1. The Israeli system of local government finance
Chapter 1 describes the structure, role and functions of local governments in Israel. It highlights their expenditure responsibilities and the structure of revenues used to finance both their regular and capital budgets. It provides comparisons with other OECD countries concerning in particular the importance of taxation as a revenue source, and the role played by property taxes. The chapter then focuses on the Israeli property tax (Arnona), describing how it functions and illustrating the large revenue disparities it generates across municipalities. The final section of the chapter describes the Israeli system of grants to local governments, focusing particularly on education and social welfare grants, the balancing grant, and the Equalisation Fund grant.
Israel is a unitary parliamentary democracy established in 1948 by the Declaration of the Establishment of the State of Israel. Israel has no formal written constitution but thirteen “Basic Laws” (and a temporary one) that were passed in 1957 to set up a legal framework. Israel has two levels of governments, the central level and the local level. Local governments are governed by British colonial Municipal Ordinances of 1934 and 1941 that are still in place.
Although having only one level of local government, this level is quite diverse. It is composed of different categories of local councils mostly based on demographic size. In addition, local governments are further classified according to their population characteristics, socio-economic characteristics (clusters defined by the Central Bureau of Statistics) and fiscal wealth and budgetary performance characteristics. These classifications may have some impacts on public policies applied to municipalities according to their category, resulting in some kind of asymmetric decentralisation.
The role that local governments play in the provision of public services in Israel is somewhat ambiguous, as it will be described below. Overall, compared to other OECD countries, Israeli local governments have little spending responsibilities. In addition, these have been declining as a share of GDP between 2004 and 2011, stabilised between 2012 and 2015 and increased since, still at a lower level than in 2004.. Local expenditure is funded quite equally by tax revenue and grants and subsidies from the central government, which is quite uncommon in a centralised country, where in general local governments tend to rely more on grants and subsidies from the central government. Also quite uncommon, except in countries having strong Anglo-Saxon traditions, the property tax (Arnona) is the main component of local tax revenue, although there are large differences in the ability of local governments to raise revenue from their own source. The Arnona has also several unique qualities that make it quite different from property taxes typically used by local governments throughout the world. By contrast, the system of grants and subsidies is mainly based on block and matching grants for education and social welfare while equalisation grants (general balancing grants and new equalisation fund) remain limited.
Israel is a unitary country. It is one of 10 OECD countries with only one level of subnational government. All other OECD countries have two or three levels, such as states, regions, counties, and municipalities. Its 257 local governments can be divided in four categories:
77 municipal councils (cities). These are urban jurisdictions with at least 20 000 inhabitants. 76% of the country’s population (6.3 million residents) reside in municipal councils.
124 local councils. These jurisdictions have fewer than 20 000 inhabitants. 15% of the country’s population (1.2 million residents) reside in local councils.
54 regional councils. Regional councils are responsible for governing a number of settlements spread across rural areas (mainly kibbutzim and moshavim). About 10% of Israel’s population (750 000 residents) are governed by regional councils.
2 industrial local councils. These councils are composed entirely of industrials zones and thus have no residents.
Most local governments in Israel can be characterised as mostly inhabiting Jewish or mostly Arab population. In 2016, 163 local governments were predominantly Jewish and 85 were predominantly Arab. The remaining 7 local governments were either mixed or in a few cases, mainly Druze or Christian (CBS, 2019[1]).1
In 2017, the population of local councils ranged from 1 200 residents in the smallest council to 901 300 in the largest council (Jerusalem). Table 1.1 displays the distribution of local governments by population size. The median sized local government has a population of 14 400 and half of Israel’s local governments have populations between 10 000 and 50 000. As shown in Figure 1.1, based on 2016 data, the average Israeli local council had a population of 33 514, a figure that is 3.5 times higher than average local government population size in OECD countries.
Nine local councils in Israel (3.5% of the total) are very small, with populations of less than 2 000. In the majority of the 35 OECD member countries, the share of local governments with fewer than 2 000 residents is substantially higher. In 11 countries more than 50% of local governments have populations below 2 000 and in four countries over three-quarters of local governments are very small, with populations under 2 000 (OECD, 2018[2]).
Several attempts have been made to reduce the number of local councils through mergers. In 2003, 23 local councils were consolidated into 11. As can be seen in Figure 1.1, in subsequent years some of these unions were annulled. Since 2012, the number of local governments has remained unchanged at 255. Consequently, as Israel’s population grows, the average number of residents per local government has grown. In 2017, the average size local council had a population of 34 243, an increase of nearly 40% since 2001. Figure 1.2 illustrates the wide range in average and median size of municipal governments in OECD countries. In 2016, average municipal size in OECD countries ranged from 1 688 in the Czech Republic to 223 782 in Korea (OECD, 2018[3]; n.d.[4]).
Source: OECD calculations using Central Bureau of Statistics local government data, 2017 (https://www.cbs.gov.il/en).
Sources: OECD elaboration based on OECD (2018[3]), Subnational Governments in OECD Countries: Key Data, http://www.oecd.org/regional/Subnational-governments-in-OECD-Countries-Key-Data-2018.pdf (accessed on 16 May 2019)
In recent years, attempts have been made to establish voluntary associations of neighbouring local governments, called “clusters.”2 Initially these were created through a “bottom-up” process, e.g. the Western Galilee Cluster in 2009. A pilot program to establish Voluntary Regional Clusters was created in 2012 under the initiative of the Ministry of Interior, the Ministry of Finance and several civil society organisations. Subsequent legislation passed by the Knesset formalized the legal status of clusters. At present (2019), 11 regional clusters have been established.
The existing clusters are mainly located in Northern and Southern Israel. About 12% of the Israeli population and 120 local governments are members of these regional clusters. Clusters operate in very different ways. Some clusters are run by an Assembly composed of representatives from the local councils. They rely on voluntary contributions from member local governments to finance specific projects of common interest. This type of cluster thus requires a double agreement from each local government. First, an agreement to join the cluster and then a separate agreement to participate in each project. The Western Galilee Cluster provides an alternative model for the operation of clusters. That cluster is made up of 18 (rather small) local councils with a total of 200 000 residents living in 115 different communities spread over 2 000 square kilometres. The cluster itself has been given responsibility for specific services including environmental protection, waste removal, and veterinary services. The cluster also provides specialized education programs, which supplement the education programs provided by municipal governments.
The Israeli clusters are quite similar to the French inter-municipal syndicates with multi-purpose (Syndicats intercommunaux à vocation multiple). Box 1.1 provides a brief history of French efforts to encourage cooperation in public service provision among neighbouring local governments. The French experience highlights both the benefits and the difficulties in establishing cooperation among local governments.
Local government is highly fragmented in France, with 36 000 communes with an average population size of only 1,900 inhabitants. Since the mid-nineteenth century there have been numerous attempts to merge small municipalities. All these attempts failed. Unable to take advantage of economies of scale in the provision of local public services, municipalities began creating inter-municipal associations, called syndicates which can be single or multi-purpose). These syndicates functioned on a pure voluntary basis. Municipalities made a voluntary decision to join the syndicate and a voluntary fiscal contribution to the expenses of the syndicate). But an increasing number of these municipalities chose to go further and decided to share a tax base in order to secure and to enlarge their cooperation. After several attempts, a new decisive step was taken in 1999. New types of inter-municipal bodies were created under the form of inter-municipal cooperation public bodies (Etablissements publics de cooperation intercommunale or EPCI) in rural (communautés de communes) and urban areas (communautés d’agglomération). Later on, other bodies called métropoles were introduced. They were all based on a common framework. The municipalities that chose to join an inter-municipal body sent representatives to the inter-municipal assembly. The fiscal responsibilities of the municipalities and the inter-municipal body are distributed between the two tiers (although sometimes both tiers retain responsibility for a public service). The power to tax local business (using the local business tax - taxe professionnelle -, which had generated more than 50% of local government tax revenues) was transferred to the new inter-municipal bodies named EPCI à fiscalité propre (inter-municipal cooperation structures with own-source taxes). The tax revenues newly available to inter-municipal bodied was used for three purposes. First, it financed a fiscal transfer to the municipalities in lieu of the foregone tax revenues; second, it financed the provision of inter-municipal public services, and third, it funded an inter-municipal fiscal equalisation fund. In order to incentivise local governments to join theses new inter-municipal cooperation structures, the municipalities received a fiscal bonus from the central government. As these bonuses were financed out the (close-ended) overall amount of transfers from the central government to local governments, they were quite successful. In only a few years, almost all French municipalities choose to enter these new inter-municipal bodies. As of January 2019, there were 1 258 inter-municipal bodies with own-source tax including all French municipalities. In addition, nearly 1 900 municipalities decide to merge into 567 “new municipalities” as of January 2018 (communes nouvelles). This arrangement of “new municipality” allows the abolished municipalities in a merger process to remain and retain some specificities such as a delegate mayor, a town hall (annex), an advisory council, which function as deconcentrated localities.
