Analysis / The Time Has Come to Examine Israel's Tax Policy

The top candidate for a reduction is the 18% value-added tax, but others may need to rise.

Ofer Vaknin

The next government, no matter which party leads it, is going to have a full plate of fiscal issues to address. Should it cut taxes, and if so, which ones? Should it raise them, as the Bank of Israel says is necessary? If so, can it be done by ending exemptions, which is politically unpopular? Or can it create the extra money it needs to increase Israel’s low level of government spending by cutting the defense budget?

One thing the next government can look forward to is a relatively comfortable fiscal situation. As the Finance Ministry reported on Tuesday, tax revenues continued to rise over the first two months of 2015, by 2.6% from a year ago to 45.5 billion shekels ($5 billion). That is 600 million shekels more than treasury planners were expecting.

Tax revenue is now growing at a 4% to 5% annual pace, led by a 7% increase in direct taxes like personal and corporate income taxes.

Lacking a 2015 budget, which never won parliamentary approval before the Knesset dispersed for next week’s election, the government is operating according to the framework of the 2014 budget.

It ran a 3.5 billion-shekel deficit in February, which left it with a 12-month trailing deficit of just 2.77% of gross domestic product, the Finance Ministry said.

One easy and obvious place for the government to reduce Israelis’ tax burden is by lowering the 18% value-added tax. VAT was last raised by Yair Lapid when he was finance minister in the last government, to help cover what was then a widening budget deficit.

VAT is an easy tax to raise or lower – it’s been done 15 times since it was first introduced at an 8% rate in 1976 – because it only requires the finance minister to sign an order. Every one percentage point change in the tax adds or subtracts 4.4 billion shekels a year in tax revenues.

Lapid proposed eliminating VAT altogether on new-home purchases for people who qualified. Since then, other candidates, including Prime Minister Benjamin Netanyahu, have spoken about eliminating it for basic food.

Another possibility is to halve the rate to 9% on all foods and medicines. As it is, there is zero VAT on fresh produce.

From the point of view of social policy, VAT is a regressive tax, whose burden falls disproportionately on lower-income groups that spend more of their income than the rich, who can save. Israel is unusually reliant on VAT and other, regressive indirect taxes, compared to other developed economies.

Fifteen years ago, revenues from direct taxes, which are more progressive on the balance, were 1.5 times the revenue from indirect taxes. In recent years, the ratio is 1:1 and in some years indirect taxes actually bring in more.

Although every party that has addressed the issue has said it will not raise taxes, the fact is that Israelis pay relatively little tax compared to their peers in other countries belonging to the Organization for Economic Co-operation and Development.

In the 1980s, Israel’s tax burden was 10 percentage points higher than the average for developed countries. By 2000, it had dropped to 35.3% of GDP, the about average for OECD countries. Since then is has declined to just 30.6%, lower than most of the OECD.

The lower tax burden has come at a cost in the form of smaller government and fewer, poorer-quality government services. In 2013, in the average OECD country, government accounted for 47% of GDP. In Israel it was 40%, putting it at close to the bottom. By many accounts it was the steady decline in government services that drove Israelis onto the streets in the summer of 2011 for the mass social-justice protests.

That figure, in fact, understates how small a role the government plays in Israeli life in terms of spending. That is because Israel has an outsized defense budget and also heavy debt-serving obligations, all of which leaves less money for health, education and welfare. For that reason, the Bank of Israel has been urging the government to raise taxes.

One obvious place the next government could turn to capture more revenue is by eliminating tax exemptions, which if the 2015 budget were in place now would be depriving the government of some 52.6 billion shekels in revenues (including the 2 billion shekels zero-VAT on homes would have lost). The catch has been that closing tax loopholes is politically very unpopular, especially with the powerful labor unions.

Another option is to impose an inheritance tax, like the one that was in force between 1949 and 1981. The last serious effort at reintroducing the levy was in 2000, when Avraham Shochat was finance minister. The new government will likely take up the matter again.