The OECD recommends granting local authorities’ greater autonomy in setting local taxation. The program being pursued by the current government raises fears of the central government taking control of the local Arnona (municipal tax) Fund, as has happened in the past.
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Many Israelis are struggling to understand the fierce struggle currently being waged in the Knesset Finance Committee between the government and the heads of local authorities over the issue of the “Arnona (municipal tax) Fund.”
The roots of this struggle can be traced to the structure of Israel’s housing market. Experts agree that local government constitutes one of the main barriers to increasing the country’s housing supply. This is due to the structure of local taxation. According to the current model, residential tax is relatively low and business tax is high, such that every additional resident translates into a financial loss for local authorities, while every added business improves their balance sheet. Consequently, local authority planning committees lack incentives to allow residential construction, and instead prefer zoning land for business use.
Against this backdrop, the government is seeking to advance the Arnona Fund in this year’s Arrangements Law, which will take funds from local authorities receiving taxes from businesses and transfer it to other local authorities, based on the number of residential building permits they grant. The main goal of the fund is to incentivize authorities to issue more building permits, but it is also claimed that it will help reduce inequality by transferring funds from the “first Israel” (wealthy local authorities) to the “second Israel” (poorer authorities). However, a close analysis of the law reveals that it will reduce inequality only to a very limited extent. Since the majority of residential building permits are in any case issued in the center of the country, very few local authorities in the periphery will benefit, and certainly the most disadvantaged authorities — those in the Arab sector — will see no gains.
While there is no doubt that the main purpose of the proposed law — increasing the housing supply — is extremely important, the way the government is pursuing this goal has negative consequences that run counter to any democratic logic. In December 2021, the OECD published a detailed report on the structure of local taxation in Israel, including proposals for comprehensive reform of the system. The report’s authors recommended that Israel act in precisely the opposite manner to the current proposals: instead of taking control of local authorities’ tax funds and redistributing them in a way that will incentivize authorities to encourage residential construction, the OECD recommended that Israel bolster local authorities’ independence in setting taxation.
The accepted approach in the developed democratic world is that local authorities, as democratic institutions, should decide on the tax levels they collect from their residents, in accordance with residents’ needs and preferences. In Israel, however, the situation is reversed. The report highlighted a remarkable statistic: Israel’s local authorities have almost no control over how much tax they collect, with 95.1% of local taxation being determined by the central government, compared with a parallel average of just 7.8% throughout the OECD. In effect, the report reveals that it is the system of (dis)incentives set by the government for local authorities that gives them every reason to limit residential construction.
The solution proposed by the OECD report is to grant local authorities’ greater autonomy in determining taxation levels, while setting a fixed and logical ratio between business tax and residential tax (as is commonly the case in France and Germany). In this way, local taxation will better reflect the respective cost of residents and of businesses to local authorities, and will remove the current deterrence to residential construction.
The proposed change in the Arrangements Law, which attempts to “nationalize municipal tax,” is in stark contradiction to democratic logic and to the OECD’s recommendations. Moreover, it raises very real fears among local authorities that, in the future, the government will take absolute control of the Arnona Fund for its own purposes and will not return the funds to local authorities.
Past experience shows that these concerns are more than justified. In 2007, the government established the Cleanliness Maintenance Fund, which was designed to prevent dumping of trash and promote municipal cleanliness and was funded mainly via levies imposed on local authorities. In practice, the state comptroller recently found that NIS 1.66 billion from the fund was transferred to the state budget between 2016 and 2020, such that the fund was used as a “budgetary source for funding government activities” (to quote the state comptroller), in clear contravention of its stated purpose and of the law.
The OECD’s recommendations are far preferable to the government’s proposal for several reasons: they are more systemic; they have the potential to significantly reduce inequality; and, most importantly, they are aligned with the approach bolstering local autonomy, and bringing Israel’s model of local taxation more in line with the accepted model in the democratic world.
They also do not provoke negative responses from residents who face having the taxes they paid locally taken away and transferred to another local authority. Under the OECD model, it would be difficult to divide the State of Israel into “first Israel” and “second Israel.” Sad to say, but it may well be that these were the very reasons why the government chose not to adopt it.