On the whole, positive lessons can be drawn from the French experience. A decisive step has been made towards more integrated local governments in France. A large part of local governments’ responsibilities are now provided at the inter-municipal level. The residents have access to a larger range of local public services than in the past. The coordination of local public decisions is made easier.
But there are also less positive lessons. As in most cases municipalities have not disappeared, the number of local governmental bodies has increased. The local democratic process still relies on the direct voting of residents at the municipal level and the democratic legitimacy of the inter-municipal bodies is less clear. The integration of municipalities in fully democratic supra-municipal bodies has yet to be achieved, and it is not on the political agenda at present.
Moreover, the responsibilities of municipalities and inter-municipal bodies are partially overlapping, increasing the overall cost of the provision of local public services. The inability or unwillingness to fully exploit economies of scale has thus lead to higher the local taxes
Thanks to these recent reforms, France is now moving towards a reduction in the number of municipalities and a complete integration of municipalities into two-tier inter-municipal bodies. However, additional steps need to be taken to reinforce local democracy and improve economic efficiency in the provision of local public services.
Sources: Gilbert, G. (2012[5]), “Beyond inter-municipal partnerships towards two-tiers municipalities: The case of finance”, IEB’s World Report on Fiscal Federalism 09, pp. 26-35; OECD (2017[6]), Multi-level Governance Reforms: Overview of OECD Country Experiences, https://doi.org/10.1787/9789264272866-en; OECD/UCLG (2019[7]), 2019 Report of the World Observatory on Subnational Government Finance and Investment, Country Profiles, http://www.sng-wofi.org.
Expenditure responsibilities of the local government sector in Israel
The role that local governments play in the provision of public services in Israel is somewhat ambiguous. Israel has no written constitution, and hence local governments have no formal or permanent status in the Israeli fiscal system. Compared with many OECD countries, local governments in Israel have very limit power and control over both their expenditures and revenues. Over the years, the Knesset has enacted legislation that assigned responsibility for the provision of some services to local councils. The largest share of local government spending, however, is associated with functions, namely education and welfare, that the central government has delegated to local councils. Subject to resource constraints, local councils can supplement spending on these functions beyond the level that is directly financed by the central government. In addition to these shared functions, local governments have some discretion to finance public services and public investment beyond those that are delegated or mandated by statute. The central government sometimes refers to these public services as “voluntary.” Table 1.2 provides an overview of the major functions carried out by local governments in Israel. The expenditure functions are divided into those mandated by statute, those that are delegated functions, and those that are discretionary.
Local government budgets are expected, first and foremost, to provide for public services in the areas of their statutory responsibilities and for the budgeting of matching funds for the provision of dedicated national services. If some budget remains, the local council is allowed to spend it on discretionary services and/or on “toping up” expenditures on delegated public services, primarily education and social services.
Although the central government plays an important role in financing local government services in many OECD countries, the ability of the central government to tightly control local governments’ activities and actions is much more extensive in Israel than in many other unitary countries. The powers of the Minister of the Interior over local governments are extensive. The Minister has the authority to approve budgets, to approve or deny changes in local property tax rates, the power, under certain circumstances, to terminate local elected official, and approve bi-laws passed by local councils (Wittes, 2018[8]).
Although the central government places significant constraints on local government behaviour, local governments play an important role in providing public services in Israel. As seen in Table 1.2, local governments are responsible for delivering to local residents a wide range of public services. The current operating expenditures of local governments are found in their regular budgets, while spending on capital infrastructure is found in local governments’ so-called irregular budgets. The pie chart in Figure 1.3 illustrates how the regular budget of local governments was allocated among various expenditure functions in 2017.
Over one-half of total spending is devoted to spending on public services delegated to local governments by the central government. A little over a third of spending is for education. The rest of the local budget is divided among government administration and the provision of the services listed in Table 1.2. Figure 1.4 allows for the comparison of the mix of spending by function in Israel with the mix of spending by subnational governments in most of the OECD countries. The data show that local governments in Israel devote a much higher proportion of their total spending to education than most OECD countries. The share of spending on recreation, culture, and religion is also considerable above the OECD average. Figure 1.4 also makes clear that while most subnational governments spend considerable amounts on health and on public order (especially on police and fire protection), local governments in Israel spend almost nothing on those functions, because they remain the direct responsibility of the central government.
Source: OECD calculations based on CBS data (https://www.cbs.gov.il/en).
* Denotes non-unitary countries.
Note: Data unavailable for Canada, Chile, and Mexico.
Sources: OECD elaboration based on OECD (2018[3]), Subnational Governments in OECD Countries: Key Data, http://www.oecd.org/regional/Subnational-governments-in-OECD-Countries-Key-Data-2018.pdf (accessed on 16 May 2019).
The economic size of the local government sector in Israel
Figure 1.5 focuses on OECD countries with unitary governments, and shows that local governments’ share of total government spending range from 7% in Greece to 65% in Denmark. The local government share is 14% in Israel, somewhat below the average among all unitary governments (28.7%). Figure 1.5 also displays local government spending relative to GDP in OECD countries with unitary governments. It is not surprising that local government spending in Israel is only 5.5% of GDP, near the low end among unitary countries and well below the OECD average for unitary countries.
Note: 2015 data for New Zealand and Turkey.
Sources: OECD elaboration based on OECD (2018[3]), Subnational Governments in OECD Countries: Key Data, http://www.oecd.org/regional/Subnational-governments-in-OECD-Countries-Key-Data-2018.pdf (accessed on 16 May 2019).
Reductions over time in local governments’ operating budgets as a percentage of GDP
In 2005 the regular budgets of Israel’s local governments totalled 5.5% of GDP. After a slight uptick in 2006, the aggregate size of local governments operating budgets declined steadily relative to GDP until they reached a level of 4.9% of GDP in 2012. As illustrated in Figure 1.6, between 2012 and 2016 local government budgets grew proportionally to the country’s GDP. In 2017, regular budgets of local governments increased to nearly 5.1% of GDP.
Despite this recent increase, the total of the regular budgets of local governments remained (in 2017) 0.4% below their level in 2004. This difference is significant. If in 2017, the regular budgets of local government had been equal to 5.5% of 2017 GDP, they would have been 69.9 billion NIS, or 8.4%, higher than they actually were. In per capita terms, if the operating budgets of local governments 2017 were the same proportion of GDP that they had been in 2004, per capita spending in 2017 would have been 618 NIS higher than it actual was.
Source: OECD calculations using CBS local government data (https://www.cbs.gov.il/en).
Box 1.2 explains why the government went through a period in which it constrained sharply the growth in government spending at both the national and local government levels. The box also outlines the actions taken to constrain the budget growth of local governments.
Since 2014, local governments have been classified according to several budgetary performance criteria related to fiscal stability. “Stable” local governments that fulfil standards have been granted more independence from central authorities, and are exempted from obtaining approval with respect to wages, hiring, bank loans, enactment of municipal by-laws and other regular operations. As of 2018, 24 councils met these criteria. Conversely, authorities that fail to meet the standards are put under administration (the “fiscal rehabilitation” programme) and are run by a state accountant. Despite substantial improvements in the budgetary discipline of councils since 2004, there are still many councils under the central government’s rehabilitation programme.
The contraction of the government’s share of GDP over the past 20 years was accompanied by major reductions in country’s budget deficit and a substantial lowering of the public debt-to-GDP ratio. While, two decades ago, debt amounted to 90% of GDP, today’s ratio is 60%. This lower-debt-to GDP ratio was a result of a policy of fiscal discipline that has characterized the state budget in recent years. The government imposed strict spending rules at the end of the last decade in order to reduce government spending, and it lowered the deficit ceiling. As a result the deficit fell from the 3% to 6% range (as a percentage of GDP) during most of the relevant period to 2% to 3% of GDP in the last few year (OECD, 2018[2]; Bental and Brand, 2018[9]).
The policies undertaken to reduce the deficit in 2004 included specific measures related to local governments. The central government intervened in local government fiscal affairs in three ways:
1. by appointing an accountant that had to approve each expenditure and provide reports directly to the Ministry of Finance
2. by imposing a recovery plan specifically tailored for each local government. These plans included a balanced budget constraint that was imposed for a specified number of years. The recovery plans included details on the type of expenditures to be cut, the workers to be fired, and the required increase in tax collection rates
3. by, in some cases, dismissing mayors and council members and replacing them with an appointed board.
