In Israel, Trimming the VAT Is No Way to Go

Benjamin Netanyahu’s proposal to exempt basic food from the tax would ruin a regime that has worked remarkably well.

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Reducing VAT on food is a slippery slope.
Reducing VAT on food is a slippery slope.Credit: Ofer Vaknin

You can say lots of bad things about Prime Minister Benjamin Netanyahu, but it’s impossible to deny that he’s experienced, educated, intelligent and has a broad knowledge of economics. In 2003, Netanyahu was the man who led Israel’s most ambitious economic program since the 1985 stabilization plan that saved the country from financial collapse.

Similarly, it’s impossible to take from Netanyahu his deep acquaintance with the world’s leading economists and their reports — especially those of the OECD. So it’s quite likely that Bibi read the 2013 OECD report on the Israeli economy, which was presented to the prime minister personally last year.

Netanyahu is well-versed in international institutions’ phrasings, so he certainly noticed a key sentence in the OECD report. It was in the chapter on Israel’s value-added-tax system, which the economists called “admirable,” a turn of phrase I don’t remember seeing anywhere in an international report on Israel.

Without a doubt, this formulation suggests that OECD economists are amazed that Israel’s VAT regime is uniform. In other words, Israel imposes only one rate (with the exception of no VAT in Eilat or on fresh fruits and vegetables). Most developed countries make the mistake of differential rates, with the most popular trend to lower it on essentials such as food, schoolbooks, medicine, electricity and water.

VAT exemptions, said the OECD, are usually awarded to promote social goals, but experience shows that this isn’t a valuable tool. Differential VAT almost always creates distortions, complicates the tax system, feeds the bureaucratic machine and increases enforcement costs. It encourages lobbying pressure to add new exemptions, the OECD noted.

Netanyahu speaks during a faction meeting at the Knesset, December 3, 2014.Credit: AP

The report thus praised Israel’s uniform VAT; on average, Israel enjoys higher collection rates than the other OECD countries, even though Israel’s tax rate is higher. The only recommendation the OECD had for Israel about VAT was to end what few exemptions there were.

Moreover, in a prophetic statement, the OECD discussed the possibility of canceling VAT on food products. It said that since many food products in Israel were under price supervision, the question of access to food was being addressed and there was no need to add VAT exemptions on food.

A foolish tradition since 1927

This rare compliment from the OECD to Israel didn’t come out of nowhere. It stemmed from the enormous amount of knowledge the organization has collected about differential VAT, which has existed in developed countries since 1927 — almost 90 years — and is used in most of them. And yes, the experience has been unequivocally negative.

In a 2010 report, the OECD states that VAT exemptions to aid the poor have been a complete failure. VAT, remember, is paid by consumers. Therefore, lowering VAT puts money back into the pockets of both the rich and the poor. Since the rich always consume more than the poor — food too — most of a VAT reduction will accrue to the rich.

Since VAT is a money-spinner — every percentage point means 4 billion shekels ($1 billion) — a VAT reduction means the state is forgoing a key revenue source. But only a very small part of this phenomenon helps the people it was intended for: the poor.

So VAT reductions in order to lower prices for the entire population is a bad policy. As the OECD notes, a VAT discount creates complications in tax collection alongside costs for enforcement and bureaucracy.

In reality, a significant chunk of a VAT discount winds up in the pockets of middlemen and retail chains, and only a small part reduces prices for consumers. In a famous case in France, in which the government tried to draw tourists by granting VAT exemptions for hotels and restaurants, it took less than two years for the price of tourism services to return to the level before the VAT exemption went into effect.

According to a European Union report back in 2003, VAT reduction is very rarely passed on fully to consumers. In practice, the effect is usually temporary and small. All the promises that VAT discounts will lead to lower prices and increased consumption are simply wrong, the EU said. Similar things have been written by the International Monetary Fund.

The main study on the issue in Israel came from the Bank of Israel in 2005. The central bank found that lowering VAT for food products would help the rich — the top two deciles would enjoy 21.5% of the reduction, while the two lowest deciles would enjoy only 18.9%.

In 2013 the Israel Tax Authority found even worse ratios — for every shekel the lowest decile would receive, the top 10% would receive 3.30 shekels. The Tax Authority determined that only half the VAT exemption for food would reach consumers; the rest would benefit retailers.

The report by the Trajtenberg committee on lowering the cost of living, set up after the 2011 social-justice protests, was even more skeptical. It estimated that only 40% of the reduction would reach consumers.

Political suicide

Karnit Flug, the Bank of Israel governor, recently retreated from her objection to a VAT exemption. But like the OECD, Flug told the cabinet that a great advantage of Israel’s VAT system was its near uniformity.

The proposed VAT exemption for certain buyers of new homes would increase the pressure to add on more exemptions, threatening the precious uniform-VAT policy, Flug said. It could require the increasing of other taxes to compensate for the lost revenue.

The problem is that all the reports by the European Union, OECD and International Monetary Fund on differential VAT have fallen on deaf ears in Israel. This is critical because when differential VAT starts, it’s impossible to go back. In Europe, for example, no politicians are willing to call for VAT on food, dairy products or medicine.

Every Western politician knows that such a proposal is political suicide, so Western countries stick with an idiotic policy. This also explains the OECD’s amazing praise for Israel’s VAT regime. Its experts have finally found a country that hasn’t experimented much with differential VAT, so they melted with pleasure.

The only problem is that Netanyahu, who understands all this better than anyone, is threatening to make exactly the same mistake — to reduce VAT on basic food, some of which is already under price controls anyway. It’s impossible to suspect that Netanyahu doesn’t understand how foolish his idea is; he’s proposing it for one of two reasons.

Netanyahu could be trying to divert attention from the failure of his policies to lower food prices so far. Under this thinking, instead of addressing the strangling government bureaucracy and the lack of competition in the food industry, let’s blind everyone with a proposal to reduce VAT on food.

Or Netanyahu is losing control after realizing that his Likud party might not win the March 17 general election. So now he’s pulling a rabbit out of his hat with a populist proposal. The people are invited to choose which version they prefer.

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