Prime Minister Benjamin Netanyahu and Defence Minister Moshe Yaalon have asked the head of the Israeli military administration in the occupied West Bank, General Yoav Mordechai, to draw up a range of options, the Haaretz newspaper reported.
The move came despite appeals from Israel's US ally for politicians on both sides to demonstrate leadership and refrain from "unhelpful" tit-for-tat moves that further jeopardise the teetering peace process.
Israel says the Palestinians' application on Tuesday to adhere to 15 international treaties violated the undertakings they gave when the peace talks resumed last July.
Haaretz said the options under consideration included withholding tax revenues levied by Israel on behalf of the Palestinian Authority.
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Israel briefly imposed the same financially crippling measure in December 2012 to punish the Palestinians' successful drive for observer state status at the United Nations, over its own strong opposition and that of the US.
Other options under consideration include tightening the restrictions imposed on Palestinian activities in the more than 60 per cent of the West Bank which is under the sole control of the Israeli army, Haaretz said.