Dery’s Challenge: Forget VAT, and Focus on Increasing Competition

Reforming markets and busting cartels should be the goal of the new economy minister, if he really wants to lower the cost of living.

Olivier Fitoussi

The incoming economy minister will need to get to know the structure of markets controlled by cartels and how to open them up to competition, as well as the labor market. That’s more important than value added tax.

The 61 Knesset members of the incoming coalition will bring the new government to face the conflict between what needs to be done and what is doable. It’s well known that there is no connection between the necessary and the possible. The shelf life of Israeli cabinet ministers is short, putting them under pressure to do what is possible and to avoid what needs to be done. The result is economic damage in the form of a higher cost of living, lower productivity, inequality and a surrender to powerful interests, and even worse.

There is already a hint of this pattern in the new government, as reflected in the agreement between Prime Minister Benjamin Netanyahu’s LIkud party and Moshe Kahlon’s Kulanu party on the issue of tax benefits for the top 10 percent of pension account holders. The concept involves limiting the

tax benefits on pension savings from a ceiling of four times the average monthly Israeli wage (meaning a ceiling of about 38,000 shekels or $9,800) to a ceiling of twice the average wage or 19,000 shekels.

Purportedly that would hurt the strong, in the process leading to less inequality. In practice, the strong are the ones with defined-budget pensions. These are pensions that are fully funded directly out of government coffers for state employees. The employees also enjoy full job security, which is why they are strong, but their pensions won’t be touched at all by the proposal.

As usual, the government, like all governments, is not prepared to go head-to-head with this group of people (including not only regular state employees, but also staff at the defense establishment). These are people who are well-connected to the Histadrut labor federation, so there is concern that they would strike. In practice, it would have been better to limit the tax benefit on continuing education funds (“kranot hishtalmut” in Hebrew) and not pension savings, since pensions are more important than buying a car, which is what many people do with the continuing education funds since their use is not limited to education. But concern over the Histadrut’s reaction has pushed the idea off the table. There is reason to be concerned that the pattern will be repeated again and again, certainly in a government with such a slim majority such as the incoming one, in which every party can veto anything it wishes.

In general, one could say that the difference between what is possible and what needs to be done is that if it involves a significant and painful fight, it needs to be done. If it is a decree imposed on some reticent group that will swallow the bitter pill in silence, that is what is possible to do. The rule is that it is impossible to make fundamental, significant change that is worth something without confrontation with some kind of pressure group.

The VAT trap

Another rule is that things that can be accomplished quite easily create new problems. Take for example, the initiative of Shas leader Arye Dery,the incoming economy minister, to exempt basic staples from value added tax. Purportedly, that’s an easy decision. You push a button and reduce the purchase price by the 18% tax. It’s hard to see anyone objecting to paying 18% less for anything. But that’s where the distortions begin. First of all, it’s a benefit provided to the entire population, including the very wealthy along with those who are simply economically secure and don’t need the benefit.

Secondly, such a move could cause the black market to grow and in the process do damage to state tax revenues (as happened when fruits and vegetables were exempted from VAT). Third, there’s no such thing as a free meal. If we get a benefit in one place, we will pay for it somewhere else. Differential value added tax rates are the easier and more problematic way to lower the cost of living, but it’s clear that the temptation to do so is great, because it shortens the process. At least, most of the time. In the case of previous Finance Minister Yair Lapid, who insisted on pushing for a VAT exemption to qualifying purchasers of new residential construction, the only thing that was shortened was his political career at the Finance Ministry. He was steadfast in his commitment to the idea, refused the advice of the experts and lost his job. Along the way, he also caused damage to the housing market, which was at a standstill for months on end, resulting in pent up demand that surged into the market upswing in recent months.

The right thing to do is much more complicated. Lowering prices requires real reform to various markets. The ways to accomplish this are well-known and involve increasing supply (of housing), eliminating quotas, opening the market to exports (when it comes to food). It also means breaking up cartels and injecting competition (in the electricity, port and banking sectors), etc. All of these involve a high price for politicians who think in the short term. These steps call for confrontation and tough battles, but anyone who manages to do so wins the public’s favor and most importantly manages to have a significant impact on the economy over time. There were hints that what the outgoing government did in the dairy market could be considered such a success.

The social justice protest of the summer of 2011 targeted the non-competitive food and dairy sectors, as reflected in the protests that focused on lowering the price of cottage cheese. The Israeli dairy market, which is entirely controlled by cartels, is expensive by international standards and even price-controlled dairy products here are costly compared to prices elsewhere. The reason for this is the highly concentrated nature of the dairies. Fully 58% of the dairy market is controlled by one dairy company, Tnuva, and there are only tiny changes in the market share over the years of the country’s big three dairy producers: Tnuva, Strauss and Tara.

The outgoing government (the finance and economy ministries) developed recommendations to gradually open up this market by eliminating some customs duties and opening the market to imports. When it comes to yellow cheese, a duty-free quota constituting 20% of the market was approved, and its has resulted in a drop in prices. When it comes to government-controlled milk prices, which have always been uniform, we are even seeing the Super-Sol supermarket chain selling its new store brand milk for 5.40 shekels ($1.40) per liter, 20% less than the maximum selling

price. Super-Sol is following the lead of its competitor, Rami Levy, which sells Tara milk for an identical price as the Super-Sol milk.Super-Sol is now selling other discounted products under its own brand name, including chocolate milk, sweet cream and yellow cheese. That’s a nice beginning, but it’s not enough to really lower food costs in general.

The chicken cartel

The food sector still suffers from a large series of cartels and barriers to competition. Take, for example, the cost of chicken, which has shot up by 25% over the past two years as a result of a legal cartel under the auspices of the Egg and Poultry Board, which totally controls supply. The

Israeli poultry sector is inefficient and relies on a lot of small producers. The result is high prices, for both chicken and eggs. The dilemma of policy makers is that eliminating the cartel will clearly result in lower prices, but it could do a lot of harm to the chicken farmers’ income, most of whom are in outlying areas of the country.

And then finally, there is the added cost to most of our food caused by the cost of kashrut supervision provided by a kashrut monopoly, a “kosher tax” of sorts on the consumer. But due to a lack of competition, we are also saddled with a “tuna tax” and an “electricity tax” and a “defined budget pension tax.” This is the challenge that this new narrow government has to face.