Analysis

Israeli Finance Minister's Choice: Which Taxes Should I Cut?

Moshe Kahlon is determined to act, but all his options are problematic

Finance Minister Moshe Kahlon speaks at a conference, March 30, 2018.
Olivier Fitoussi

The treasury’s report on March tax revenues due out this week will be an important one, as Finance Minister Moshe Kahlon has made clear. That’s because the first-quarter figures will serve as the starting-off point for discussions in the treasury over whether to move forward with another round of tax cuts.

The government has already implemented reductions that have saved tax payers 13 billion shekels ($3.7 billion) a year. The latest cut was in the framework of Kahlon’s “Net Reductions” program in which he eliminated duties on a wide range of consumer products.

But Kahlon has made clear he’s not finished and ahead of Independence Day, April 19, he would like to bestow another tax cut on the voters.

Meetings on tax cuts with senior treasury officials have been set. This week Kahlon is expected to meet with the new head of the Israel Tax Authority to look at how big a cut the government can afford to undertake.

If the positive trend in state revenues that occurred in January-February continued into March, Kahlon won’t face any fiscal obstacle to declaring a tax cut. The budget deficit over the last 12 months through the end of February was just 1.9% of gross domestic product, way below the 2018 budget’s target of 2.9%.

Israel's low tax burden
Taxes % of GDP, 2015 data

Just before the Passover holiday, Kahlon clashed with Karnit Flug, the Bank of Israel governor, over the tax issue. The central bank’s annual report warned against further tax reductions as fiscally risky, but Kahlon claims that Flug has predicted trouble for years and been proven wrong each time.

He contends that lowering taxes gives economic growth a boost.For Kahlon, the choice isn’t whether to cut taxes but which taxes to cut.

The corporate income tax is an obvious candidate after the U.S. approved corporate tax cuts of its own. But Israeli rates are low enough in most cases, certainly for businesses in the export sector or based in Israel’s periphery, to remain competitive with the new American rates.

The only businesses that could benefit from a lower corporate tax are ones that operate in the center of the country and don’t export, like banking and insurance. But those kind of firms can’t pick up and leave Israel, so the government doesn’t have to worry whether its tax rates are competitive globally.

Another option is the personal income tax.But that wouldn’t square with Kahlon’s goal of reducing income inequality because Israel’s lowest income groups already fall under the minimum threshold to pay any tax. Thus, any tax reductions will benefit higher-income earners and widen the gaps.

A third option is lowering taxes on home purchases, but that would encourage buyers and undermine Kahlon’s efforts to rein in soaring home prices. Lowering National Insurance Institute payments isn’t in the offing because the NII already faces a deficit.

So, if Kahlon wants to cut taxes and help the poorest, the obvious candidate is the value-added tax. That’s a tax that falls, relatively speaking, hardest on the lowest income groups.

The catch here is that a significant cut in VAT will be costly. The rule of thumb is that every one percentage point drop in VAT deprives the state of 5 billion shekels in revenue, a figure that would quickly cause the budget deficit to swell.

The last choice seems to be the best. We should expect the finance minister to cut VAT, but by less than one point. Alternatively, he may settle for a tax cut aimed at the middle class.