These programs were instituted in more than 50% of the municipalities. The impact on expenditures of these programs is quite clear. Per capita local expenditures decreased significantly, primarily because of cuts in salaries of municipal employees and increases in local government tax collection rates. Ben-Bassat, Dahan, and Klor (Ben-Bassat, Dahan and Klor, 2016[10]) concluded that this program has proved to be an “effective tool to bring about a decrease in the municipalities expenditures without affecting the municipalities ‘provision of local public goods” (p. 72).
Sources: OECD (2018[2]), OECD Economic Surveys: Israel 2018, https://dx.doi.org/10.1787/eco_surveys-isr-2018-en; Bental, B. and G. Brand (2018[9]), “Economic developments in Israel: An overview”, http://taubcenter.org.il/wp-content/files_mf/economicdevelopments2018en.pdf; Ben-Bassat, A., M. Dahan and E. Klor (2016[10]), “Is centralization a solution to the soft budget constraint problem?”, https://doi.org/10.1016/j.ejpoleco.2016.09.005
The financing of local governments’ regular budgets
The regular budgets of local governments in Israel, as in most other countries, are financed from a number of sources, including taxes, user fees and charges, and grants from the central government. Total local government revenue in Israel equalled 5.6% of GDP in 2016. This figure is relatively low compared to the OECD average of unitary countries of 12.3%. This level of local government revenue reflects the fact that Israel’s total government revenue as a percentage of GDP is below the OECD26 average (37.4% compared to 40.7% in 2016) and, as shown in Figure 1.7, local government revenue as a share of total government revenue (15%) is below the OECD average of 31.1%. Israel’s relative position is not surprising. Israel is a unitary government and the central government retains responsibility for a number of functions such as public safety and health care that are local government functions in many other OECD countries. Also, as discussed above, total government revenues as a share of GDP declined during the first decade of the 2000s and the growing importance of public enterprise operations has moved some public functions “off-budget”.
Sources: OECD elaboration based on OECD (2018[3]), Subnational Governments in OECD Countries: Key Data, http://www.oecd.org/regional/Subnational-governments-in-OECD-Countries-Key-Data-2018.pdf (accessed on 16 May 2019).
The revenue of local governments used 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 totalled 64.5 billion ILS. The largest share of this amount (59.3%) came from own-revenue. Grants contributed 39.7% and loans 1%.
Figure 1.8 shows the composition of own-revenues. For the country as a whole, 65% of own-revenues come from the property tax, referred to hereafter as the Arnona, with 56% of total Arnona revenue derived from the tax on non-residential property. Fees and charges associated with education and welfare account for 4% of own-revenue, with the remaining 32% coming from miscellaneous sources.
The distribution of government grants by type are displayed in Figure 1.9. The two largest grants are combinations of block and matching grants from the Ministries of Education and Welfare. These grants finance a large portion of local government spending on education and welfare. 15% of grant revenue comes through the General Balancing Grant. This grant is designed as an equalising grant targeted to local governments with limited amounts of own-revenues. Equalisation Fund grants are a new grant program initiated in 2017. It accounts for a little under 1% of grant revenue. The final 7% of grant revenues are allocated through a number of other grant programs. The grant programs will be described in more detail below.
Source: OECD calculations using CBS local government data (https://www.cbs.gov.il/en).
Source: OECD calculations using CBS local government data (https://www.cbs.gov.il/en).
The financing of local governments’ irregular (capital) budgets
Local governments in Israel maintain separate capital budgets, referred to as irregular budgets. Capital spending accounts for 21.1% of total local government spending, a percentage that is nearly double the OECD average of 10.7% (13.8% in unitary countries). OECD data indicates that 69% of public investment in Israel is carried out by local governments. This very high percentage, however, reflects the fact most central government investment in Israel is done by public companies whose investment is not recorded in official statistics as general government expenditures. As a result, the real extent of central government investment is substantially under-estimated, and consequently, the local government share is over-estimated. This is confirmed by the low level of local government investment in GDP (1.2% as compared to an average of 17% in OECD unitary countries).
In 2017, the irregular budget of all local governments was about NIS 17.7 billion, which is equivalent to 1.4% of GDP. According to local council law, the irregular budget is a “budget of a municipality that is intended for a nonrecurring activity or for a certain areas of activity that includes an estimate of proceeds and payments for that activity or for that area of activity and funds that were intended by law for purposes that are not [funded in the] ordinary budget” (Ministry of Finance, 2019[11]). In effect, the irregular budget is intended to fund capital investment projects, such as the construction and paving of roads, developing municipal parks, and the construction of schools and other public buildings. Irregular budgets are financed by grants from various central government ministries, the proceeds from the sale of local government assets, local taxes and fees authorized by central government legislation and municipal bylaws, transfers from local governments’ regular budget, donations from various institutions, and from the issuance of debt (Figure 1.10).
Source: OECD calculations using CBS local government data (https://www.cbs.gov.il/en).
Central government ministries transfer development budgets to local government where the funds are intended to finance local capital projects, such as the construction of school buildings. In most cases, government grants to the irregular budget of local governments are project grants that are intended for a specific project. Local governments are generally prohibited from using the grant funds for an alternative project.
The most important source of own revenue for capital projects comes from the betterment (or improvement) levy. When property values increase due to changes in zoning and land-use regulation or because additional building rights were granted, a betterment levy equal to half of the appreciated value of property is required of private land owners. No exemptions are permitted. Revenue from the betterment levy must be used solely for local government capital spending. It is complemented by the improvement levy substitute. This substitute is paid by the Israel Lands Authority, which is not required to pay the regular betterment levy. Revenue from the improvement levy substitute accounted for 12% of the proceeds from the betterment levy. Additional own revenue for the irregular budget comes from development levies. Municipal ordinances empower local governments to charge fees to developers. Revenues from the fees must be used to develop infrastructure that supports development, such as paving roads, building sewage lines, channelling and draining water, and developing open public spaces. Land sales constitute another source of financing. A local authority may use proceeds from the sale of properties it owned only for the purpose of buying new properties unless the Minister of the Interior permits other uses for the funds. The sale of the properties is only possible by a resolution passed by the municipal council, and as stated, with the minister’s approval.
If a local council complies with its statutory duties related to its regular budget, it is permitted by law to transfer surplus funds from its regular budget to its irregular budget. Local governments irregular budgets also receive donations from institutions. The Payis (lottery), and some other enterprises allot resources to local councils, which the councils use for building public buildings.3 Development debt is the last category of financial resources for the irregular budgets. Local governments are permitted, with the consent of the Minister of the Interior and the Minister of Finance, to issue debt (borrow) for funding capital projects included in the irregular budget. Note that debt is not a resource as such, but only a mechanism for financing public investments.
As illustrated in Figure 1.10, the transfers from the regular budget to the irregular budget are very limited (3% of total budgetary resources in 2014). This is not surprising if one considers that the regular budgets of a large number of local authorities are in deficit or hardly balanced. In other words, only the strongest local authorities are able to fulfil their “statutory duties funded by their regular budgets”. Consequently, as very few local governments are able to self-finance their capital projects, there is almost no direct link between the Arnona and the financing of local government investment.
There are, however, two indirect links between the Arnona and local public investments. First, investments in local public services generate recurrent operating expenses, which are mainly financed by Arnona revenues. So insufficient Arnona revenues combined with unfunded mandates make it impossible for local authorities to fully respond to their fiscal needs. Box 1.3 provides data from France on the magnitude of recurring (operating) costs associated with public investments. Second, a portion of capital expenditures are financed through debt. As debt service (interests plus capital repayments) is included in regular budgets, it is financed from Arnona revenues, and in some cases, with revenue from the balancing grant.
Some local public investments entail a reduction in operating costs. For example, installing insulation in public buildings reduces heating costs. Other investments generate additional fiscal resources through user fees or tolls. In general, however, local public investments generate net recurrent costs. Some costs are financial (debt repayment for example), while others are recurrent operating costs. New capital investments in equipment and buildings generally require addition employees, additional purchases of goods and services, including utilities, interest payments for debt financing, and additional depreciation expenses for future repairs.
The magnitude of recurrent costs relative to the size of an investment depends on the type of financing (debt finance or self-financing), and on the type of investment. In France investments in infrastructure (such as water networks, roads, rail tracks, bridges, or tunnels) require annual recurrent costs of 3% to 4% of the capital investment. Investments in buildings generally require higher recurrent costs. For example, a kindergarten entails annual recurrent costs equal to 30% to 35% of the investment.
