With No Tax Policy, Israel Improvises

But tax revenues aren't supposed to be Krazy Glue, slapped on to make a pesky problem just go away.

Truth be told, Israel hasn’t had a tax policy for three years. Recent changes in taxation have all been based on makeshift, short-sighted decisions driven by budget constraints, rather than genuine policies, such as encouraging growth or reducing inequality.

This might seem to be to our benefit at the outset of 2014, since the government has decided to rescind the tax hikes declared just eight months ago. But we should be worried, because the lack of tax policy ultimately leads to the tax system being used arbitrarily, and economic and social goals like growth or reducing income disparities are overlooked. Furthermore, using taxes as a band-aid for every budgetary problem can also keep the economy from moving forward and can sidestep the resolution of structural problems, that can't be solved by means of the tax system.

A decade ago, it could have been said there was a clear policy to reduce tax rates on labor, an approach championed by Silvan Shalom and even more so by Benjamin Netanyahu when both served as finance minister. But that's not altogether true, because along with reducing income and corporate tax rates, we also saw a rise in indirect taxation, like excise taxes on gasoline, value-added tax, municipal tax and costs for services such as water and electricity. Over the past three years, though, everything came unglued.

The 2011 cost of living protest gave rise to several hasty moves, like freezing the gradual drop in corporate and income tax rates then raising them again and, this week, the freeze of another hike. On the other hand, we’ve seen the impressively consistent use of VAT as a salve for every budgetary problem. In two strokes, the Finance Ministry raised the VAT rate from 16% to 18%. This might not be the highest rate in the world but, since Israel doesn’t have differential VAT, as commonly seen in many countries, Israel’s effective VAT rate is quite high.

On examining the basic question of who pays taxes in Israel, some interesting answers emerge. When it comes to salaries, people in the lowest four deciles in terms of income clearly don’t reach the tax threshold and therefore barely contribute anything to state revenues, and some even receive tax payments from the government (negative income tax). A report issued last week by the Tax Authority says the same phenomenon occurs with corporate taxes. According to the report, only 51,500 of the 135,000 companies operating in Israel in 2009 paid corporate taxes; 50% to 60% of all corporate tax revenues came from just 500 companies in recent years. The economy’s dependence on income generated by these few companies is immense, obviously a result of the economy being small and concentrated.

Unsurprisingly, tax breaks also go largely to those paying taxes – whether salaried people in the top deciles with exemptions mainly in the areas of pension savings and advanced training funds, or big companies with exemptions and tax benefits through the Encouragement of Capital Investment Law or due to international activities that allow them to enjoy more lenient tax regimes around the world.

Any analysis of income taxes is obviously lacking, since government revenues include many indirect taxes. In recent years, we’ve seen many cases of the government removing its hand from one pocket just to put it in another. The trade-off is generally between direct and indirect taxes. Corporate tax may be reduced but, at the same time, electricity, water, gasoline, and local tax rates are increased. Income tax rates might be reduced, but VAT and gas tax are raised. This means that each and every one of the 84,000 companies that didn’t pay any corporate tax did invariably pay other, indirect, taxes – and their workers paid tax on their earnings.

Among wage earners, the four lowest deciles are commonly viewed as not contributing to overall income tax revenues, but their contribution through indirect taxes is heavy and the burden they shoulder from indirect taxes is enormous. A study by the Knesset Research and Information Center found that the highest burden of VAT and taxes on gasoline and cigarettes in 2009 was carried by the poorest decile, with 44.2% of their income spent on indirect taxes, as opposed to just 11.5% by the wealthiest 10%.

Direct taxes have the opposite effect, with the burden rising as incomes get higher and peaking in the top decile. Indirect taxes, accounting for about half the government’s tax revenues, are considered a more effective way to collect taxes from tax evaders. Even people working under the table and not paying income taxes are forced to pay VAT and municipal tax and gas tax. But saying the lowest four deciles are made up exclusively by tax evaders is a stretch by any imagination.

A concrete and coherent tax policy is needed for several reasons. One is that the tax regime is a critical element in private and business decision-making and long-term planning. Secondly, the tax system is a key policy instrument for issues concerning growth and income distribution. Thirdly, a lack of policy turns the tax system into an haphazard alternative for attacking urgent problems, rather than finding them proper solutions.

This was well illustrated when the Trajtenberg Committee recommended granting benefits to parents with small children, while indicating how this should be paid for – by cutting the defense budget and canceling upcoming tax rate decreases. What we actually got was higher VAT and an increase in the defense budget. In other words the structural, conceptual change wasn’t made, but the easy solution of pulling the VAT trigger was put into immediate effect.

The current Netanyahu government is zigzagging on taxes. In less than a year in office, it has managed to decide to raise taxes and then freeze the raise, while over the horizon the Bank of Israel and the International Monetary Fund are signaling us that taxes will need to be raised again soon. But the central bank and IMF both know that Israel’s low level of spending on social services is problematic and worsens inequality. Therefore, the IMF recommends canceling tax exemptions, which are mainly enjoyed at top income levels, continuing to boost indirect taxes, including VAT, and introducing new taxes, such as on road congestion and pollution. It also recommends using indirect taxes that reduce inequality, such as by raising land value tax.

Before the government decides on new, old, or creative taxes and all that, if should analyze the Israeli tax system and pinpoint its major distortions. Because if it doesn’t, we’ll continue to watch the annoying zigzagging of raising, lowering and freezing taxes without any clue to which way we’re headed.

The problem with the tax system is just one symptom of the lack of clear policy by the current government. Can it be true that the Prime Minister and Finance Minister see eye-to-eye on the economy? While both say they want growth, one talks about “security” from morning till nightfall while the other doesn’t stop invoking “the middle class” from the moment he wakes up until he goes to sleep.

Before dealing with the tax system or harassing citizens by imposing more taxes on behalf of the Bank of Israel and IMF, questions should be asked about what direction is being taken and what the government policy goals are for growth, inequality, and the government’s role in steering towards these goals. In the absence of such a process, economic policy seems like one long, continuing improvisation.

Israel Tax Authority offices in Jerusalem.
Lior Mizrahi