Analysis

Israel Doesnt Need to Join America in the Tax-cutting Race

Our headline rate will be higher than America's if the U.S. tax cuts are approved, but the companies we need to be concerned about pay much lower rates

Demonstrators protest against government's tax reforms next to the New York Stock Exchange at the Manhattan borough in New York, U.S., December 2, 2017.
EDUARDO MUNOZ/REUTERS

After the U.S. Senate over the weekend approved tax cuts that include lowering the corporate rate to 20% from 35%, Prime Minister Benjamin Netanyahu felt compelled to react to the news a day later. The United States made a decision last night to lower taxes. We cannot lag behind in the relief we are giving our business sector regarding both taxes and reduced regulation and bureaucracy, he told the cabinet.

Netanyahu went on (justifiably) to praise the reforms in Israels business licensing system aimed at making it simpler to open a business.

But pay attention to what the prime minister didnt say. He didnt say that Israel has no choice but to follow in the footsteps of the United States and match the reductions in the U.S. corporate tax with our own, although such an option remains on the table.

Israels corporate income tax is scheduled to go down one percentage point to 23% in January, but it will still be higher than the American rate for the first time in a long time. Does this mean Israel has to join America in a race to the bottom by cutting its rate?

In fact, the race has already begun. Senior officials in the Finance Ministry admit they are examining the tax differential between Israel and the United and weighing policy options. They include cutting the Israeli rate more than the one-point cut now or cutting the rate in the framework of the Law for the Encouragement of Capital Investment.

The third option is to leave the rate where it is on the assumption that between the United States and Israel there is little competition in the realm of taxes.

There is a wide gap between these three options, and already the debate between their respective proponents has spread to verbal abuse.

The Israeli corporate income tax regime is really two regimes. The first is the ordinary corporate rate, which will be going down to 23% next month. It is paid by domestic companies that serve the local market.

The second is a special regime for exporters, which is defined in the Law for the Encouragement of Capital Investment and offers rates as low as 6% (for high-tech companies that register their intellectual property and are located in the countrys outskirts) to 16% (for exporters not in the high-tech sector located in the center of the country).

For companies that make major investments in Israel, that ranges between 5% and 8%.

There are a lot of explanations for why Israel has two tax regimes, but in the end the explanation is simple: Israel learned years ago that its in competition – a race to the bottom in terms of tax rates – to keep its most successful exporters based here.

To keep them in Israel, when most countries are courting them with low-tax offers, Israel had to enter the race, too. The Law for the Encouragement of Capital Investment offers low rates only to companies that have the choice of basing operations overseas.

The corner grocery and Bank Hapoalim, which cant pick up and move to Ireland, have to pay 23%, while global players like Intel and Teva Pharmaceutical Industries pay a lot less.

This tale of two taxes is at the center of the debate in Israel over how to respond to the proposed U.S. tax cuts. For most Israeli companies, the lower U.S. rate offers no alternative, so theres no reason to lower the ordinary rate. But concerning the big exporters, there is a serious debate about how to respond to the U.S. challenge.

At least some treasury officials hold that the gap between the United States 20% rate and Israels top rate for exporters of 16% is too small. Israel wont be sufficiently attractive for U.S. companies to invest here. If so, Israel will have to yet again amend the Law for the Encouragement of Capital Investment.

On the other hand, many officials argue that lowering the rate is a needless sacrifice: The companies Israel cares about are high-tech outfits, and they pay just 12%, eight percentage points less than the proposed U.S. rate. In any case, these officials note, of the 10 biggest companies to receive benefits under the law, only two are American (and one of them, Intel, benefits more from grants than from tax breaks).

Most U.S. companies that invest in Israel invest in local research and development centers and pay little if any tax in Israel.

Adi Brander, who heads that Bank of Israels economics and policy division, told TheMarker last week that the encouragement of investment law was sufficient to protect Israel from competition from America. Thats because companies that do come to Israel dont do it because of the low tax rate but because of the quality of the workforce.

To ensure that the quality remains higher, Israel should be collecting more taxes – not less – to help fund quality schools and universities.