1. Introduction

This document discusses the economic aspects of a future final status agreement between Israel and Palestine on the issue of Jerusalem. Its main goal is to offer ideas for the economic agreements and arrangements that should accompany such an agreement.  It also studies how economic considerations might affect reaching and sustaining a political agreement on Jerusalem.

We bear in mind that an economic agreement will be part of a broader Israeli-Palestinian final status agreement, which will be very difficult to reach. Since we are so far away from an agreement, it is hard to imagine how it will look. The difficulties in forecasting an agreement are even greater in Jerusalem, where the current positions of the two sides are much farther apart than on most other issues of the conflict, and so the shape of a future agreement is even more uncertain. Thus, in some cases our recommendations for economic arrangements do not address a single solution, but rather a range of possible solutions.

  1. Background

Jerusalem has national-historical significance to both Israelis and Palestinians. It was the capital of the country in most historical periods. After the British Mandate, in the years 1948 – 1967, the city was divided between West Jerusalem in Israel and East Jerusalem, controlled by the kingdom of Jordan. The dividing line was called the “Green Line.” Immediately after the 1967 War the Israeli government decided to annex East Jerusalem. This annexation added East Jerusalem, an area of 6.5 sq. km, and a larger area of 70 sq. km, which included 28 villages close to the city.  The annexed territory became part of the greater municipal Jerusalem. The Palestinians in the annexed areas became residents of Israel, but not citizens.

After the annexation in 1967, Israel began massive construction in the annexed area of both neighborhoods for Israelis and of infrastructure. In 1982, the Israeli Knesset passed special legislation that further formalized the annexation of East Jerusalem by defining Jerusalem as a unified city within the Israeli municipal borders. These borders created a line between East Jerusalem and the West Bank and thus began to separate the Palestinians in the two areas. Palestinian residents of East Jerusalem differed from residents of the West Bank by identification, by participation in Social Security programs, and by ability to enter Israel and work. The separation increased over time. Access restrictions on entry of West Bankers to Jerusalem intensified during and following the Second Intifada (2000-2005). The separation became almost hermetic with the building of the wall which separates East Jerusalem from the West Bank, and served to reduce mobility between the north and south of the West Bank as well. Further intensifying the separation of East Jerusalem from the West Bank is the on-going expansion of Ma‘aleh Adumim, a settlement east of Jerusalem founded in 1975, and its many satellite settlements. This expansion threatens to effectively close the eastern gate of Jerusalem, and sever the West Bank in two.

We next turn to a brief description of the economic situation of Palestinians in East Jerusalem. In 2005 the total population of Palestinians in East Jerusalem was 251,000, which comprised 33 percent of the total population of Jerusalem. This has been a rather young population, as 42 percent were younger than 15 years old, and only 3.3 percent were older than 65. It is also an economically poor population relative to Israelis in Jerusalem, but not relative to the rest of the Palestinians. The Palestinian poverty line is at US$2 a day per person, and according to this, the poverty rate in East Jerusalem was 3.6 percent in 2003. The Israeli poverty line, however, is relative and according to it, the poverty rate among Palestinians in East Jerusalem was 42 percent in 1999. It has worsened since then. Another indication for poverty in East Jerusalem is the low level of property tax paid to the municipality, which is only 11 percent of the municipality revenues. Palestinians in East Jerusalem are also heavily discriminated against in the municipality budgets and they receive only 12 percent of the expenditures. With a population of one-third of the city, and a population that is poorer and with a higher share of children, this number is indeed staggering.

The participation in the labor market in East Jerusalem is quite low. In 2005 the participation rate was 37.2 percent overall, reflecting 66 percent of men and 8.2 percent of women. The unemployment rate reached 20 percent. Half of the workers from East Jerusalem work in West Jerusalem and in the rest of Israel and they work mainly in the service industry. The main economic sectors in Palestinian East Jerusalem are construction, tourism, transportation, small to medium size manufacturing, retail and commerce. The main service sector in East Jerusalem is tourism, but it suffers strong fluctuations in demand in times of violence and political unrest, much more than tourism in West Jerusalem. Firms in East Jerusalem are small, and 85 percent of the firms have  fewer than five workers each.

  1. Potential Outlines of the Final Status Agreement

Any attempt to describe economic arrangements of the final status agreement must make some assumptions on the possible political characteristics of the final status agreement itself. We next present our working assumptions, which reflect the basic requirements of any future final status agreement:

  1. There will be two states, Israel and Palestine, living side by side, with an agreed border between them.
  2. Jerusalem will be divided, with East Jerusalem as the capital of Palestine under Palestinian sovereignty, and West Jerusalem as the capital of Israel under Israeli sovereignty.
  3. The agreement will determine the precise location of the border between the two cities. In general, the Aix Group assumes that the border between the two states will be based on the June 4th, 1967 “Green Line” with small and equitable exchanges of territory. Since many of these modifications will be in Jerusalem, they will be substantial relative to the city.
  4. Whether divided physically or not, the two cities will have separate municipalities.
  5. Access to the holy places in both cities should be free for all.
  6. The implementation of the agreement after it is signed will take between one year in some issues to five years on others, all specified in the agreement.