In the period from 1982 through 2012, average recurrent spending in France as a percentage of public investments were highly stable. They averaged 11.2% for operating costs--6% for wages and 5.2% for purchases of goods and services, 4.3% for debt repayment, 3.7% for depreciation, and 0.6% for interest payments (Guengant and Le Meur, 2018[12]).
Source: Guengant, A. and Y. Le Meur (2018[12]), Décrypter les finances publiques locales, 3rd édition, Editions Le Moniteur, Paris.
Local government revenue comparisons with OECD countries
Figure 1.12 allows for the comparison of the distribution of the sources of revenue across OECD countries. The data are for all subnational governments, because sufficiently detailed data are not available for local governments alone. Countries are ranked by the share of total revenue coming from taxes. The share of revenue from all own sources is indicated by the length of each solid bar. The data show that local governments in Israel rely relatively heavily on tax revenues. On the other hand, Israel, relative to most OECD countries, raises a small share of subnational revenue from user fees and charges. As a result, the share of self-revenue in the total revenue of local governments in Israel is about equal to the median share among subnational governments in OECD countries.
Although Figure 1.12 indicates that Israel’s share of tax revenue is about equivalent to the OECD average, it is important to note that the OECD average is influenced by countries, especially federations, which rely heavily on tax revenues raised by state or provincial governments.
* Non-unitary countries (federal or quasi-federal).
Sources: OECD elaboration based on OECD (2018[3]), Subnational Governments in OECD Countries: Key Data, http://www.oecd.org/regional/Subnational-governments-in-OECD-Countries-Key-Data-2018.pdf (accessed on 16 May 2019).
Figure 1.13 focuses just on OECD unitary countries. It shows that in Israel taxes account for 44% of the total revenue of local governments, a share that is substantially above the OECD average of unitary countries of 39% (OECD26) and on par with the OECD average for all countries (OECD35).
Sources: OECD elaboration based on OECD (2018[3]), Subnational Governments in OECD Countries: Key Data, http://www.oecd.org/regional/Subnational-governments-in-OECD-Countries-Key-Data-2018.pdf (accessed on 16 May 2019).
However, although tax revenues are a major source of local government revenues in Israel, they amounted to only 2.5% of GDP in 2016 (vs 4.7% in the OECD unitary countries on average) and 9.5% of public tax revenues (vs 19.8% in the OECD unitary countries on average) as shown in Figure 1.14.
One characteristic of Israel compared to other OECD countries is the high concentration of local tax on one tax, the property tax (Arnona). 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. In other OECD countries, there is a great diversity of tax funding models through taxation. First, subnational governments can receive a share of national taxes; Second, they can raise a large variety of own-source taxes.
Sources: OECD elaboration based on OECD (2018[3]), Subnational Governments in OECD Countries: Key Data, http://www.oecd.org/regional/Subnational-governments-in-OECD-Countries-Key-Data-2018.pdf (accessed on 16 May 2019)
Shared taxes in the OECD
Subnational governments in many OECD countries receive a share of national taxes (personal income tax – PIT , corporate income tax – CIT , value-added tax - VAT, excise taxes, environmental taxes), either under the form of a portion of tax receipts redistributed according to a tax-sharing formula, which may include some equalisation mechanisms, or under the form of a surtax or a surcharge, which can be assimilated to a own-source tax if subnational governments have some power over the rate (see Box 1.4). “Tax sharing” should be distinguished from “tax revenue sharing”. Tax revenue sharing is a special case of intergovernmental transfer, the only difference with a block grant being that in the first case the tax revenue is specified and, in the latter,, the tax revenues which are financing the transfer are not specified.4
Shared taxes are frequently found in federal countries (except the United States, Mexico and Australia). They are also used in Italy and in many Central and Eastern European countries. In Latvia, Slovenia and Poland, the sharing of the personal income tax is a major source of revenue, accounting for more than 50% of subnational tax revenues.
Shared taxes are increasingly being used in France. Examples are the apprenticeship tax (shared with the regions), the special tax on insurance contracts and a tax on network companies-IFER. From 2018, following the regional reform, regions will benefit from a share of the VAT. In Portugal, since 2007, municipalities receive a share of the PIT, capped at 5% of tax receipts collected from local residents (municipalities can decide to reduce this percentage rate).
When subnational governments have the possibility to levy a surtax or a surcharge on a national tax, they enjoy a higher taxing power. “Piggy-backing” is also found in several OECD countries (Box 1.4).
Piggy-backing provides some taxing power to subnational governments as they can decide on their own marginal rates and reliefs, within lower and upper limits. They can be thus assimilated to own-source taxes. In countries using piggy-back taxes, rates are generally low but these taxes provide a substantial amount of revenue because of the large size of the taxable base. Piggy-back taxes offer several other advantages: they are quite easy to administer as they use the already existing national taxes’ collection and management system. They have thus the value of simplicity and harmonisation with existing tax bases. They have however, some drawbacks as they may raise vertical fiscal externalities that are possibly harmful.
In Belgium, the municipal personal income tax is an additional tax on income. Rates are set by local authorities and apply to municipal residents of where the income is earned) and income tax collection is done by the federal government. In Italy, there is also a surtax on the PIT (imposta addizionale comunale), with some municipal leeway on the rate with a maximum of 0.8% (for Roma Capitale, 0.9%). In Portugal, municipalities levy a municipal surtax on the corporate profit tax (derrama) of up to 1.5% of taxable income. In Korea, local governments benefit from a local income surtax on households and companies. In Switzerland, local governments can levy a surtax (subject to lower and upper rate limits) on a large array of higher-level government taxes including the PIT and the CIT. In France, regional and departmental governments can levy a surtax on the internal consumption tax on energy products (“pollution tax”).
The variety of own-source taxes at subnational level in the OECD
In OECD countries, the most common local own-source taxes are taxes related to the provision of local public services. Examples include taxes on waste collection and street lighting.
Frequently, local governments also apply license taxes to specific local activities, such as advertising, gambling, entertainment, markets, real estate transactions. They also can raise business taxes (Box 1.5).
Local governments in some OECD countries also use general consumption or sales taxes. For example, in the United States, 37 states have implemented tax-sharing systems with local authorities within their jurisdictions, by allowing them to impose their own general sales taxes in addition to the state tax. Local rates range from 0.5% to 8.3%. In 2016, the share of local government sales tax accounted for 12.5% of local tax revenue (OECD/UCLG, 2019[7]).
Several OECD countries utilize local business taxes. These take different forms, from business licences to more sophisticated taxes on salaries, capital structure, company or operation profit, added-value, economic activity, etc. In Germany for example, the local business tax (Gewerbesteuer) is the most important municipal tax, representing 44% of municipal tax revenue and 17% of total municipal revenue in 2016. Levied on all industrial and commercial companies, the rate of the local business tax is a combination of a uniform tax rate of 3.5% (base rate) and a municipal tax rate set by municipalities (Hebesatz or multiplier). In Austria, the municipal business tax (Kommunalsteuer) also generates the bulk of municipal tax revenue (68% in 2016). The Austrian local business tax is a payroll tax of 3% on total salaries and wages paid each month by permanent establishments based in Austria. The payroll tax base and rate are both fixed uniformly across all local jurisdictions by the federal government. In Luxembourg, the most important tax by far is the municipal trade tax (impôt commercial communal – ICC). Established in 1936, the ICC represented 91.5% of municipal tax revenue in 2016, 26.1% of municipal revenue, and 1.4% of GDP. This tax is levied on the profits of commercial companies only. Each municipality determines a rate - approved by the central government - which is applied to the tax base. The central government collects the tax, but only a portion is returned to the local governments from where the revenue is raised. A horizontal equalisation mechanism redistributes around 65% of ICC receipts among municipalities according to a set of criteria. In France, the local business tax (taxe professionnelle) has been abolished in 2010. It has been replaced by a “territorial economic contribution”, paid by companies, and itself comprising a real estate tax (contribution foncière des entreprises or CFE) and a tax on business added value (contribution sur la valeur ajoutée des entreprises or CVAE). The CVAE is shared as follows: 26.5% for the communes and EPCIs, 23.5% for departments and 50% for the regions).
Local business taxes are however often criticised, for being too sensitive to business-cycle fluctuation (recession or boom), for having a potentially negative impact on employment and investment, and for often creating inequities both among local governments and among businesses.
Source: OECD elaboration based on OECD/UCLG (2019[7]), 2019 Report of the World Observatory on Subnational Government Finance and Investment, http://www.sng-wofi.org.
Finally, the use of taxes related to motor vehicles (motor vehicle tax, road tax, vehicle registration tax), paid by owners of vehicle, is also widespread in OECD countries, as they are also related to subnational governments responsibilities in terms of transportation (Box 1.6).
