Israel’s Cost of Living Is High, but the Middle Class Can’t Blame Taxes

Are Israel’s tax policies just? While the wealthy and middle class have nothing to complain about, it's the poor who are hit disproportionately hard.

Tali Meyer

In line with the character of public discussion since the 2011 social-justice protests, the Israeli media greeted the new year with stories about people who have left the country – how happy they are with the decision, lauding the quality of life in their new homelands and their enhanced buying power.

It’s reasonable to assume that the stories are accurate. The cost of living in several respects – mainly housing and food – is shockingly high here. Nevertheless, those emigrants aren’t looking at the whole picture, particularly cases where costs aren’t any higher than in Western countries. One of those is the tax burden.

Taxes in Israel are relatively low. The total tax burden, according to the latest Bank of Israel annual report, comes to 30.4% of gross domestic product, compared with an average of 34.7% for countries belonging to the Organization for Economic Co-operation and Development. Israelis’ tax burden is about 12% lower than their peers in the West.

Still, there is a problem. While the average is low, Israel’s tax burden is the product of two extreme components: direct taxes – namely income, corporate and capital gains taxes – which are among the lowest in the world; and indirect taxes, mainly value-added tax, which is among the world’s highest.

The ratio between these two extremes is among the highest among the world’s developed economies, with the exception of South Korea. That ratio, in turn, brings us back to the question of the cost of living in Israel and the extent to which living in Israel is insufferably expensive.

Low rates of income tax are good for those who work, and serve as a major incentive for people to enter the labor force. In a country that has a large component of the population that voluntarily chooses not to work – ultra-Orthodox Jews – a low income tax rate acts as an important driver for the national policy of encouraging them to find jobs and boost output.

All other things being equal, a policy of low income tax rates would normally benefit people at the high reaches of the income ladder. In Israel, though, that’s not the case. The strategy of lowering income tax rates, which began in 2003 when Benjamin Netanyahu was finance minister, benefited mainly the middle class.

After the end of a decade of income tax cuts, the top rate remains pretty much at the level it was before 2003, while rates of middle-income brackets remain relatively generous. The result was that ordinary families benefited as much as the rich from the tax-cut policy. Israeli income tax policy is remarkably progressive on that account – the top fifth of all income-earners pay 60% of all the taxes.

From an income tax perspective, Israelis have every reason to celebrate. Not only that, corporate income tax and capital gains tax rates in Israel, which impact the rich for the most part, are relatively high. The bottom line is that, measured by direct taxes, Israel has a remarkably progressive system.

But the 18% value-added tax – one with virtually no exemptions – is another story. VAT is extraordinarily regressive: The poorest fifth of the population spend 23% of their income on VAT, while the top fifth spent just 8%. The middle class also hands over more of its income to VAT than the rich.

VAT is not just a source of income inequality, it a major factor is increasing the cost of living in Israel. Its advantage, from the point of view of the Finance Ministry, is that it generates a lot of tax revenues for the government and is especially hard on those who aren’t working for a living.

Moreover, the dual policy the government has practiced since 2003, of low income tax and high value-added tax, is part and parcel of its drive to increase participation in the workforce, which is a critical factor in increasing the standard of living for the country.

What it actually produces when you plot out the tax burden by income levels is a smiley graph. At the far left of the graph – occupied by the lowest income groups – and on the extreme right – where the richest sit – the tax burden reaches 30%, including direct and indirect taxes. That is, 30% of their income goes to paying taxes of one sort or another. In the middle of the graph, the burden is about 25%.

In other words, it’s the middle class that has benefited from the Netanyahu policy. Justice and fairness say that the wealthiest should pay more tax, but it is hard to reason why Israel’s poorest are also paying high rates of tax.

Are Israel’s tax policies just? For the middle class, they are; as they are for the wealthiest, who account for about half of all the combined direct and indirect tax revenues. But for the poor, not at all.

Not only that, Israel’s government gives its poorest a paltry package of social welfare services, certainly relative to other Western countries. Even the aid it gives to the working poor, in the form of negative income tax rates or incentives to hold a job, is small – among other reasons because of the Knesset’s stubborn refusal to renew the Wisconsin plan, an employment program that had been designed to accomplish that but was dropped in 2010.

The middle class’s problem isn’t taxes, it’s the presence of monopolies – both the ones controlled by the government in land, water and electricity, and in the private sector, such as food. But unlike the tax burden, the state has yet to address this problem with anything like the gusto required.

Eyal Toueg