We next classify the many possible regimes in Jerusalem into three main types:

A Physically Divided City

In this regime the two cities are divided by a physical barrier. Passage between the two cities is possible only through a few controlled gates.

An Open City

In this case, there is free movement of people and goods between the two cities, but then Jerusalem must be separated physically both from the rest of Israel and from the rest of Palestine, to avoid smuggling and trade violations through the city.

Semi-Open City

The third case is a combination of the two above cases. A smaller area in the city is open, for example the Old City, while the rest of the two cities are divided physically.

In order to analyze the different regimes, we need to consider the possibilities with respect to the location of the political border since the two are strongly related. There are three main possible locations of the border:

  1. The political border between the two cities goes along the 1967 lines, which involves the evacuation of most Jerusalem settlements/neighborhoods from East Jerusalem. In this case, the “open city” scenario becomes quite impossible, since such a massive evacuation will create a huge hostility between the two peoples in the city. Hence, this case fits the “physically divided” city option best.
  2. The second case is that the border will reflect the current main divide between Jews and Arabs, as proposed by the Clinton parameters (2000). This case raises serious problems of continuity within the Palestinian city and with the rest of Palestine and also for some Jewish neighborhoods. For this case, all the above regimes are possible, but the “open city” becomes preferable, as it solves mobility issues.
  3. The third case is between the above two cases. The border will leave some Jerusalem settlements/neighborhoods in Israel, but will also include the evacuation of some to enable greater “contiguity” in the Palestinian city. Examples for such evacuated settlements/neighborhoods can be Atarot, Har Homa, Neve Yaacov, or Pisgat Zeev. Using the above reasoning, we conclude: the larger the evacuated area, the less possible is the “open city” regime.

From this discussion we reach the following conclusion: The future decision on the regime in Jerusalem will be significantly affected by the location of the future political border in Jerusalem. The closer the border is to the 1967 line, the stronger the “physically divided city” option becomes. If, however, the border is close to the current divide between Jews and Arabs, then the option of an “open city” rises. It is also important to note that there are some economic considerations with respect to the choice of regime in Jerusalem. One consideration is the current income gap between the two parts of the city. An “open city” regime might continue the specialization in low-skill services in East Jerusalem and it might also hamper economic development.

  1. Institutions for Economic Negotiations

The issues related to Jerusalem require special arrangements in many areas, both political and economic. We suggest that in conjunction with the political negotiations, there will be a special negotiation mechanism for the economic arrangements in Jerusalem that will consist of:

  • Jerusalem Economic Negotiation Teams (JENT): Special negotiating teams will decide on the economic-specific aspects of the agreement on Jerusalem. The teams will begin their work after the signing of the political agreement, or even earlier if possible, and end it before the full implementation of the agreement.
  • Jerusalem Economic Arbitration (JEA): In the event that the JENTs will not be able to reach an agreement, the matter will be brought to an agreed arbitrator, the JEA.
  1. Trade Arrangements

The general regime of international trade recommended by the Aix Group for Israel and Palestine is a Free Trade Area. This means bilateral free trade between Israel and Palestine, while each country sets its own independent trade policies with third countries.

We next examine whether Jerusalem should have the same trade regime. We begin with the following immediate conclusions:

  1. If the city is “physically divided,” the trade regime in the city can and should be the same as between Israel and Palestine elsewhere.
  2. If the city is “open,” it must keep a uniform set of tariffs and taxes, including with respect to goods from third countries. This follows from the free transport of goods in the city.
  3. As a result, an “open city” in Jerusalem must be a special trade zone for goods from third countries relative the rest of the two states, with lower or equal rates. This imposes restrictions on transportation between West Jerusalem and Israel and between East Jerusalem and Palestine, at least for commercial vehicles.
  4. In the “semi-open city option,” the open area is relatively small and trade should not create problems if it can be restricted only to goods like food, textiles and tourism.