Motor vehicle taxes have a strong link with local transportation infrastructure provided by subnational governments, in particular the construction and maintenance of roads. Therefore, if the tax is used to finance roads and other transportation, it can match payment for services to the benefit from the service. These taxes have other advantages: they have a potentially large tax base; they are relatively fair, especially if the tax is based on the value of the vehicle; they have a non-exportable base, and they are easy to pay and to collect. Finally, relative to other tax, revenue capacity is evenly distributed across local governments, while being consistent with environment goals of counteracting the negative externalities associated with local traffic congestion and air pollution. However, the freedom given to local governments on the setting of tariffs or rates taxes should be limited due to potentially harmful fiscal competition.
In Australia for example, vehicle-related taxation on registration and transfers accounted for 15% of states’ tax revenue in 2016. In Italy, there is a regional tax on vehicles, which is paid by the owner or user of the vehicle and which represented around 9% of subnational tax revenue in 2016. In Chile, the motor vehicle tax accounted for 16.4% of municipal tax revenue and 6.8% of municipal revenue in 2016 while it amounted to 16% of States’ tax revenue in Mexico.
Source: OECD elaboration based on OECD/UCLG (2019[7]), 2019 Report of the World Observatory on Subnational Government Finance and Investment, http://www.sng-wofi.org.
The property tax in the OECD
Figure 1.15 and Figure 1.16 illustrate that revenue from the Israeli property tax contributes 81.1% of the total tax revenue raised by local governments (i.e. 2% of GDP), a share that is nearly double the OECD average of 41.4% in 2017.
Note: 2016 data for Australia, Greece and Mexico.
Source: OECD elaboration based on OECD (n.d.), OECD Revenue Statistics, https://doi.org/10.1787/tax-data-en (accessed on 15 May 2019).
Note: 2016 data for Australia, Greece and Mexico.
Sources: OECD elaboration based on OECD (n.d.), OECD Revenue Statistics, https://doi.org/10.1787/tax-data-en (accessed on 15 May 2019); OECD (2018[13]), Revenue Statistics, https://stats.oecd.org/ (accessed on 16 April 2019).
Combining the important role played by revenue from taxes in local government finance in Israel with the country’s heavy reliance on property taxes as a source of local tax revenue, it is not surprising that the share of total local government revenue from property taxation in Israel is significantly higher than OECD average (36% vs 13%) as shown by Figure 1.17. Among OECD countries only New Zealand and Australia rely more heavily on the property tax for the financing of its local governments.
Sources: OECD elaboration based on OECD/UCLG (2019[7]), 2019 Report of the World Observatory on Subnational Government Finance and Investment, http://www.sng-wofi.org and OECD (2018[13]), Revenue Statistics, https://stats.oecd.org/ (accessed on 16 April 2019).
How the Arnona functions
The Arnona has several unique qualities that make it quite different from property taxes typically used by local governments throughout the world.
Israel uses an area-based property tax system. In most countries, property taxes are based on the value of property. The assessed value of property for purposes of taxation can be determined in many ways. Assessed values in some countries, in particular in the United States and Canada, reflect quite accurately the market value of property. In other countries, especially when properties are reassessed infrequently, the link between the property tax base and current market values can be weak. In Israel, annual Arnona charges depend on the square meters of property. The tax is determined by multiplying area by an appropriate tax rate. Tax rates differ by type of property and in some cases by location within a local jurisdiction. Area-based property tax systems are quite rare. Within the OECD only the Czech Republic, Poland, and the Slovak Republic utilize area-based property tax systems.
In Israel the Arnona is levied on the user of each property. Property taxes in most countries are levied on the owners of property. France and the United Kingdom are the only countries where a residence tax exists (taxe d’habitation in France and Council tax in the United Kingdom. In France, the residence tax is only one component of a “property tax system” (Box 1.7). In both countries, this tax is being reformed (see Box 2.1, Chapter 2). When the property is occupied by someone other than the property owner, the property owner remains liable for the tax, although depending on market conditions (demand and supply elasticities), some or all of the ultimate incidence of the tax may fall on the user (renter) of the property. In Israel, however, the user of the property, whether a resident or a business, is responsible for paying the Arnona.
In Israel, local governments have very limited ability to change Arnona rates. In most OECD countries, local governments have a substantial amount of tax autonomy. A local government with tax autonomy, or taxing power, has the ability to determine the amount of revenue it wants to raise. A local government with full tax autonomy would be able to set property tax rates and to determine the level and composition of any tax reliefs offered to its residents and businesses. In many countries, tax autonomy is at least somewhat limited by the imposition of restrictions on tax autonomy imposed by higher level governments. Since the mid-1990s, the OECD has been carrying out periodic studies of the tax autonomy of state and local governments in OECD countries. The OECD has developed a taxonomy, which allows officials in each country to determine the degree of taxing power granted to its sub-national governments (Blöchliger, 2015[14]). In its latest compilation, using 2014 revenue data, the OECD determined that local governments in Israel have less tax autonomy than all other OECD countries (OECD, 2019[15]).
The system of property taxes in France is based on four main local taxes: a residence tax (taxe d’habitation), two property taxes on building and land (taxes foncières sur les propriétés bâties et non bâties) and a real estate tax on business (contribution foncière des entreprises or CFE). Together these property taxes contributed 59% of subnational government tax revenues and 30% of their total revenues in 2016, thus representing a major source of revenue for municipalities, inter-municipal cooperation bodies and departments. They amounted 3.4% of GDP one of the highest level in the OECD where the average is 1.1% of GDP. This system is however being reformed. In particular, the residence tax will be abolished, the abolition being phased in over three years for all tax payers (see Box 2.1, Chapter 2).
As in Israel, the residence tax is an example of a local tax, regardless of whether they are owners or renters, or whether they use the taxed property as a permanent residence or not. The tax is levied at the municipal, at the inter-municipal, and at the département levels. The tax is based on the rental value of residential properties (“valeurs locatives cadastrales des propriétés bâties”). The last overall estimation of rental values was conducted in 1970 using data collected on housing markets and on the physical characteristics of residential properties. Information on the physical characteristics of each property comes from cadasters and from information provided to local officials by property users. Since 1970, the rental values have not been re-estimated (except for a limited re-estimation at the département level in 1980). The existing rental values are simply indexed at a rate voted annually in the Law of Finances. The annual increases have been approximately proportional to changes in the consumer price index. The rental value of new housing units is estimated based on their physical characteristics and on local housing market data.
The tax rates are set independently by the different tiers of local government, subject to several constraints. The rates cannot increase or decrease by more than changes in local tax rates on businesses. Rates are also subject to limits related to average tax rates at the département and national levels. Low-income households are either exempt from the taxe d’habitation or their tax liability is limited to a specified percentage of their personal income.
Despite these provisions, the taxe d’habitation remains a regressive tax with respect to personal income. Perhaps for this reason, the government recently decided to exempt 80% of local taxpayers from the tax. Local governments will be fully compensated by the government for their loss of local tax revenue. The government has also established a special tax commission to study proposals for eliminating the taxe d’habitation for the 20% of the population still subject to the tax.
Owners of residential property in France are subject to a pair of additional taxes on property. The tax on improved and unimproved properties (taxes foncières sur les propriétés bâties et non bâties) is levied on the rental values of properties, discounted on average by 50% for build properties and by 20% for unimproved land. These taxes are levied by municipalities, by the départements, and, on an optional basis, by the inter-municipal bodies. Local governments are free to set their own tax rates subject to the same constraints that apply to the taxe d’habitation. However, the rate limitations with respect to personal income do not apply.
Businesses in France also face a local property tax, the Contribution Foncière des entreprises (CFE). The tax is based on the rental value (minus a rebate of 30%) of properties used for business purposes. Minimum tax liabilities are set by law and depend on the turnover of the taxed businesses. The legislation governing the tax also contains a long list of exemptions and rebates. The tax rates of the CFE are set by local governments. The rates are subject to the same conditions as those applying to the property tax on individuals. An additional constraint is that for each business, the sum of the local tax on business value added (the Contribution à la valeur ajoutée) and the Contribution foncière des entreprises cannot exceed a specified percentage of each business’ value added. In contrast to the taxes foncières sur les propriétés bâties et non bâties levied on individuals, the property taxes on business are based on actual rents as reported by the business or on an annual-determined assessed value, which is calculated on the basis of the physical characteristics of the properties used for business purpose, the type of business activity, and an index of market values.
