Karnit Flug: Tax Revenue Must Rise to Ensure State Services

Bank of Israel head warns of shrinking tax base as population ages and Haredi, Arab communities grow.

The state must increase its tax revenues over the coming years in order to provide an effective level of services to the population while reducing the national debt, Bank of Israel Governor Karnit Flug said on Monday. She was addressing a conference on the future of Israeli society that was sponsored by the Central Bureau of Statistics.

The easiest way to increase revenue from taxes is by raising taxes, but that suppresses economic activity and growth, Flug said. Other options include curbing tax exemptions and cracking down on the underground economy.

“The more effective we are in streamlining exemptions and heightening [tax] collections, the more we can increase tax revenues without raising tax rates,” said Flug, who was appointed to head the central bank in November.

Her remarks at the conference placed her on a potential collision course with Prime Minister Benjamin Netanyahu and Finance Minister Yair Lapid. Both men have shown a preference for cutting taxes, as rising tax revenues have eased the state’s fiscal woes.

Flug warned that demographic changes in Israel, including an aging population and the growing proportion of Arabs and ultra-Orthodox Jews, pose challenges to the country’s long-term economic prospects.

Low employment levels for Haredi men and Arab women, in particular, hinder growth, she said. While members of both groups are increasingly joining the workforce, the trend must accelerate, Flug said. Haredim and Arabs account for 10% and 20%, respectively, of Israel’s population of eight million, and both communities are among the fastest-growing in the country.

Meanwhile, the ratio of working-age Israelis to retirement-age Israelis is expected to fall to just 3 in 2050, from 5.5 today. That will necessitate increases to contributions for old-age allowances as well as spending on nursing and medical care and the like just to maintain current payment and service levels, Flug said.

Israel’s per-capita gross domestic product in 2011 was half that of the United States. If the demographic projections hold, in 2060 the gap will be the same but Israel’s ranking among OECD member-states will have fallen four places. Flug said that to increase productivity, the education gap between the Arab and ultra-Orthodox communities on one hand and Israelis as a whole on the other must be closed.

“‘Automatic pilot’ policies will not enable us to narrow that gaps with the developed world,” she said. “But there is cause for optimism about effective and integrated policies that could surely improve our situation in the long run.”

As to the underground economy – Flug cited World Bank estimates according to which off-the-books transactions account for about 20% of Israel’s GDP – the government is taking steps such as changing the definitions of money laundering activities to facilitate the exchange of information between tax authorities and the Anti-Money Laundering Authority, increasing penalties for tax crimes, increasing cooperation and reducing the use of cash and open checks in business.

Poverty is another challenge the government must address, said Flug, citing concerns about increased numbers of working poor. There are large parts of the job market where salaries are too low to ensure a decent standard of living, she said. To address the problem, the government should expand its negative income tax program, which she termed a more effective tool to deal with the problem than allowances because it encourages people to work. But in the long term the solution to poverty is increased spending on education to increase earning power, she said.

Olivier Fitoussi