The Real Source of Israel's Economic Woes

Azure has an astounding article on the massive impact of taxes on the Israeli public and the extent that this is the underlying problem in their economic stagnation.

Most economists and public figures have pinned the blame on the collapse of the world high-tech market, as well as the downturn in tourism and foreign investment since the outbreak of war with the Palestinian Authority in September 2000. Although these factors account for part of the economic malaise, they are far from explaining how these setbacks have succeeded in bringing Israel to the brink of financial ruin; and they are even less helpful in pointing towards a solution. To get to the heart of the matter, one has to look at a more systemic, long-term problem: The reckless spending and taxation policies of successive Israeli governments, which have relentlessly choked off economic initiative.

Last year, government spending in Israel constituted 55 percent of the country's economic activity. This puts Israel three percentage points ahead of Sweden for the dubious distinction of having the largest public sector in the industrial world. And tempting as it is to blame excessive spending on the threats Israel faces, defense expenditures account for only one-fifth of its annual budget of $56 billion. The real problem lies with social benefits, transfer payments, and the bloated government payroll, which together comprise more than half the budget. In other words, even if it were possible to lower Israel's defense spending to the level of a typical European country (3 percent of GDP, instead of 10 percent), the Jewish state would still rank with Sweden, Denmark, and France as a world leader in budgetary profligacy.

Though Israelis have been slow to acknowledge this long-festering problem, the current crisis has led to a growing awareness of it, especially since the appointment of Finance Minister Benjamin Netanyahu, who has made deep budget cuts the centerpiece of his ministry's emergency recovery plan. "The problem," he explained at a March press conference unveiling the plan, is that "the public sector… which does not create money and only consumes it… constitutes 55 percent of economic activity, while the productive sector constitutes only 45 percent."

Spending AND high taxes are crushing Israel.

Indeed, it might well be that the greatest problem facing Israel's economy is not the size of its government, but the tax burden needed to fund it. It is here that Israelis at every level—workers, employers, and investors—face a grueling string of disincentives. Consequently, a systematic effort to reduce taxes is essential if Israel is to find a path to stable growth.

The tax burden is sky-high.

Just how high are the taxes Israelis face? In the two areas that wreak the greatest havoc in the life and work of the individual—taxes on labor and purchase taxes on goods and services—Israeli rates are among the highest in the world.

A family of four who earns $13K is in a 38 percent marginal bracket. At $28K, 55 percent. At $50K, 60 percent. But that's not all you get.

These figures, however, tell only part of the story, as Israelis are confronted with a battery of additional taxes that sharply diminish the purchasing power of whatever is left of their earnings. Most burdensome among them is an 18-percent value-added tax (VAT) levied on virtually all goods and services, including staples like bread and milk. This means, for example, that a middle-class worker earning less than $30,000, who is already in the 55-percent tax bracket, loses another one-sixth of his net salary the moment he needs to buy something with it.

Yet VAT is only part of the problem, as many items considered essential in the industrialized world face punitive taxes and customs duties in Israel. Suppose that the middle-class worker from our example above decides to take a second, part-time job in order to earn enough to buy a car. Were he living in the United States, he could purchase a modest vehicle such as a Honda Civic for about $13,500, including taxes; and if he were taxed at American rates, he would need an additional salary of $20,000—no small feat, but feasible over a period of a year or two. In Israel, however, due to customs duties of 110 percent and VAT of 18 percent, the same car costs $25,400. To retain that much income after taxes, the Israeli would have to earn an additional $56,400—nearly three times more than his American counterpart would need.

But the tax burden faced by the Israeli car owner does not end once he has finished paying for his new vehicle. Since the sticker price is nearly twice what it is in the United States, car insurance in Israel is also far more expensive, costing about $1,600 annually for the Honda Civic. Gasoline is taxed even more aggressively; today, the price for a gallon of unleaded gas in America is around $1.80, while in Israel, due to a purchase tax of 190 percent (plus the omnipresent VAT), the same gallon costs $3.90. Thus, if the Honda owner were to drive 10,000 miles a year, gas alone would cost about $1,000 more than an American driver would pay. To add insult to injury, the Israeli even has to pay an annual tax of $25 on his car radio to help cover the costs of the deficit-ridden government broadcasting network.

Israel is even worse than the typical socialist offenders in Europe.

According to a study by Adi Brender of the Bank of Israel's Research Division, such a worker in Israel paid a marginal tax rate of 40 percent in 2002—a full 26 percentage points more than was paid by his counterpart in Germany, 14 points more than in France, 10 points more than in Norway, and 7 points more than in Sweden. Similarly, an Israeli whose income is twice the national average is taxed at 55 percent, a rate exceeded only by two Western countries, Denmark and Belgium.

But even this analysis downplays the degree to which the Israeli tax burden is high. For starters, taxation in the leading welfare states of Europe includes substantial set-asides for pensions, whereas Israeli workers have to fund their own pensions. Taxes in many European countries also fund crucial services for which Israelis must pay extra: In Sweden, for example, education is free of charge, whereas Israeli parents have to pay for school supplies, books, field trips, and "supplemental" classes for their elementary, middle, and high school-age children. Swedish university studies are likewise covered by the government, whereas college-bound Israelis have to foot the bill for tuition, room, and board.

The article goes on to discuss the economic and ethical disincentives caused by the tax system.

The devastation caused by Israel's tax burden plays itself out in a long string of disincentives that quash economic activity at every turn. High taxes on labor undermine the individual's incentive to work harder, while discouraging employers—who typically must give the government one dollar for every dollar they add to the net income of an employee—from promoting workers or hiring new ones. These same taxes also stifle capital development, since they leave Israelis with little disposable income to save or invest. And, by raising the expenses of companies both for labor and for the procurement of goods and services, high taxes are a formidable obstacle to Israel's competitiveness internationally.

All this is bad enough, but it may not be the worst of it. High taxes dramatically increase the incentive to cheat, as anyone who has ridden in Israeli taxis quickly discovers. The reason the meter is typically "broken" is that cab drivers prefer not to run it, as it produces an official record that will be used for calculating income tax and VAT payments. In the same way, Israeli teachers often supplement their income by teaching private lessons after school hours, for which parents pay with personal checks on which the payee line is left blank. Virtually the entire industry of home additions and repairs likewise operates on a cash basis, which entails the creation of "unofficial" receipts given to the customer, but not to tax authorities. The prevalence of illegal economic activity, driven in large part by exorbitant tax rates, turns hundreds of thousands of otherwise law-abiding citizens—most of whom unhesitatingly leave their families to serve their country in army reserve duty—into tax cheats, accustomed to duplicity in their economic transactions.

But perhaps the worst result is that Jews from Western countries are deterred from moving to Israel, while many Israelis—including some of the country's most skilled workers and entrepreneurs—are driven to emigrate.

...Instead of encouraging Jews to come to Israel and take part in the ongoing effort to build a Jewish state, the current tax regime creates every possible incentive for Israelis to leave. As such, it is nothing less than a threat to the success of the Zionist enterprise.

At least the article goes on to mention that Israel certainly can pull itself out of this morass by following the tried-and-true methods of Thatcher, Reagan, and New Zealand.