Although the local government property tax originated under the British mandate, the modern Arnona was established in 1948. Originally, the tax rate was calculated as a proportion of each property’s rental value. As most of the housing stock was at that time privately owned or rented, the Arnona could be easily estimated as a percentage of the rental value of the property (Daran, 1999[16]; Portnov, McCluskey and Deddis, 2001[17]). Between the mid-1950s and mid–1960s, the share of public housing in the total housing stock increased as the country provided housing for a flood of new immigrants. Consequently, the estimation base of Arnona was changed. During this period, the Arnona was estimated proportionally to the number of rooms for residential uses, and in proportion to the area of each parcel used for non-residential purposes.
Since 1970, the Arnona has been estimated as a function of the surface area of the property, measured in square meters. The tax is imposed on residential and non-residential properties as well as on undeveloped and agricultural lands. In general, the Arnona rate is determined by a combination of four criteria:
1. The actual use of the property, commercial, industrial, residential or agricultural. The basis of taxation is determined by actual use and not by the land use specified in official land use plans.
2. The location of the property within a local jurisdiction, usually determined by the establishment of several zones.
3. The type of property (single-family houses, large apartments, small apartments, etc).
Through the mid-1980s, local councils had the authority to set their own Arnona rates. However, in response to a period of high inflation, in 1985 the Knesset enacted the Economic Stabilization Law (5745-1985), which froze all Arnona rates and required that any future increase in rates must be approved by the Ministers of Finance and Interior. In 1998, the Knesset passed the so-called “Arrangements Law”. This legislation included a provision that pegged annual increases in Arnona rates to the rate of inflation as measured by the official consumer price index. Changes in rates, however, still required approval of the central government. Effective in 2007, the government issued regulations that specified annually-adjusted minimum and maximum allowable Arnona rates for major categories of properties. Local authorities retain the authority to change sub-classifications of types of property and to propose changes, both increases and decreases, in specific Arnona rates. All changes, however, must be approved by the Ministers of Finance and Interior (Box 1.8).
The central government established 13 primary classes for properties. Each local government, with the approval of the Ministries of Finance and Interior, can establish its own subclasses, Thus, throughout the country there are thousands of different subclasses that govern the Arnona rates levied on the users of different types of property located in different local jurisdictions. However, the most important distinction between classes of property is between residential use and business (non-residential) use.
Non-residential use is divided into more than 30 categories, including: offices and commerce, warehouses, industry, hi-tech, banks, insurance companies, cultural institutions, schools, museums, artist studios, public markets, cinemas, theatres, banquet halls, restaurants and coffee houses, department stores, swimming pools, country clubs, hotels, homes for the aged, embassies, parking lots, and petrol stations.
Within residential and non-residential classifications, location in a jurisdiction is the single most important factor. Each local government is divided into zones. Tel Aviv, for example, has been divided into five zones for residential uses and five zones for non-residential land uses. The zones are denoted as: best, better, average, poor, and poorest.
In Tel Aviv, there are four types of residential uses in the best residential district, three types in the second-best residential district, an only one type in the other three districts. In zone 1, the highest-ranked district in Tel Aviv, where 25% of the residential units and 33% of the residential area are located, the residential units are divided into four types: (a) individual houses measuring over 110 square meters; (b) apartments larger than 180 square meters; (c) average apartments, measuring between 110 to 180 square meters; and (d) all other dwelling units. In zone 2, which encompasses 34% of the residential units and 33% of the residential area, the first two categories noted above are combined into one, and the other two brackets remain the same. In zones 3, 4, and 5, which account for 41% of the residential units and 34% of the residential area, there is only one residential category. Because of the relatively low rates in these zones, there is no point in distinguishing among different residential types.
For non-residential uses, classification depends on use and size.
The final dimension of the classification system is the age of the property. There are seven age categories for residential property and only three for non-residential properties.
Once the current use, the location, the type of property, and the age of the property have been determined, the Arnona rate can be calculated.
Table 1.3 summarizes the requests by local governments for changes in their Arnona rates and indicates the proportion of the requests that were approved by the government in the years between 2013 and 2018. Although the number of requests each year were quite high, the available data do not indicate whether multiple requests were made by the same local government. In each year, more local governments requested increases in non-residential rates than decreases, and the amounts (in shekels) of the requested increases were much larger than the size of requested decreases. The picture for the residential Arnona was more mixed, with more decreases requested in 2013 and 2018. Over the five years of requests and the four types of requests (residential and non-residential, increases, and decreases) in only six cases did the Ministries of Finance and Interior approve more than 50% of the requested change in Arnona rates. In 2018, 72% of requested increases in residential Arnona rates were approved, but the amount of the requested increases was quite small (NIS 5.5 million). The generally low approval rates reinforce the limited amount of local government tax autonomy in Israel.
Table 1.4 summarizes information on 2016 Arnona rates by type of property. With the exception of agricultural land used for farming, which is taxed at very low rates per square meter, residential property is taxed at lower rates than most non-residential property. The average rate of taxation differs markedly across types of non-residential property. For example, space used for general office functions was on average subject to a per meter tax of NIS 109, while the average rate for property housing a bank or insurance company was NIS 880. In some local governments, the rates for these types of properties greatly exceeded these averages. In general, rates for all types of property varied substantially across jurisdictions. One reason for this variation is the widespread use of multiple sub-classification of property and differential rates assigned to these sub-classifications. Local governments have considerable discretion in authorizing these sub-classifications and the associated rates.
The authorized set of rates used by each local government are multiplied by the taxable area, measured in square meters, of each type of property. The result of these calculations is referred to as the Arnona initial charge (or levy) for each type of property. Initial charges are then adjusted for outstanding liabilities (or credits), for interest due of previous debts, and for exemptions, releases, or discount for which the taxpayer is eligible.
Local governments are authorised by the Ministry of the Interior to provide discounts, releases, or exemptions to certain residential taxpayers. In general, discounts are available for households that may have difficulty in paying their Arnona charges. Examples include those with low incomes, the elderly, disabled, and students. Each local authority decides whether it will provide full or partial discounts, and, within the parameters set by the Minister of the Interior, the conditions upon which discounts and exemptions will be granted. Box 1.9 provides more detail on these discounts.
Clause 12(b) of the Arrangement Law grants the Ministry of Interior the sole authority to implement regulations that determine the maximum and minimum rate of Arnona discounts given by the local municipalities, and the terms under which they are given. Each year the Ministry of Interior publishes an Arnona Discount Table that specifies the conditions under which individuals are eligible for Arnona discounts. In general, senior citizens, people with certain mental and physical disabilities, soldiers performing compulsory national service, new immigrants, and students are eligible for discounts. Individuals with low incomes can also receive discounts on their Arnona payments that are inversely related to their monthly income. Local governments decide whether they will grant these means tested discounts, and the magnitude of the discounts.
At the discretion of local governments, discounts may also be given for certain uses of property such as property used by educational, religious, or charitable organisations. Approximately 200 local governments provide 50% to 70% Arnona exemptions for government-owned property. In Jerusalem, there are no exemptions for government-owned property, and starting in 2017, in 60 jurisdictions Arnona tax liabilities on government property are allocated to the Arnona Fund. As described below, the revenues from the fund finance Equalisation Fund grants allocated to some local governments.
In 2016 and 2017, total exemptions, releases, and discounts given by municipal governments were approximately NIS 3.1 billion and NIS 3.4 billion, respectively. According to the Israeli Association of Local Governments, the increase in discounts between 2017 and 2018 created an additional loss of Arnona revenue of NIS 100 million. In 2017, residential discounts equalled 24% of the total revenue from the residential Arnona.
Arnona bills are generally issued in early January. The Arnona can be paid in a single lump-sum payment, in two or three equal payments or bi-monthly. Many local governments contract with private firms to collect net Arnona charges. To help ensure the payment of the Arnona, properties cannot be sold until the seller has remitted all unpaid property tax bills. Despite these efforts, the collection rate—the amount collected relative to the sum of net charges—remained low in many jurisdictions. In 2017, the collection rate for the residential Arnona ranged from under 10% to nearly 100%. The average rate was about 70%.
In 2016, local governments in Israel raised NIS 23.8 billion from the Arnona, with 43.6% of that amount coming from the tax levied on residential property. Table 1.5 shows that balances owed, interest charges, and various adjustments increased initial residential charges. After deducting NIS 3.1 billion in exemptions, releases, and discounts, net residential charges equalled NIS 14.2 billion. Given an overall collection rate of 73.2%, 2016 revenue from the residential Arnona equalled NIS 10.4 billion.
Differences in Arnona revenue among local governments
In Israel, as in almost all countries, there are large differences in the ability of local governments to raise revenue from their own sources. Economic activity and hence tax capacity tend to be concentrated in and around large metropolitan areas. Unless endowed with substantial natural resources, rural and remote areas have much lower tax capacity. One rough indicator of the differences across municipalities in economic activity is the average monthly wages of employees residing in each municipality. The data in Table 1.6 show that the average monthly wage in 2015 was below NIS 6 000 in 56 local governments and above NIS 14 000 in 11 jurisdictions. Average monthly wages were below NIS 4 500 in the poorest local government above 17 000 in the richest.
