Lapid's Tax Plans Backwards, Says Economist Who Resigned Over It

Former Finance Ministry Chief Economist Michael Sarel says Finance Minister Yair Lapid’s plan to exempt ‘young couples’ from VAT on new homes will cost us all more money.

Ofer Vaknin

When the chief economist at the Finance Ministry quit a month ago, it was a victory for Finance Minister Yair Lapid. Somebody in Lapid’s inner circle told me, “His strategic advisers decided to leverage the hatred people feel for economists, having concluded that a big move against the professional echelon at the ministry is exactly what would work now.”

I figured at best, he might be trying to explain away the embarrassing resignation of the Finance Ministry’s chief economist; at worst, he was describing a Machiavellian mindset, which I found hard to believe. Resigned chief economist Michael Sarel didn’t find it surprising, though.

“There are two possibilities,” Sarel said. “The first is that Lapid really doesn’t understand the damage his plan would cause,” in which case economists are to blame for not explaining it to him clearly. Or Lapid knows full well it’s a bad move but couldn’t withstand the temptation to cut a quick political coupon.” He thinks it’s No. 2.

Lapid certainly does know how to use public sentiment. Nobody did better at leveraging the 2011 social-justice protests, when hundreds of thousands of Israelis took to the streets to protest the cost of living.

Three years later, and a year and three months since Lapid became finance minister, his voters can only despair at his handling of a key source of discontent: housing prices. Lapid did nothing about it during his first year, but scenting the rising discontent and political danger, he moved, suddenly adopting the bizarre plan proposed last year by the housing minister: Abolish value-added tax on new, low-cost housing for certain people.

The entire professional echelon at the Finance Ministry was horrified by the idea, but that seems to have just spurred Lapid on. Two days after Lapid announced his decision, Sarel quit, with an unprecedented open letter to the public explaining why.

Sarel, who was awarded his doctorate from Harvard University at age 31, has always been low-profile in his public jobs. In his letter, he explains why Lapid is wrong. Then he went home and wrote a 10,000-word essay on the problems in the Israeli real estate market and why the VAT plan is a bad one.

Getting it backwards

“Zero VAT on housing is exactly the opposite of what’s needed,” said. “It won’t lower housing prices; it will require complex, costly supervisory mechanisms, and there’s a good chance it will just channel money to the contractors, as well as damage the tax system.”

How did a plan this bad get the blessing of the finance minister and prime minister?

“The first possibility is that despite sweeping opposition to the idea, economists failed at their job. The chief economist at the Finance Ministry [Sarel] failed to explain to the finance minister how bad and wrong the idea is,” Sarel said. The head of the National Economic Council failed to explain the same to the prime minister. The Bank of Israel governor failed to explain it to the housing cabinet. Nor did economists in academia explain that the concept doesn’t serve the greater good of the public. Meanwhile, the builders, initiators and certain social activists applied heavy and very effective pressure on the decision makers, he says.

Sarel thinks a second possibility is much more likely, though. “Apparently, I never had a chance of persuading him. He understood that the policy proposal was bad in substance and would cause great economic and social harm, but he also saw that it sounded good to the public and that at first glance, it seemed right. He couldn’t withstand the temptation and chose style over substance.”

As in many cases of style over substance, the reason is the public’s difficulty in grasping the true cost of the policy move. “That feeling that there’s no real cost is completely wrong, but it’s convenient for the decision makers,” Sarel said. It sounds great, it's easy to explain and a lot of people hope to personally benefit. “Obviously, homes are cheaper without VAT than with VAT. Obviously, Lapid is improving things for the public. People think a tax break, as opposed to a grant, has no cost,” he observes. But it will lead to tax hikes for everyone, or at least to forgoing tax cuts, a decrease in government services or an increase in the national debt, which will be paid by generations to come. Yet the siren song of the immediate gain beckons, while the damage seems far off, unclear, Sarel says.

Lapid figures that people won’t necessarily make the connection between a tax break today and cuts in next year’s budget, Sarel explains.

Anyway, it’s a win-win for the finance minister, he says. “If real estate prices do fall in the next year, the ones who decided on the VAT break can claim the credit … and if they continue to rise, they can explain they tried to do something bold,” he said.

