Why Israel's Government Doesn’t Use Its Arsenal to Reduce Inequality

Could the tax system by itself turn out to be a powerful tool to deal with both growth and inequality?

A homeless person lays on a dirty stone step in Israel.
Olivier Fitoussi

It’s no secret that one of the most prominent problems of Israel’s society and economy has been the growth of inequality, the gap between high-income earners and low-wage earners, which has steadily expanded for three decades.

It is no secret that the reasons for this gap are tied to, among other things, the existence here of three separate economies: the flourishing export and high-tech sectors, in which wages are high and job security is moderate; local, monopolistic services and the public sector, in which wages are medium to high and stability is high; and the poor sector – half of the wage-earning public that earns up to 6,500 shekels ($1,655) a month, in which wage and job security are miserable.

It is no secret that we are a country of immigrants, and there are gaps between people who arrived at different times with a decided advantage for those who came first. It is also no secret that we are a religiously, nationally and ethnically heterogeneous nation, which also has implications for inequality. Nor is it a secret that gender wage gaps also contribute their share.

However, what is less known is the influence of government policy via its tax system on the growth of inequality. The tax system is a powerful tool for managing both growth and inequality. However, this system struggles to multitask. When it stimulates growth it usually increases inequality and vice versa.

Over the last three decades, since the 1985 stabilization plan, the supreme goal has been growth. Inequality is not perceived as a policy goal, and in any event there were never any quantitative measures created to track it. The result is that Israel has become during this period one of the four most unequal countries in the OECD.

Inequality is a tricky matter. When it stands on its own without growth parameters, it can lead to mistaken conclusions. You can find in Israel communities in which equality is relatively high and try to draw inspiration from them. But, that is not recommended because these are usually poor towns. A certain measure of inequality is necessary for economic growth and development. If incentives for ambition, talent, investment or diligence are not given, the economy declines. It may bring equality, but also a host of other problems.

The Finance Ministry published this week a report that analyzes the influence of the government’s tax policies on inequality. This study does not leave room for doubt. Israel’s tax system encourages growth similar to the OECD norm, but encourages equality less than most developed nations. The study’s writers, Assaf Geva, Lev Drucker and Zeev Kril of the treasury’s economic branch, mapped out the types of taxes according to their contribution to inequality and found that there is one tax that hurts both growth and equality – the municipal tax known in Hebrew as arnona. It turns out that the arnona burden in Israel is relatively high compared to other countries.

Taxing the gap

But it’s not only arnona. The researchers analyzed the influence of tax policy on the growth of inequality between 1995 and 2011, and found that the tax system contributes to 65% of that growth. In those same years there was a continuous process of reducing the tax burden in Israel, in contrast to the economic trend in OECD countries.

The analysis of the tax system’s contribution to inequality growth is important for understanding what is being done to close that gap. While the government has no such declared policy, there are steps in this direction, such as increasing the share of ultra-Orthodox men and Arab women in the labor market, raising the minimum wage, instituting a negative income tax bracket and improving the wages and status of contract workers.

However, in contrast there are other decisions that reduce this influence, including raising the value added tax (2% in the last four years and lately reduced by 1%) and increasing arnona (in authorities with weaker socioeconomic strata like Bnei Brak, Betar Ilit and Beit Shemesh, which received approval this week for an exceptional arnona hike).

But if the government was interested in reducing inequality, the tax system could clearly be a powerful policy tool to do so. There is a certain distortion in the structure of the Israeli tax system because the part of indirect taxation is higher than that of direct taxation. The tax share we pay for consumption (e.g., VAT) to state revenues is bigger than the direct tax share we pay – mainly income tax. The opposite is true in the OECD. It’s hard to determine which is preferable, but clearly raising the direct tax burden and lowering consumer taxes will harm growth.

And there’s another matter. The four lowest deciles in Israel don’t even earn enough to pay taxes. The only way to charge them taxes is when they consume. In practice, the only way to collect taxes from tax evaders is also to charge them when they buy something.

High growth, low unemployment

The government’s dilemma in using the tax system derives not only from economic cost-benefit and growth considerations, but also from the ideology that Prime Minister Benjamin Netanyahu has promoted the past decade of reducing the tax burden to encourage growth and the incentive to work. This ideology proved itself in the particularly low unemployment rates and reasonable growth rates (even if they are far from exhausting Israel’s economic growth potential), but its side-effect is substantial gaps.

Israel does not need to completely revamp its tax system in order to lose its leading and dubious status at the top of unequal countries. It perhaps needs a few tax amendments (like eliminating all sorts of exemptions), but what is more important is to take action in the labor market and education system by improving productivity, higher education and vocational training. These, in addition to affirmative action for the weaker groups, will be much more effective in the long run than the tax system.

P.S.

The forces acting in the direction of enormous growth in inequality are Israeli demography, in which natural growth among Arabs and ultra-Orthodox Jews is the highest; higher life expectancy; the high yield of education being biased toward talents and technology in contrast to the low yield of the rest; and the political fragmentation that barely allows a long-term systemic view. They are a major threat to inequality.

The government’s decision last week to divert 10-12 billion shekels to Arab communities and to correct the discriminatory allocation mechanisms is an important step to changing direction regarding inequality. It is not enough by itself. It has to be only the start of closing the gaps. This step must not be used as a whip to obtain results from the Arab population.

When the country did this in past in other instances, like with the fire-fighting authority that did not receive basic funding because it refused to promote reform, it was burned badly. After the government takes care of the weak populations and advances reform in the labor market, it will be possible to take care of a more equal distribution of income through the tax system. That is the correct order.