To provide a more comprehensive assessment of both the resources and the economic and social needs of each local government, the Central Bureau of Statistics (CBS) developed a Socio-economic index. The index combines data on the demographic composition, education, quality of life, employment and retirement status of the population of each local government. The latest version of the index uses data for 2015. Although the index is constructed as a continuous variable, the CBS used cluster analysis to divide local governments into 10 “clusters” with cluster 1 containing the local governments in the weakest socio-economic condition and cluster 10 containing those in the strongest condition. The clusters are constructed so as to minimize the variation of the index values within each cluster. The largest number of governments are found in cluster 2 (42) and cluster 8 (40). Box 1.10 provides additional detail on the construction of the socio-economic index.
In order to characterize the socio-economic condition of the population of local governments, the Central Statistical Bureau (CBS) has constructed a socio-economic index. The latest index is based on demographic, economic, and social characteristics of the populations of local governments in 2015. The index is calculated as a continuous variable and its value is used in the allocation of government’s General Balance Grant to local governments. The index is constructed from the following 14 variables using factor analysis techniques:
2. Dependence ratio – the ratio between the number of old (>64) and young (<20) person and the working-age population (20 to 64).
8. Percentage of people with income over twice the average salary.
9. Percentage of people with work income below minimum wage.
10. Percentage of people receiving a fixed income and supplementary income for old age and survivors.
12. Motorization level – total number of privately-owned cars and trucks up to 3.5 tons divided by the number of residents in the geographical unit in 2015.
13. Average auto licensing fees (vehicle value assessment) – total fee paid for privately-owned cars and trucks of residents of the geographical unit in 2015.
14. Average number of days spend abroad – total number of days spend abroad of people age two and older in 2015, divided by the number of people age two and older in the geographic unit.
Once each local government’s socio-economic index value has been calculated, the local governments are allocated to one of ten clusters, with cluster 1 being the weakest and cluster 10 being the strongest. The clusters are determined by employing cluster analysis methods, which minimize the variance of the indices within each cluster and maximize the variance between clusters. The cluster assignments are used by the government in the implementation of a number of policies related to local governments.
Figure 1.18 displays average per capita revenue from both the residential and non-residential Arnona for each of the 10 socio-economic clusters. The total height of each bar indicates the average total per capita revenue from the Arnona in each cluster. The differences across clusters are striking. The bottom portion of each bar represents the residential Arnona. As the socio-economic status of a local government increases, so does its per capita revenue from the residential Arnona. The average residential Arnona revenue in the first two clusters are NIS 155 and 531, respectively. The per capita residential Arnona revenue in the ninth and tenth cluster is NIS 3 513 and 8 214. Average per capita revenue in the ninth cluster is 6.6 times higher than the average in the second cluster. These differences are only exacerbated by the distribution of non-residential Arnona among local governments. Average per capita revenue rises from NIS 141 in the first cluster to NIS 1 384 in the tenth.
The data presented in Table 1.7 help explain why per capita revenue from the residential property tax is very low in the first few socio-economic clusters and rises steadily as one moves to higher clusters. The third column demonstrates that on a per capita basis, residential area, measured in thousands of square meters, is lowest in cluster one and larger with each subsequent cluster. The data show that residential area per capita is about twice as large in the ninth cluster as compared to the second cluster. The next column illustrates the pattern of average residential rates. The average residential rate is below average in cluster 1 and way above average in cluster 10. However, looking at residential rates in clusters 2 through 8 (the clusters that include most local governments), the variation in average rates is muted, although the rates in clusters 2 through 5 are somewhat higher than average rates in clusters 6 through 8. The data in the fifth column clearly demonstrates that the sum of exemptions, releases, and discounts as a share of initial residential charges is largest in cluster 1 and declines as the cluster numbers increase. In cluster 2 total exemptions, releases, and discounts are 41.5% of residential charges, while in cluster 9 they account for only 9.7% of charges.
Note: Havel Eilot and Tamar are not included in these calculations.
Source: OECD calculations using data from the Central Bureau of Statistics (https://www.cbs.gov.il/en).
Although the per capita net charges after exemptions, releases, and discounts is not shown in Table 1.7, they are lowest in cluster 1 and highest in cluster 10. Net charges per capita, however, are quite similar in clusters 2 through 7. As shown by the data in the next to last column of Table 1.7, collection rates are under 50% in clusters 1 and 2, and over 90% in clusters 9 and 10. The result of applying these collection rates to net charges is that per capita collections from the residential Arnona are lowest in low-number clusters and rise as the cluster numbers increase. In summary, the data in Table 1.7 demonstrates that there are multiple reasons for the low levels of per capita residential Arnona in local governments with low-values in the socio-economic index. Although differential collection rates are important, the observed pattern of revenue from the residential Arnona is also due to differences in housing consumption, in residential rates, and discounts among local governments with different socio-economic characteristics.
The central government plays an important role in the financing of local governments in Israel. As shown in Figure 1.19, in 2010, 33.8% of the regular budget of local governments came from central government grants. This percentage has been steadily rising. In 2017, grants from the central government contributed 39.7% of regular budget revenue.
Source: OECD calculations using Central Bureau of Statistics local government data (https://www.cbs.gov.il/en).
Figure 1.20 compares Israel to other unitary countries within the OECD. Available data indicate that Israel’s central government fiscal support for local governments is about equal to the average among OECD countries. The figure shows that in Israel in 2016 central government grants to local governments comprised 48% of the total revenue of local governments. This amount includes the revenue in both the regular and irregular budgets of local governments. On average, grants to subnational governments in OECD unitary countries equaled 48.8% of the total revenue of subnational governments in these countries.
As was shown in Figure 1.9, in 2017 slightly more than three-quarters of the total revenue from grants came from grants from the Ministries of Education and Welfare in support of local government spending on education and social welfare respectively. The next most important source of grant revenue is the General Balancing Grant, which contributed 15.2% of the total local government revenue from grants. Finally, a set of other central government grant programs contributed 8.1% of revenue from grants.
Sources: OECD elaboration based on OECD (2018[3]), Subnational Governments in OECD Countries: Key Data, http://www.oecd.org/regional/Subnational-governments-in-OECD-Countries-Key-Data-2018.pdf (accessed on 16 May 2019).
Grants for education and social welfare
Both education and welfare are local government responsibilities that have been delegated from the central government. As delegated functions, they are largely funded by the central government. Most of the ministerial grants for education and welfare come in the form of what public finance economists refer to as block grants. The revenue from the education grant must be spent on teacher salaries and on other necessary expenses involved with operating local schools. Within these broad categories, local governments have some discretion on exactly how they spend the money from the block grant portion of the education grant. In addition, both the education and welfare grants have a matching grant component. To receive money through a matching grant, local governments are required to “match” the additional grant with some additional resources from local government sources. In the case of education, grant revenue for use in paying school secretaries and janitors is subject to a 13% matching rate. This means that for a local government to increase spending on janitorial pay by 1 000 shekels, it must use 130 shekels of its own fiscal resources (in most cases, primarily from the Arnona) in order to receive a matching grant of 870 shekels. The matching grant component of the welfare grant is larger than for the education grant. Salaries of social workers are financed using a 25% matching rate.
General balancing grant
The balancing grant was designed to be explicitly equalising by providing larger per capita grants to local governments that have insufficient fiscal resources to meet their public service responsibilities. The allocation of the balancing grant to local governments is determined annually by the Ministry of Interior. The Minister calculates individual local government allocation using a complex formula, often called the Gadish formula, named after the chair of a committee that developed the formula. While most of the balancing grant is distributed as a block grant in support of local governments’ regular budgets, a portion of the grant (no more than 15%) is conditional on meeting certain criteria (to be described below).
Each local government’s balancing grant depend on the calculation of a Model Grant and the actual grant received in the previous year. The Model Grant is calculated as the gap between each local government’s normative expense and its potential revenue. Box 1.11 provides details involved in calculating per capita normative expenses for the 2019 balancing grant, and Box 1.12 describes the calculation of potential revenue.
The starting point for estimating normative expenses is actual regular budget expenditures in 2002, with certain exclusions. The general formula for the calculation of normative expenses per capita is composed of a lump-sum part (A) and a part (B * P) that is proportional to the number of residents. The formula is:
Y = Normative per-capita expense.
P = local government’s population as of October 31 2018.
A/P = lump-sum per capita expense
B1,2,3 = proportional per capita expense.