These conclusions help us to analyze the interaction between the city regime and the trade regime. Once independent, Palestine might decide to impose higher tariffs and taxes on various goods, reflecting both the need to finance its expenses and the protection of local infant industries. Israel, however, has relatively low tariffs and purchase taxes. Such discrepancies in tariffs and taxes between Israel and Palestine might lead to massive smuggling through Jerusalem, which could be quite costly for both sides. We estimate that the costs of smuggling to Israeli public finance will not exceed 1 percent of GDP. While this figure is not very high, it is not negligible and is around 3 percent from the total tax revenues. It is hard to draw conclusions to losses of income to the Palestinian government, but we can say that these losses could be much higher, since income from purchase tax and tariffs will be larger relative to income in Palestine. There would be additional non-pecuniary costs, both social and moral, to making Jerusalem a main channel for smuggling between the two states. These potential costs of the trade arrangements in Jerusalem, imposed by the “open city” regime, should be taken into consideration when the future regime of the city is discussed in the political negotiations as they make the “open city” option less attractive.

  1. Labor Arrangements

Generally, the Aix Group recommends that labor flows between Palestine and Israel will be free, subject to regulation through taxes and/or permits. We adopt this idea for Jerusalem as well, with one addition. First, unlike trade in goods, labor arrangements do not depend much on the possible regime in the city. The main reason is that while trade in goods is anonymous, labor contracts hold for well-known parties. Hence, it is possible to allow labor flows across a physical border, and it is possible to regulate labor flows even if the city is open. Hence, labor arrangements in Jerusalem can be similar to the general labor arrangements between the two states. One difference arises from the fact that Palestinians from East Jerusalem have been working for Israeli employers for many years. We therefore suggest that there should be an additional provision for Jerusalem, that Palestinians from East Jerusalem who have been working in Israel prior to the agreement will be able to keep their jobs until retirement, or at least for ten more years.

  1. Infrastructure

The division of infrastructure between the two cities requires special attention for two issues. The first is that infrastructure projects have significant network externalities. The second is that infrastructures are much more developed on the Israeli side than on the Palestinian side. For example, West Jerusalem and the settlements/neighborhoods have 680 km of roads and streets, while East Jerusalem has only 87 km. West Jerusalem has 650 km of sewage, while East Jerusalem has only 76 km.

Our recommendations on dividing the infrastructure between the two cities are:

  1. The infrastructure networks should remain intact on impact. Citizens of one city who use services of the network of the other city or state will continue to use them for a transitional period of 10 or 15 years, as agreed by both sides.
  2. During the transitional period, citizens of each side will pay their own state’s providers for the infrastructure services, and the provider will settle accounts with the other side’s provider. For example, an Israeli neighborhood that gets electricity from the Jerusalem Electric Company will pay the Israel Electric Company, which will settle accounts with the Jerusalem Electric Company. The Jerusalem Economic Negotiating Teams (JENTs) will agree on the rates.
  3. During the transition period, each municipality will build its own infrastructure, so that by the end of this period they can separate the networks.
  4. It is also possible for the two sides to continue to share infrastructure beyond the transition period mentioned above if both sides wish it.
  1. Costs of Setting a Border

Since 1967 Israel has built 12 settlements/neighborhoods in East Jerusalem. Around 200,000 Israelis live in East Talpiot, Gilo, Givah Tsarfatit (French Hill), Giv’at Ha-Matos, Har Homa, the Jewish Quarter of the Old City, Ma’alot Dafna (East), Neve Ya’acov, Pisgat Ze’ev, Ramot Allon, Ramat Shlomo and Ramat Eshkol. To this we should add Atarot, which is mainly an industrial and commercial center. While Israel views them as legitimate neighborhoods that should remain in Israel, the Palestinians view them as illegal settlements that should be evacuated. Still, it seems that any future agreement on Jerusalem might leave some settlements/neighborhoods under Israel’s sovereignty, within the framework of a land swap, but might also include the evacuation of some to enable more contiguity and future development space for East Jerusalem.

Hence, our working assumption is that a future agreement on Jerusalem will determine which settlements/neighborhoods will become part of Israel and which will be evacuated. Here we deal only with the economics of such an agreement. While we cannot foresee the exact location of the future border, we can foresee two types of economic-geographical issues that such a border will create. One is how to conduct an evacuation of a settlement/neighborhood, if it remains in Palestinian territory. The second is how to build and finance infrastructure adjustment for contiguity, like tunnels, bridges, or circumventing roads. Even if the source of many finances will be the international community or donor countries, we discuss the payments as bilateral, to clarify responsibilities and mechanisms.

