Enterprises and institutions do not collapse as a result of one dramatic decision, but from a series of small, mistaken decisions over a long period. It looks as though Israel's fiscal policy is following this pattern. Let's remind ourselves of a few basic facts of the situation. First of all, the process of producing revenue involves three factors of production: financial capital; human capital; and social capital, which is made up of the supply of goods and services and the quality of Israeli society. Secondly, the Ministry of Finance and the Tax Authority seem to be focused of nurturing financial capital. In a long series of wrong decisions, they have neglected our human capital, and badly damaged it. Thirdly, cuts in government spending have inflicted continuing damage on our social capital: on our welfare system, on education, and on law enforcement. As a result, economic growth has not been optimal.
The decision to continue cutting rates of direct taxation: income tax on capital, capital gains tax, and companies tax, and to raise indirect taxation and tax on work, is mistaken from the point of view of both economic efficiency and social values. The rates of income tax on capital and capital gains tax (20%) and companies tax (25%, and planned to fall), together with far reaching benefits under the Law for the Encouragement of Capital Investment, are among the lowest in the Western world. On the other hand, tax rates on work reach as high as 57%, if health and national insurance payments, that are imposed only in this kind of income, are taken into account. The reasons for the low rates of tax on capital are twofold: blind faith in engaging in global tax competition as a means of attracting foreign capital to Israel; and the view that lowering taxes always leads to economic growth. Both assumptions are false.
Tax competition has brought several nations to the brink of bankruptcy. Ireland, which aggressively led this trend, reached social and economic collapse even before the global financial crisis. Many wise people termed this competition "a race to the bottom" that would lead to the end of the welfare state. Israel's government paid no heed, and sprinted to the bottom with incomprehensible zeal. Poverty rates and social gaps in Israel are among the highest in the Western world. In addition, the encouragement of financial capital alongside neglect of, and actual damage to, human capital, has led to a brain drain from Israel of extraordinary dimensions, and to a fraying of social solidarity and individual morale.
As to the connection between tax reduction and economic growth: all taxation hits welfare. If the tax does not finance the provision of public goods and services that deliver benefits that outweigh the harm caused by the tax, the tax is inefficient, and may be unconstitutional. An efficient and wise administration is capable of meeting this challenge; a bad administration fails, and harms the aggregate welfare of the population. Contrary to the claims of the present administration in Israel, there is no theoretical or empirical finding that supports the argument that any tax reduction must necessarily lead to economic growth. There are empirical data showing that in certain countries, the US for example, growth rates were actually higher when tax rates were also high.
One possible explanation for this lies in a Keynesian approach: a tax reduction only partially raises aggregate demand. It does increase available income, but since the average propensity to consume is less than 100%, the rise in demand is less than 100% of the tax reduction. On the other hand, raising taxation and using it wisely for government investment in infrastructure and social and human capital will increase aggregate demand by 100% of the tax collected. In certain conditions, the taxation expands product by expanding the quantity of public goods and services. The existence of these conditions depends on the degree of the government's efficiency in delivering services, and on the balance between social arrangements and the functioning of the private sector.
The low tax burden on capital, and continuation of the awarding of benefits to capital investment at levels beyond the Western norm, will eventually lead to even more severe damage to the welfare system, education, and law enforcement. Such a situation is unsustainable in the medium and long term. Were the present administration not committed to the rhetoric of reducing direct taxation, it would presumably stop the wasteful and inefficient tax benefits, and raise the companies tax. Instead of this, the government is signaling that it is about to choose a different path: raising indirect taxation.
In the nature of things, low direct taxation on income from capital and capital gains, and breaks for high income earners, benefit only those with capital. Raising indirect taxation and taxation on earnings from work hits the middle and lower classes. The introduction of negative income tax in its current format, despite the misleading advertisements, fails to negate even part of the damage. Rates of poverty and social gaps will continue to grow. In my estimation, the government will be compelled to change its policy, and it will do so, but at too heavy a social and economic price. The behavior of our present policy makers is reminiscent of the horse breeder who decided to train his best horse to go without food. The training almost succeeded, except that, unfortunately, the horse keeled over and died just before it was complete.
Professor Yoseph Edrey is an expert on fiscal policy, a professor of law at the University of Haifa, and a senior consultant at the firm of Ori Calif & Co., which specializes in tax law and international taxation.
Published by Globes [online], Israel business news - www.globes-online.com - on July 6, 2011
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