The coefficients, which were determined through the use of an expenditure regression model, differ for different types of local governments. For local councils and municipalities the 2019 coefficients were:
B1 = 4,130 NIS per capita up to the first 20,000 residents.
B2 = 3,655 NIS per capita for the next 50,000 residents.
B3 = 2,972 NIS per capita for all residents over the 70,000 residents.
In addition, an extra 3% is added for local councils and municipalities located in the “Jewish sector” in order to account for extra expenses for religious activities and special security expenses.
Normative expenses are further adjusted by the application of a series of “preference coefficients,” which reflect specific circumstances and characteristics of local authorities. The expense coefficients are additive, but total preferences cannot increase normative expenses by more than 10%. Preference coefficients are related to the following municipal characteristics:
the socio-economic index cluster – larger preference coefficients are awarded for local governments in lower clusters. For example, a local authority in cluster 1 is given a + 10% coefficient, while a local authority in cluster 10 is given a preference coefficient of - 15%.
the socio-economic index differential (only for local authorities with more than 8 000 residents) - larger index value differentials are awarded larger preference coefficients.
education expenses – the greater the share of municipal population under age 19, the higher the expense preference coefficient.
welfare expenses – the greater the share of municipal population age 65 and over, the higher the expense preference coefficient.
Conflict lines and Jude and Samaria – for local authorities on conflict lines or in Judea and Samaria, a 4% preference coefficient is awarded.
Immigration expenses – preference coefficient set equal to the percentage of municipal population that are recent immigrants (from selected countries), but not to exceed 10%.
Regional councils benefit from two additional expense coefficients. One provides a larger coefficient for regional councils with a larger number of settlements, and the other awards larger coefficients when the distance between settlements is larger.
Once the normative per capita expenses have been calculated (based on the regression model and application of the preference coefficients), they are subject to ceilings determined by the government. The allowable maximums are substantially higher for regional councils than for other local authorities, and the maximums are also several percent higher for local governments in socio-economic clusters 1 through 4 as compared to local governments in clusters 5 through 10. For example, for the 2019 balance grant allocations, the maximum per capita normative expense for local authorities in clusters 1 to 4 is NIS 5 961 and NIS 5 812 for local authorities in clusters 5 through 10.
Per capita revenue of local authorities consists of revenues from property taxes, other revenue from own-sources, and grant revenue from the central government. The calculation of potential revenue from the property tax is based on normative Arnona tax rates and Arnona collection rates that vary by socio-economic cluster. Based on actual tax bases of each local authority, one can calculate the potential tax revenue that a local authority would collect if it used the normative tax rate associated with its socio-economic cluster and successfully collected taxes at the normative collection rate associated with its socio-economic cluster. Table 1.8 below lists the normative collection rates for residential and non-residential property taxes and the normative residential tax rate. Regardless of the results of the calculated potential property tax revenue, minimum per capita potential property tax revenue was set at 1 040 NIS.
Potential per capita revenue from own-sources other than the Arnona is calculated as a normative lump-sum amount and an amount that varies with population size and type of government. These calculations are further adjusted according to the socio-economic cluster to which local government belongs. Potential revenue is reduced for local governments in clusters 1 through 4, and increased for local governments in clusters 5 through 10. An additional adjustment is made for local authorities that are absorbing a large number of new immigrants. Potential revenue is reduced because of immigration, but not by more than 5%.
Finally, if the result of the above set of potential revenue calculations fall below the minimum per capita revenues listed in Table 1.9 are imposed.
Prior to the calculation of the final Balance Grant allocation, special account is taken of two additional categories of normative expenditures. Pension expenses up to a rate of 13.33% of the calculated expense for general salaries are recognised in full. In addition, loans repayments (out of loans for water and sewage) are added to normative expenses. These supplementary expenses are subject to a ceiling of 30%.
The actual allocation of Balancing Grants to local governments is rather complex. First, a “normative Balancing Grant” is calculated as the difference between normative expenses and normative revenues as defined in Box 1.11 and Box 1.12. Normative Balancing Grants are then adjusted by a “realization rate”, which is a weighted average of the socio-economic index and the peripherality index, with weights of 70% and 30% respectively. The result of this calculation is the “potential balancing grant.” This potential grant is then compared to the actual grant allocated in the previous year. Annual percentage reductions in grant allocations are determined by the Ministry of Interior, with the allowable reductions being smallest for local authorities in the bottom three socio-economic clusters.
Finally, the allocations of balancing grants to local authorities are subject to a tax collection condition. The Ministry of the Interior “considers meeting yearly collection goals an important source of income and a necessary condition for the proper economic management of the local authorities”. Thus, a portion of the balancing grant is provided as a conditional grant, which will be transferred to the local authority subject to it meeting the required collection goals for the year for which the balancing grant is allocated. The collection rate that local authorities are required to meet was increased at a rate of 1% per year between 2016 and 2018 from 80% to 83%. To receive the conditional grant, local authorities must increase their collection rates relative to their collection rate in the previous year.
Table 1.10 illustrates the results of the balancing grant allocation process described above. Two-hundred two local governments received balancing grants in 2017. The data in Table 1.8 show clearly that the balancing grant is in general equalising. Average per capita balancing grants are largest in the local governments in the lowest socio-economic clusters. All but five local governments in the bottom five clusters receive balancing grants. The average per capita grant in the top five clusters is substantially smaller and 47 jurisdictions in those clusters receive no balancing grant allocation.
Table 1.10 also shows that within clusters there is a wide variation in the per capita grants received. The maximum per capita grants in clusters two through eight are larger than the maximum grants in clusters one and two. An indication of the magnitude of the within-cluster differences in per capita grants is given by the fact that in clusters six through nine, the standard deviation of per capita grants is larger than the average grant.
Equalisation Fund grant
In 2017, the government created an equalisation fund, called the Arnona Fund. The fund was financed from the money that the central government would have paid local governments if the Arnona was levied and paid on government-owned property located in 60 local jurisdictions. The revenues in the Arnona Fund are allocated to local governments in an equalising manner. Each year, the total amount to be distributed is fixed by the Law of Finances. In 2017, allocations from the Equalisation Fund totaled NIS 138,000,000.
The formula for allocated Equalisation Fund grants to local authorities is based on the following variables, with the percentage weight on each listed in parentheses: the socio-economic index (13,5%); the lack non-residential property (27%); the peripherality index (10%); the financial management index (28%); and other criteria (21.5%). In 2017, 75 local authorities receive no allocation from the equalisation fund. The average allocation among local governments receiving grants was NIS 1 350 900, or NIS 73.3 per capita.
Figure 1.21 illustrates the allocation of Equalisation Fund grants among local governments classified by their socio-economic cluster. On average, local governments in cluster one receive small grants, only NIS 14 per capita. The average per capita grants in clusters two through seven are very similar. Almost all local governments in the first six clusters receive Equalisation Fund grants. In the seventh cluster, 20 out of 37 local governments receive Equalisation Fund grants, while only one government in clusters eight through 10 receives a grant.
Source: OECD calculations using Central Bureau of Statistics local government data (https://www.cbs.gov.il/en).
Distribution of grants by socio-economic cluster
Figure 1.22 illustrates the allocation of all per capita central government grants across socio-economic clusters. Because the average per capita education grant in cluster one is more than twice as high as the average education grant in any other cluster, the total average per capita grant in cluster one is 64% higher than the second highest average grant (in cluster 6). Local governments in clusters two through six receive similar levels of per capita grants, although the average per capita grant in cluster six exceeds the average grant in cluster 2 by NIS 373. Above cluster 6, average per capita grants decline in each subsequent cluster. Because of their relative small size, the distribution of Equalisation Fund grants has almost no impact on the allocation of total grants across local governments.
Source: OECD calculations using Central Bureau of Statistics local government data (https://www.cbs.gov.il/en).
References
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Notes
← 1. Local governments were characterised as Jewish or Arab, if 70% or more of their residents were Jewish or Arab respectively.
← 2. The word “cluster” is also used in Israel to group local governments with similar socio-economic characteristics (see Box 1.5). The cluster numbers assigned to local governments play an important role in the distribution of general balance grants and other government programs providing benefits to local governments.
← 3. Prior to 2019, local councils also received donations from Toto (sports gambling).
← 4. This distinction is important. In the framework of the revision of the System of National Accounts (SNA 2008), effective since 2014, the classification of some shared tax revenues has changed. In several countries, certain tax receipts (PIT, CIT, etc.) have been reclassified as transfers and no longer as shared taxes. Several countries have seen the share of subnational tax revenue in total subnational revenue fall sharply: from 54% to 10% in Austria; 44% to 4% in Estonia or from 46% to 7% in Slovak Republic.