Legally, they could've done as I suggested. There are two reasons why they didn't. Both are political:
1. Israel simply could not absorb millions of new Palestinians into her borders -- especially as they exhibit an unregenerate lust for Israeli blood. This problem did not confront us in the Southwest. The country was thinly populated and the once-Mexicans stayed, and adjusted peacefully.
2. Thus, in order to successfully annex the West Bank, Israel would have been confronted with conducting mass deportations. "World opinion" would not have cottoned to this. And, inasmuch as Israel owed its creation to the UN, who had voted it into existence only 19 years prior, they chose not to swim upstream against the resultant international condemnation.
Ergo, Israel agreed to "occupy", as opposed to "annex", in search of good PR. You can argue they would be more secure today had they chosen to take a PR hickey thirty-or-so years ago.