Bank of Israel Agreed to 1 Percent VAT Cut as Part of Greater Compromise

Treasury had wanted 1.5% cut but it would have cost NIS 5 billion a year; 1% cut will cost NIS 3.4 billion

The 1 percent VAT cut declared yesterday was a compromise, after the Bank of Israel strenuously objected to treasury plans to reduce the tax by 1.5 percent.

Prime Minister Ehud Olmert and Finance Minister Avraham Hirchson yesterday announced the VAT cut, which reduces the tax to 15.5 percent from July 1, 2006.

Originally the treasury had wanted to slash VAT by 1.5 percent in order to round it out to the more convenient figure of 15 percent.

But the difference is not minor: that half-percent is worth NIS 1.5 billion a year to the state treasury.

Cutting VAT by 1 percent costs the state NIS 3.4 billion a year in lost tax revenue. But reducing the tax by 1.5 percent would have cost it NIS 5 billion a year.

Bank of Israel governor Stanley Fischer strongly believes that Israel should use surplus tax collection to reduce the national debt, not to cut taxes further.

At present surplus tax collection (compared with expectations) should run at about NIS 10 billion in 2006. Under the compromise reached between treasury and Bank of Israel officials, NIS 3.4 billion will cover the 1 percent VAT cut and the rest will be used to repay debt.

In general, Fischer argues that there is no need to cut taxes any further, after the tax cuts the treasury instituted in recent years. The government would do better to save its tax cuts for years of slowing growth, as a means to stimulate the economy: there is no need for tax cuts in a boom, the governor says.

At present Israel's national debt is equivalent to about 95 percent of GDP (a change now coming  into force about how GDP is calculated reduced the figure from 100 percent). The average in OECD countries is closer to 70 percent.

Fischer felt satisfied with the compromise, evidently, given that he did not vigorously oppose it during yesterday's meeting between Olmert, Hirchson, himself and treasury officials. Also, the government means to adopt a deficit target of only 2 percent of GDP in 2007, compared with 3 percent this year.