Taking Stock / Reality Now

"Finance Minister Benjamin Netanyahu plans dramatic changes in the tax system already this year and plans to reduce the maximum tax rate to 35 percent ... the finance minister has decided to implement the economic policy he has preached in recent months, starting with substantial tax cuts this year. The reduction will bring the rates to a maximum 35 percent and will be implemented in two stages - the first at mid-year and the second, more substantial cut, is expected next year." (From an Israeli newspaper - March, 4, 2003)

The preparation of economic policy is always accompanied by leaks to the press, spin, trial balloons, red herrings, china-shop bulls and the rest of the media's farm - but it seems there's never been a wave of reports so completely groundless as the one we have witnessed in the past two weeks on Netanyahu's "tax revolution."

When Netanyahu presented his plan for dramatic reductions in taxes prior to the elections, it could be treated exactly thus: the kind of thing politicians say before elections despite the fact that everyone knows the chances of implementing them are exactly zero.

So, how great the surprise when the wave of reports on the "tax revolution" that would lower Israeli tax rates to 35 percent - only increased after the election. How great the surprise when it became clear that many citizens and various market players actually thought the plan could be executed.

The tax revolution is the biggest bubble inflated here since the elections, but it came along with a few other bubbles like massive privatization already in 2003, slashing Bank of Israel interest rates, and canceling all sorts of tax exemptions, all of which would put tens of billions of shekels into the state coffers.

Before the elections, those bubbles were an unavoidable part of campaigning, but today with the economic situation and the public crisis of confidence in economic policy - they cause great, unnecessary damage to the economy.

The new finance minister, who wants to turn over a new leaf in relations between the public and the government, would do well to quickly come out and tell the public the truth and burst all the economic bubbles inflated here in recent weeks.

l "Marginal tax will drop to 35 percent" - No, there is no chance of reducing marginal tax in Israel to 35 percent in 2003 or in the year after. Despite the fact that everyone clearly understands that tax reduction is necessary and correct economically, current economic conditions do not allow it.

The cost of such a tax reduction is tens of billions of shekels, and the "dream" that slashing taxes would lead to tremendous growth in economic activity that would boost tax revenues has no basis in reality. The only way to implement tax reduction is through a long-term reform of the economy that starts with dramatic reduction in public sector current expenses, moves through structural changes in the competitive structure of the economy and ends in a downward-moving tax range. Ends, not starts.

l "Netanyahu will make a deal with Bank of Israel Governor David Klein that includes interest rate reduction" - There is no chance of seeing any substantial interest rate reduction this year - not even as part of a "package deal". We should remember that we got a "package deal" a year and half ago that almost ended in financial crisis. Since then, the economy has only gotten worse and more vulnerable.

The high interest rate is the only anchor stabilizing the economy today, the primary thing preventing a run on foreign currency assets and rapid devaluation. Lending rates can come down only after the implementation of economic policy centering on deep cuts in government spending, a change in the composition of the state budget and resumption of structural economic reforms.

l "Massive privatization, such as only Bibi can do, that will awaken the economy" - No, the chances of mass privatization of companies this year or next is low and the boost to the economy will be similar. The economic situation and the state of the capital markets will make it very difficult to sell state-owned companies. And worst of all, the sale of the companies that will be relatively easy to sell won't produce any real structural change, so their contribution to growth will be zilch.

The real contribution can come from privatization and structural change in the "tough" companies, but here every government has failed until now because politicians are not willing to clash with the titans.

l "We will raise the deficit target to 4 percent of GDP, cancel a few tax exemptions - and we'll call it economic policy" - In my wildest dreams, the current state budget will bring us by the end of the year to a deficit of 6-7 percent of GDP, compared to the targeted 3 percent. The huge deviation is not only in tax revenues collapsing from month to month, but in huge spending excesses.

The defense establishment has completely ignored the required budget cut and its pace of spending in January and February will lead it to overshooting the budget in the government's 2003 budget book by NIS 6 billion. And that's before the war even starts.

The budgetary measure necessary to prevent unprecedented fiscal collapse is the largest any treasury has ever been forced to implement since the stabilization plan.

l "Treasury officials are presenting Prime Minister Ariel Sharon with a series of ideas and plans to deal with the situation. Netanyahu just has to choose" - No, that is far from the truth. Freedom to manage Israeli macroeconomic policy has never been less. A huge portion of the budget is mortgaged to covering interest and other payments that are difficult to evade. The treasury has almost no space to maneuver. Most of the plans to abolish tax exemptions and presumably create new sources of income, have no base in reality since no one has any idea how much tax can be collected after the revocation.

l "Cutting spending will only worsen the recession and increase unemployment. The deficit must be increased" - No, there is no real option to increase the deficit, we have a free economy and if we let the deficit expand in the general direction of 6 percent - or 5 percent or 7 percent - we risk financial crisis and a series of huge business sector bankruptcies.

Those who claim there is nowhere to cut from should remember the mountain of excess fat in the public sector. With today's publication of the treasury wage director's report that will reveal hundreds and thousands of workers with enormous salaries, we will all have a perfect opportunity to remember that.

l "Netanyahu is the right person to handle the economic crisis" - One can only hope. What Netanyahu can do is still under a question mark. But what is certain is that without complete backing from the prime minister and the rest of the coalition, it is impossible to ratify a single significant economic measure. This time, painful decisions, of the kind that haven't been made by the Israeli political system in many years, must be made.