People are using all the wrong terms

During the past several decades, Israeli real estate prices went through three waves of change, Sarel said: The Russian aliyah in the early 1990s created tremendous demand, and then from the start of 1997 to 1998 and from the start of 2008 to the present day, housing prices grew by 66% in real terms. At the start of 2014, housing prices were 23% higher than at the previous peak, in 1997.

Why? Supply grew ever smaller, while demand grew bigger. Sarel think the dominant factor is demand.

While home prices rose 66% in six years, rental prices (“housing services’) increased by just 26% in real terms. If the problem had been entirely on the supply side, if for instance a housing shortage had been created because builders couldn’t keep pace with population growth, rental prices would have increased by the same amount as home prices, Sarel explains. The reality indicates that the problem is on the demand side, and not necessarily demand for housing services, but specifically — to buy a home. To invest in property.

Assuming we buy Sarel’s theory that demand is responsible for inflating housing prices, we need to ask what drove that demand. Sarel has an unconventional answer.

“Usually demand for housing is divided into two segments: people buying a home to live in or investors. The first segment is also divided into two: people buying their first home (young couples) and upgraders. Investors can also be divided into two: those who rent out the apartment and those who keep it empty, which is a small minority,” he said.

These are the terms used in the real estate market, and they come with value judgments: young couples: good; investors: bad, Sarel explains. “But use of these terms doesn’t necessarily reflect economic theory or social reality,” he said. “It leaves out a big group, a fourth one — renters.” And in any case, sometimes “upgraders” actually move to a cheaper home — they’re downgrading, he points out. “So-called young couples are often not couples, or young. Investors may be parents buying for the kids. And if an apartment is bought for a child and registered in the child’s name, even if the parents paid for the whole shebang, it’s considered a “young couples'” apartment.

Loving, penniless ‘young couples’ need not apply

“The very phrase ‘young couples’ begs the image of a penniless pair whose love helps them overcome the brutal materialism of life,” Sarel said. “In practice, a couple like that isn’t even eligible to buy a home because of the equity needed when making the purchase. A couple like that would almost certainly rent, not buy, despite tax breaks. Young couples who buy usually belong to the higher deciles of society.”

In his view, all homebuyers are investors, pure and simple, and the tax on all should be the same. “There’s no economic logic in discriminating against investors versus upgraders or young couples,” he says.

Nor, in principle, should there be different tax treatment for young couples buying a home or ones that rent. But the tax system is drastically skewed in favor of owning property for one’s own use, and against renters, he says. The tax treatment of a financial asset versus a home, and between a rented-out apartment and one the owner lives in, distorts investment decisions, he argues.

All this also hurts labor force mobility and pushes people to invest in property, which doesn’t contribute much to economic growth, he says.

“The tax system as is encourages long-term savings through leveraged investment in property. At the level of the individual, the result is an illiquid investment with high transaction costs and high risk that can’t be diversified,” Sarel said.

Personal property ownership doesn’t bring value to the state relative to things like Zionism, army service, collective shocks such as wars and peace agreements and so on, he says.

If growing demand for housing was a response to discriminatory taxation, why just in recent years? And what caused the dissociation between housing and rental prices?

“Simple: the tax regime changed," Sarel said. "Before 2003, there was no discrimination in favor of homebuyers relative to renters. If anything homebuyers were slightly discriminated against (purchase tax and sometimes betterment tax). The change in tax regime was gradual ... From 2003 to 2013, real tax on capital gains was increased to 25%-27%.”

It was in 2003 that housing prices started to dissociate from rental prices, Sarel says, a gap that would continue widening for 11 years to the present 39%. There were other causative factors such as low interest rates and developments in the labor market, he says, but tax discrimination played a significant role.

Tax breaks on buying property for investment are worth more than 8 billion shekels, Sarel estimates, which is even more than the tax breaks on capital investments and training funds. It’s the biggest tax break around, second only to the break on pension savings, he says.

