The Taxing Question Israeli Voters Must Ask: More Growth or More Equality?

With an emphasis on direct over indirect taxes, Israel’s policy over the last decade has heavily favored growth over equality. The upcoming election is an ideal chance for voters to decide if that’s what they want.

Meirav Arlosoroff
Meirav Arlosoroff
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Israelis pay less direct taxes than in most OECD countries, but far more in consumption taxes such as VAT on a car purchase.Credit: Bloomberg
Meirav Arlosoroff
Meirav Arlosoroff

The befuddled voter who doesn’t understand why Israel’s 33rd government was dissolved and why elections are around the corner, or how to tell one party from another, or whom to vote for, can – and should – read the brief report published last week by the Organisation for Economic Co-operation and Development (OECD). It’s a summary of the taxation map in developed countries, and Israel has a respectable place because of its highly unusual taxation policy.

Israel stands out in the survey for three reasons.

First, it is cited as the record-holder in reducing the tax burden among developed countries from 2007 to the end of 2013. During that time, in most developed countries the tax burden as a percentage of GDP remained more or less unchanged, while in Israel it sank by 4% – from an average of 34.7% to 30.5%.

Second, Israel’s tax burden is about four percentage points lower than the average for developed countries, which puts Israel in the bottom third in terms of the tax it collects from its citizens.

Third, our tax structure is also unusual. We collect very little income tax and quite a lot of consumption tax. Income tax, corporate tax, capital gains tax and payments to the National Insurance Institute make up only 48% of our tax revenue, compared with 60% in other developed countries.

But our indirect taxes – those that tax consumption, such as value-added, purchase and real estate taxes – bring in 52% of our tax revenue, compared with only 40% in the other developed countries.

In this context, we should note a fourth point where Israel stands out: The huge effectiveness of our value-added tax, which is 16% more effective than in other countries, because there are virtually no exemptions and the rate is the same on all goods and services.

Is it wise?

As elections for the new Knesset approach, Israel’s taxation policy – which is the heart of its economic policy – should stand also at the center of the political debate. We should be asking whether the current policy is wise.

The sharp decrease in the tax burden since 2007 is the outcome of an aggressive tax-reduction policy by the Ariel Sharon government, in which Benjamin Netanyahu served as finance minister from 2003. The reduction in the tax burden came after 2007 but, practically speaking, it was the result of those decisions made in 2003.

Quite a few amendments have been made to the tax-reduction policy since the global economic crisis of 2008: the top personal income tax rate rose, as did corporate income tax and, of course, VAT.

Still, Israel’s income-tax burden is very low thanks to the spacing of the tax brackets in 2003 – and the burden of direct taxes imposed on lower income groups and the middle class is unequivocally among the world’s lowest.

For this reason, the Israeli income tax regime is regarded as one of the most progressive in the world. The top tax rate [50%] is high in comparison with the rest of the world, and cannot be raised much more. Thus, anyone who calls for raising income taxes is really calling to increase the tax burden on the middle classes.

There is no need to elaborate on this policy’s advantages when it comes to lowering the cost of living in Israel and encouraging people to join the labor market. But its disadvantages are also obvious. Lower taxes mean fewer government services.

The crowds that took to the streets in the summer of 2011, demanding free preschool education, got what they wanted. But let’s not forget that free education isn’t really free. It costs money, lots of it, which comes from Israeli taxpayers. The more services the government is asked to provide for its citizens, the more taxes it will have to collect.

The reverse is also true: The more the citizens agree to give up government services, the more the government will be able to stay out of their pockets. The policy of lower taxes and fewer services increases people’s disposable income.

Since 2003, the disposable income of Israel’s middle class has risen by about 15%, which in turn encourages people to seek employment and contribute to the growth of the economy. Economists are divided as to how much low taxes really stimulate growth (the effect seems to be variable and influenced by the level of average tax). But this policy could definitely have positive effects on growth.

However, this policy has another, very high, price in the form of increased inequality. In a welfare state, government services are allocated progressively – more to the poor, who also pay fewer taxes or none at all, and less for the middle class and the wealthy, who do. So a policy of easing the tax burden on the middle class comes at the expense of the weaker segments of society, who, subsequently, receive fewer government services. The increased inequality over the long term risks slowing economic growth and financial stability.

Bigger impact

So which has the bigger impact – faster growth due to lower taxes, or compromised growth due to an increase in inequality? It is hard to know.

A parenthetical note: While the wealthy in Israel pay high taxes, the government compensates them with benefits such as exemptions from inheritance tax and low taxes on certain savings, including an exemption on advanced-study funds (kranot hishtalmut) and pension savings.

These exemptions are unnecessary, and the time has come to do away with them.

Israel’s tax policy is unilateral and unequivocal when it comes to the size of the pie as well: yes to growth and employment; no to more equal income distribution. The choice to reduce taxes to the minimum on labor, and to keep investment tax rates at a similar level to the rest of the world while imposing steep consumption taxes, also lightens the tax burden on those who work, and increases it on those who don’t. This pincer move has levied an enormous penalty on Israel’s poor – mostly on the nonworking poor – since it began 11 years ago.

The huge increase in the percentage of the working-age population holding a job or actively seeking one has stemmed, in large part, from that tax policy. But this choice exacts another cost, apart from inequality. It increases the cost of living because of high taxes on, for instance, cars.

Let’s bear in mind that the OECD strongly recommends that developed countries adopt tax policies similar to Israel’s. But we should be concerned that Israel has gone too far. In any case, it is clear that Israel’s tax policy over the past decade has favored employment and growth over income distribution and reducing inequality. It is also clear that while this policy succeeded in meeting its goals, stimulating growth and employment did very little to reduce inequality.

It is also clear that this policy is a matter of choice. It is proper in the election season that voters focus on that choice.