Lower Taxes, Higher Growth

State revenue for 2005 will be NIS 5 billion higher than expected, thanks to rapid growth. Should it be used to increase expenditures, or to reduce the budget deficit? Or perhaps it should be used to lower taxes?

When the prime minister's associates talk about economics, they create a sense of confusion: It seems as if economic truth has been pushed aside and replaced by the prime minister's narrow political interests. On the eve of the holidays, they said there is no room to reduce value-added tax and no need to cut the defense budget. Two major mistakes in a single sentence.

State revenue for 2005 will be NIS 5 billion higher than expected, thanks to rapid growth. The question that arises is what should be done with this money. Should it be used to increase expenditures, or to reduce the budget deficit? Or perhaps it should be used to lower taxes?

Increased expenditure is out of the question. It is true that Ehud Olmert raised this possibility when he first assumed the role of acting finance minister, but since then, he has undergone a "reeducation," and now, even he considers this option out of bounds.

The second possibility is to end the year with a lower-than-expected deficit, and thereby reduce Israel's debt burden, which currently stands at 102 percent of gross domestic product. This is indeed a heavy burden, which entails huge outlays of NIS 30 billion a year on interest payments, as well as high interest rates and the constant danger of a financial crisis. But is a low budget deficit the only way to reduce this debt?

Not necessarily. There is also another possibility, which has proven itself over the past two years: lowering taxes. This is an efficient way of encouraging growth, and as a result, reducing the debt as a proportion of GDP. The proper move, therefore, is to reduce VAT by half a percentage point now - the prime minister's associates to the contrary. Lowering taxes also has two other important advantages: It forces the government to reduce expenditures in the long run, and it pulls the rug out from under the predictable demands for increased spending by ministers and MKs.

Reducing VAT also has a social aspect: It is a progressive move, because the poor consume their entire income (as opposed to the rich, who save part of their income), and therefore, benefit more, proportionally speaking, from a reduction in VAT.

The Finance Ministry erred two months ago when it bowed to pressure from Bank of Israel Governor Stanley Fischer and lowered VAT by only half a percentage point. That reduction was too small: It screwed up everyone's accounts, while also allowing merchants to evade lowering prices on inexpensive products. VAT should be set at 16 percent - and it should not be forgotten that even this is too high.

The prime minister's associates also said there is no room to cut the defense budget. This was said against the background of the Bachar Task Force, which is finalizing its recommendations for a war on poverty. The task force will not recommend a "war" that will cost several billion shekels; rather, it will recommend steps that will cost NIS 500 million to NIS 1 billion. This money will be directed mainly at encouraging people to find work by subsidizing day care for working women, subsidizing transportation to and from work, expanding professional training for adults, encouraging ultra-Orthodox men to join the workforce, and setting up plants in Arab towns that will provide jobs for women.

The treasury knows that in addition to this special budget for the war on poverty, it will also be compelled to pay Knesset factions and MKs their traditional pound of flesh in order to obtain a Knesset majority for the 2006 budget. Thus in total, about NIS 1.5 billion needs to be cut from other sections of the 2006 budget - irrespective of the surplus on the revenues side.

Granted, it is possible to choose the easy way out: an across-the-board cut in every ministry. But that would harm education, welfare, health and infrastructure. In other words, it is guaranteed to cause economic and social damage. The correct solution, therefore, is the more difficult one: cutting into the plump sacred cow of the defense budget.

The State Comptroller noted recently that while all the "social" budgets have been cut in recent years, the defense budget has not been touched, despite the significant strategic changes for the better in the region: the collapse of the eastern front and the American presence in the heart of the Arab world.

We must, therefore, take advantage of this strategic opportunity to transfer NIS 1 billion from physical defense to social defense - that is, to the war on poverty.