In these days of low interest rates, can you imagine a better investment than one that pays a guaranteed 4% per annum, with no risk? Such a creature exists, if you pay lots of taxes in Israel.
A number of Israeli companies have discovered the secret in the last few years. They pay their income tax in advance – more than they expect the final assessment will be – with the knowledge that if they’ve overpaid, they’ll get the additional payment back, plus 4% interest. You can’t get a return like that anywhere in the fixed income market without taking on risk – only from the government of Israel.
To be sure, there’s a downside: If you underpay your taxes, you’ll be liable for 4% on the difference owed.
Anyone who pays taxes is familiar with this phenomenon, but two things have occurred in recent years to make it more worthwhile than ever to overpay. The first is that the tax rate for corporations fell from 26.5% in 2015 to 23% today. The second is the low interest rates that have prevailed over the last 10 years, making it difficult for investors to find ways of earning more than 1% on fixed income assets.
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Business corporations pay their taxes in advance based on their last audited financial report. For example, in 2017 a company will initially pay based on its 2015 business results, but the final assessment will come later, based on its actual 2017 results. If it paid too much, it will get a refund; too little, and it will owe the balance.
The drop in Israel’s corporate tax rate has left many businesses basing their advance payments on the higher rate of 26.5% while the final assessment is based on the current rate of 23%. The Income Tax Authority ends up pays them a refund, which if often quite hefty.
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Figures from the authority show that last year, refunds totaled 15.5 billion shekels ($4.3 billion at current exchange rates), a 28% increase from the 12.1 billion from the year before. In 2016, refunds amounted to just 10 billion shekels.
The surge has continued into this year. Refunds were up 18% to 8.2 billion in the first five months, compared with the same time period in 2018. If the pace continues, by the end of 2019 the tax authority will have paid out 20 billion shekels in refunds.
The Finance Ministry and Israel Tax Authority hadn’t expected to be paying refunds on that scale when they forecasted what state revenues would look like in 2018. Now they understand what is happening: that the trend isn’t going to let up and the refund factor has to be taken into account when they plan the state budget.
The bigger problem is the wider economy. We live in an era of record low interest rates, or close to it – the Bank of Israel’s is 0.25%, just above the record low 0.1% that prevailed for three years. That has created all kinds of distortions in the economy, whether it’s in the management of pension money, the subsidized rates the government pays on certain bonds or life insurance plans that assume a market rate of 3%.
The fact that the authority continues to pay 4% is another distortion. Early on in the era of near-zero interest rates, officials assumed it was just a passing phenomenon and that there was no reason to tinker with it. As the years went by and they recognized that low rates were the new normal, officials were hesitant to get into a political struggle over lowering it.
It is part of a wider problem of the unacceptable distortions created by the gap between the market rate of interest and the historic rates that the government often pays.
This is evident, for example, in tort claims, on which the government imposes a 3% discount rate – which does not reflect the ability of the insured to achieve the same yield on the free market. Compare this with older pension plans, created before an industry overhaul 20 years ago, that are backed with government bonds and pay a guaranteed 4% annually at the taxpayers’ expense.
What all this shows is that the time has come for the state to rethink the kinds of interest rates it pays out. There’s no sign that the current interest rate environment will be fundamentally changed in the foreseeable future. It’s time to get real.