A Rough Morning After for Israel's Tax Authority

Steep tax hikes on alcohol, beer didn't bring more revenue, just pirating and smuggling. Last week rates were cut and the lesson learned: Excessive tax brings undesirable results.

Yaron Cohen Tzemach

In 2010, the duty-free shops at Ben-Gurion Airport accounted for about 9% of all alcoholic beverages sold in the country measured by bottle, but the airport stores accounted for more than a third of all alcohol sales by revenues.

At the time, the Tax Authority accounted for the discrepancy by noting that duty-free shops focused on the most expensive whiskey and cognac, which can cost hundreds of shekels a bottle. As a practical matter, the duty-free retailers collectively had a monopoly on whiskey sales, with 58% of the market.

It’s no coincidence that the airport duty-free shops cornered the whiskey market. They simply benefited from an overwhelming business advantage that prevented other retailers from competing. Duty-free stores were exempt from the high tax Israel had imposed on alcoholic beverages. The tax was calculated on both the percentage of alcohol in a bottle as well as the price, resulting in rates on the most expensive liquors of 120%.

While those buying a bottle of whiskey in Israel normally had to pay more than double the base price due to the tax, if they could afford an airplane ticket abroad, they could save a lot by buying at the airport (and not even trouble themselves to carry their tipple on the plane because in Israel duty-free purchases can be left at the airport and collected on return). It was no wonder that those who could, would wait till they were on a vacation or business trip.

Before it began its shake-up of the alcohol-tax regime in 2010, government policy acted perversely to lower the cost of the priciest alcohol for those with the wherewithal to shop duty-free, and created unfair competition. It was one of the reasons that taxes on alcohol were overhauled beginning in 2010. Another reason was international pressure to reform a complex tax structure that boosted the price of imported and high-end alcohol but went easy on local producers, mostly of cheap vodka.

Elsewhere around the world, they rightly viewed Israel’s policy as illegally - and also irrationally - protecting local alcohol producers at the expense of the global distillers. Around the world, taxes on alcoholic beverages are based on the alcohol content rather than its price, because tax policy is usually designed to discourage alcohol consumption generally rather than to promote sipping the most expensive brands.

Consumption holds

The tax policies in place at the time in Israel, in fact, failed to reduce consumption because most imbibers, particularly young people, opted for cheap stuff, with 74% of all alcohol in 2010 selling for no more than 40 shekels a bottle (about $10 at current exchange rates). And fully 90% went for no more than 75 shekels a bottle. The tax on cheap bottles was low.

All of this led the Tax Authority and the Knesset to begin taxing liquor based on alcoholic content. By 2014, the tax on a liter of liquor was supposed to quadruple to 80 shekels a liter, close to the average in other developed countries.

As a result, the price of high-end liquor, which accounts for about 10% of sales in Israel, was supposed to go down by a fairly sizable amount while cheap alcohol would go up by a moderate 15 to 20 shekels per bottle.

But the Tax Authority’s plan, put together after lengthy consultations with the World Trade Organization and the Knesset, ran into trouble in 2013. That was a year of severe shortfalls in tax revenues, which the Finance Ministry was looking to close. That happened to have been precisely when the last phase of the alcohol tax reform was due to go into effect, raising the tax on a liter of alcohol to as much as 85 shekels.

The Finance Ministry saw an opportunity and decided to increase the tax to 105 shekels (later adjusted to about 107 shekels). At the same time, the tax on beer (which was not part of the reform plan) was doubled. That gave Israel much higher taxes on alcoholic beverages than other countries.

Now, about two years later, Finance Minister Moshe Kahlon has returned to the original tax plan, reducing the tax to 85 shekels, while the tax on beer was cut to 2.33 shekels from 4.33. The tax cut, expected to deprive government of about 100 million shekels of revenue a year, went into effect just before Rosh Hashana so it could be presented as a benefit to the public, but the real reason for the policy shift is the failure of previous policy.

The two goals that the reform was aiming to achieve – mainly reducing alcohol consumption, but also increasing tax revenues – got lost. Alcohol consumption only declined moderately, and beer consumption actually increased. The increase in tax revenues was a relatively modest 100 million shekels, compared to projections of 250 million.

In retrospect, this was a professional failure caused by the disproportionately large tax hike involved. Clearly taxes are a tool that can be used to affect behavior, so when they are imposed, their effect on the conduct of the population has to be taken into account. One iron-clad rule is that taxes cannot be employed to excess, because then the behavioral response risks being so drastic that it cancels out the intended effect. That’s the mistake made in 2013 in altering the reform plan and raising the tax to an unrealistically steep 105 shekels.

With respect to beer, the whole process was even more problematic since from the beginning, the intent had not been to raise the beer tax, and it only applied to beer with more than 3.8% alcohol. That distinction was also an attempt to protect one brewer, namely Nesher and its low-alcohol beer.

Alcohol for industry

The distorted, excessive tax policy brought about a sharp change in consumer behavior. Beer drinkers shifted to low-alcohol brews, which went from 1% of the market to 10% — even though the risks of drunkenness from 3.8% alcohol beer are not much less than from 5% beers. Among other types of beer, consumption increased. The government had made beer more expensive, without reducing consumption.

When it came to hard liquor, drinkers shifted to high-end products. The airport duty-free shops lost their effective monopoly, but the main goal had been to lower consumption of cheap liquor, and that didn’t happen. What did occur was a strange decrease in tax revenues on alcohol, even though the tax rate had increased sharply. Officials gradually realized that tipplers were buying pirated liquor, including alcohol meant for industrial use, not human consumption. Excessive taxation encouraged pirate alcohol, smuggling and dangerous behavior.

The same questions about excessive taxation apply to cigarettes, where a sharp increase caused consumers to start hand-rolling cigarettes, which are more dangerous than packaged brands. As long as the tax on loose tobacco is not increased, nothing is being accomplished by hiking the cigarette tax. On the other hand, there have been no reports of massive smuggling of cigarettes, so at least compared to the taxes on cigarettes abroad, Israel is meeting the test of reasonableness.

A similar quandary arose this month over a report by the chief economist at the Finance Ministry showing that after the sharp increase in the purchase tax on homes for investment in July, homes being purchased for investment are being titled to the investors’ children. In other words, the investment frenzy the government was trying to deter hasn’t stopped, it is simply being done differently.

Taxation is not an exact science and tax policy has to maintain proportionality and balance. If taxes are increased too steeply, particularly at a time when exemptions continue side by side, or in an industry that is open to smuggling or pirating, it is almost certain to lead to distortions and the pursuit of loopholes.

Last week officials at the Tax Authority acknowledged their mistake and reduced the alcohol tax rate. It’s a lesson in humility that this time was learned.