A Review of Local Government Finance in Israel

Reforming the Arnona System

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.

How these services are funded is critical to ensuring that all Israelis have efficient and equitable access to public services.

As part of OECD’s Multi-level Governance Studies series, a recent report (2021) provides a comprehensive analysis of the Israeli system of local government finance, with a focus on the role of the Israeli property tax, known as the Arnona. The Arnona is levied on residential and non-residential land and buildings but is based on the physical size of properties (in square meters) rather than on their value (as is the case in most other countries).

The report is publicly available online and is divided into three chapters. The first chapter of the report provides a description of the Israeli system of local government finance. The second chapter assesses the strengths and shortcomings of the Arnona and Israel’s intergovernmental grant system. The report’s final chapter presents a set of policy recommendations, including proposals for improving the existing Arnona system as well as suggestions for a longer-run blueprint for a more substantial reform of the system of local government finance in Israel based on the establishment of a value-based system of local property taxation.

Local government finance in Israel: an overview

The revenue that local governments use to finance their regular budgets comes primarily from revenue raised directly by local governments (referred to as own-revenue, or in Israel as self-revenue) and revenue from the central government, primarily in the form of grants. In 2017, the regular budgets of local governments totaled 64.5 billion Israeli Shekels (roughly US$ 17 billion, or around US$ 1800 per capita). The largest share of this amount (59.3%) came from own-revenue.

The main source of own-source revenue in Israel is the Arnona –the Israeli property tax. The Arnona accounts for a higher share of local tax revenue (around 81%) and total local government revenue than in all other OECD countries except for Australia and New Zealand.

Grants contributed 39.7% to local government expenditures, while loans account for the remaining 1%. Over three-quarters of total government grants directly finance public education and welfare. Whereas government grants have been successful in reducing some of the fiscal disparities that exist among local governments, there remain substantial differences across local government in their capacity to provide the public services for which they are responsible. Moreover, the analysis is likely to understate the true magnitude of fiscal disparities among local governments because it focuses only on resource differences and not on differences in the expenditure needs and the costs of delivering public services in different communities.

Property taxation in Israel: the Arnona

As already noted, 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. 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 of the analysis

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 favor 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.

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 requirements attached to education and social services grants should be reconsidered.

Improve the Arnona by (1) standardizing 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 modernization 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.

Read the entire report on the website of the OECD: https://doi.org/10.1787/812dbf77-en.