from the Arnona and government grants are often not sufficient to meet these needs.

• Although government grants have reduced fiscal disparities among local governments, substantial differences remain in local governments’ capacity to provide the public services for which they are responsible. The allocation of government transfers, especially Balance Grants, to local governments reduces the disparities in local governments’ ability to finance public services. Nonetheless, significant disparities remain. They are due in part to the low magnitude of the transfers and deficiencies in the Balance Grant allocation formula.

Key recommendations

This report contains 13 policy recommendations. The first eight are designed to improve the existing Arnona system, while the last five provide a blueprint for a more fundamental reform of the system of local government finance in Israel.

Policy recommendations for improving the Arnona system

• Reduce the large disparity between non-residential and residential Arnona rates by reducing non-residential rates. The government should reduce the ratio of non-residential rates to residential rates by mandating reductions in non-residential Arnona rates. As the reduction of Arnona rates will reduce the tax revenue available to local governments, this move would be only feasible if combined with other policies replacing the lost Arnona revenue.

• To help replacing Arnona revenue, local governments could develop alternative sources of revenue. Local governments should consider raising own-revenues through tourist taxes, parking taxes, taxes on ride-sharing services, and license taxes on various local activities.

• Reform the central government fiscal transfers in support of the major delegated functions - education and social welfare. Matching requirement attached to education and social services grants should be reconsidered.

• Improve the Arnona by (1) standardising the classification of types of property across the country; (2) establishing a uniform national system for measuring taxable area; (3) addressing the problems created by the current system of Arnona exemptions and discounts; (4) allowing a limited degree of rate setting by local governments; and (5) assisting local governments in increasing their Arnona collection rates through the provision of training, technical assistance, and capital grants for the modernisation of local governments’ computer systems. These policies should already improve the effectiveness, fairness, and efficiency of the Arnona system prior to the undertaking of more substantial reforms.

Policy recommendations for a deeper reform of the Arnona system

• Establish a value-based system of property taxation for all non-residential property. Both fairness and economic efficiency will be enhanced by converting the non-residential Arnona into a tax based on the market value of property. The transition to a value-based system will be relatively straightforward, in part because much of the data needed to calculate market values are already available in the form of information that businesses must use to comply with existing taxes.

• Establish a value-based system of residential property taxation. The transition to a value-based property tax system will increase the vertical and horizontal equity of the Arnona. Recently developed methods for property assessment combined with new technologies will greatly reduce the costs involved in determining the value of residential property. Lessons gained from establishing a value-based non-residential Arnona will facilitate the establishment of a reformed residential Arnona.