We first describe how to transfer settlements/neighborhoods to the jurisdiction of Palestine. The JENT will negotiate and reach a specific economic agreement over each such settlement/neighborhood, which will follow these guidelines:

  1. Structures in the East Jerusalem neighborhoods are mainly apartment buildings suitable for Jerusalem Palestinians. Hence, we strongly recommend to sell them to Palestine and not destroy them. Such destruction would be extremely inefficient.
  2. Palestine will create an administrative body that will handle the allocation and distribution of these assets, with a priority to returning lands to their original owners. This administrative body will cooperate with the JENT.
  3. The JENT will decide the payment by Palestine for the assets, tangible and intangible, that will be left by Israel in an evacuated Jerusalem neighborhood/settlement.
  4. The JENT will negotiate an additional agreement on the past use of land of all Jerusalem settlements/neighborhoods from 1967 to the time of the agreement. This should be payment for the use of land only. It should include even settlements that remain under Israeli control.
  5. The Palestinians will describe, in the most detailed way possible, their plans concerning such evacuated neighborhoods/settlements to contribute to good will on both sides.

Dividing the city also requires building infrastructure to enable mobility between Jerusalem neighborhoods, above, below, or around neighborhoods of the other city. We divide the issue into two, construction and finance:

  1. The JENT should agree on all construction plans. The side that uses the construction should be the initiator and main decision maker, but the other side should be part of the agreement as well, to minimize harm at construction and at operation.
  2. The finance of such projects should be borne by Israel, since the construction of these Jerusalem settlements/neighborhoods has created the need for such investments. To avoid a problem of agency, where Palestine decides on construction for which Israel pays, the JENT should decide on the costs of the projects.
  1. Social Security

All Palestinians who currently have Israeli residency status are compulsorily insured by the National Insurance Institute (NII). According to the 1999 income surveys of the Inter-Commercial Business System (ICBS), East Jerusalem Palestinians received substantial amounts of their net income from the NII, 19 percent of their net income, compared with only 9 percent for residents of West Jerusalem. The Palestinians in East Jerusalem also participate in the Israeli Public Health system by paying the health tax to the NII, which entitles them to receive health services from the Israeli HMOs and hospitals.

We have four basic recommendations in this area:

  1. East Jerusalem Palestinians who have contributed to the NII in the past will continue to receive the benefits they have already earned by their contributions, until death.
  2. The Jerusalem Economic Arbitrator (JEA) will establish a body that will monitor these payments and will ensure that the rights of the recipients are fully respected.
  3. After the agreement, East Jerusalem Palestinians will pay the Palestinian Social Security Institution and will accumulate separate benefits from then on.
  4. To smooth the transition of health insurance from the Israeli to the Palestinian providers, we suggest that during a transition period (5 years) East Jerusalem Palestinians will be able to continue to pay health tax to Israel and receive health services from Israel.
  1. The Current Situation and the Final Status

Finally, we would like to highlight an economic reason why settlement building and other “facts on the ground” make it harder to reach an Israeli-Palestinian agreement, because such activity has an adverse effect on economic development. We strongly believe that economic development in Palestine is crucial to reaching an agreement and sustaining it. People who live in a developing economy and who work hard on improving their standards of living are less willing to indulge in fighting, hatred and hostility. The main barriers to economic development in the Jerusalem region are the separation wall, the expansion of settlements and the light rail. The separation wall closes East Jerusalem from the large Palestinian area and puts obstacles between the north and south parts of the West Bank. The expansion of the settlements east of Jerusalem, especially between Jerusalem and Maale Adumim, further blocks passage between the two parts of the West Bank. This hurts not only the current economic status of Palestinians, but it also reduces their ability to begin large-scale development projects for the future. The light rail also contributes to the expansion of settlements east of Jerusalem by better connecting them to the center of the city. This significantly supports the expansion of these settlements.

  1. Summary

This paper outlines possible economic arrangements that would accompany a final status agreement. We show that economic arrangements for a final status agreement in Jerusalem are possible. Despite the difficulty of reaching such an agreement, it is possible to describe various economic arrangements for almost all possible scenarios. We think that our proposals are feasible, simple and realistic, once an agreement is reached.

The agreement is feasible, but costly, mainly due to the costs of setting the border, evacuating neighborhoods/settlements and building infrastructure. This is a result of the vast Israeli settlement activity in East Jerusalem and around it. These costs are increasing over time as a result of ongoing settlement activity. One conclusion of this analysis is that imposing a settlement freeze in the West Bank in general and in East Jerusalem  specifically is required both politically and economically.

This construction activity also creates obstacles to Palestinian economic development. The physical blocking of Palestinian mobility reduces chances for Palestinian economic re-integration, derails developments of networks, reduces returns to scale, and prevents construction of large–scale development projects. This effect is significant because Jerusalem has always been the social, economic and political center of Palestinian society.

This report ends with a mixed message. Peace in Jerusalem is possible, but time is running out. There is a need to begin negotiations soon, but more  importantly there is a need to stop the building of settlements immediately, as it derails Palestinian economic development, hurts trust between the two sides, and sends a negative signal on the willingness to reach a lasting agreement.

An Outline of the Economic Issues of a Final Status Agreement in Jerusalem