A perk for the rich

During the Israeli presidential race earlier this month (which was won by Reuven Rivlin), the candidates made personal wealth disclosures, which revealed that some owned quite a bit of property. That in turn led to speculation among the public that some of them have no interest in lowering Israeli property prices.

So who benefits from the climb in Israeli property prices during the last five years?

“Homeowners. Mainly owners of prime apartments. Home ownership isn’t equal, it’s concentrated among the highest earners … the older generation benefits more than the younger generation from the increase in property prices.”

Who benefits from the huge tax break?

“The break, applicable to the purchase of single apartments, is divided unequally, benefiting mainly the higher earners: The topmost decile gets 21% of the total tax break, while the bottommost decile gets 3%.”

I have long argued that property prices are a tremendous machine that transfers wealth from the poor to the rich, from the have-nots to the haves. Sarel is saying that it’s government policy.

“The State of Israel invests a lot in trying to narrow social gaps. Social spending is a heavy consumer of taxes and requires cuts in other government spending that would support economic growth. It’s bizarre that the government gives significant tax breaks that widen inequality and that also neutralize other steps taken to reduce inequality. These breaks also drag on economic growth, since taxes in revenue and consumption (which have to stay high in order to finance the tax break on buying a home) hurt growth more than tax on property would,” Sarel says.

Moreover, while the politicians talk about “investing in the periphery,” property tax policy widens the gap between Israel’s center and the periphery, since the average value of homes in the center is much higher, Sarel explains.

Tax discrimination isn’t the only reason for the wild climb of Israeli home prices. A steep drop in interest rates also played a role. People usually take a mortgage to buy a home, which backs the loan.

Seeing Sarel’s view of taxation in inflating Israeli property prices, it’s easier to understand his concerns about Lapid’s plan. A tax break to one group means that everybody pays higher tax to cover the cost, he explains. A tax break changes the way the tax burden is shared and just leads to more skullduggery.

“Tax breaks aren’t a zero-sum game: Their outcome isn’t a neutral change of priorities in which one group wins and one loses … the main characteristic of many tax breaks is that they grant one group a gain whose aggregate benefit is infinitely lower than the cost imposed on the rest of the public.”

Moreover, Sarel says, the tax breaks distort resource allocation as the well-to-do take advantage of them, which impairs efficiency and productivity. And lobbyists will inevitably press to expand the circle of breaks, further distorting resource allocation, efficiency and productivity. The more the pressure works, the more they will apply.

One thing’s eternal: Tax breaks

Once instated, a tax break is hard to eliminate, Sarel points out. Tax credits on shift work, enacted for one year in 1986, have been extended each year since, and still apply. Even if the consensus is that the tax break isn’t achieving the goal, it could well prove eternal.

That’s especially true of VAT benefits, he claims. Fresh fruit and vegetables aren’t taxed; and the city of Eilat is a VAT-free zone, neither tax break ultimately serves a good purpose or was designed to last into perpetuity.

In short, exempting certain people from VAT on buying a home won’t smooth the warps in the tax system. They’ll just get worse. All the proposal will achieve is to transfer even more wealth from the poor to the rich, from the periphery to the center, from children of poor parents to children that inherit wealth.

“It is ironic that the main justification for the proposed tax benefit is the difficulty young couples have in buying a home because of the increase in housing prices in recent years. But that increase was largely caused by the existing tax breaks,” Sarel said.

Assuming the government has been doing all it can to increase supply, he says, it can’t do more to meet the demand sure to grow after the VAT break is instated. The result will be even more unmet demand, while supply is rigid and already at its peak — and thus housing prices are likely to increase even more, including in the long run.

That said, there are other parameters that affect housing prices — changes in interest rates, the state of the economy and labor market and expectations. For instance, expectations of an upswing in the peace process can send home prices soaring. Or people could conclude that Israeli home prices are already in bubble territory, and simply slam on the brakes. The International Monetary Fund, Sarel points out, has said that Israeli housing prices are 25% above their long-term equilibrium point, based on Israeli macroeconomic data. In other words, the IMF, for one, thinks Israeli housing prices are likely to drop by some 20% sooner or later, if and when they converge on equilibrium. That was six months ago, and since then, prices have just kept climbing.