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The 4% fallacy

TheMarker.com Staff

Who will finance the tax reform? Where will the billions of shekels needed to reduce taxation on labor come from?

The Rabinovitch Committee on tax reform found two answers. One is to tax the capital market. The other is based on assumed economic growth averaging 4% a year, starting in 2004.

Thus, when the phased reduction of taxation on labor is completed in 2008, and the cost of the tax reform reaches a peak of NIS 10.4 billion - Israel's economic growth is expected to provide NIS 6.5 billion of this sum. Capital gains taxes is expected to provide the additional NIS 3.9 billion.

A previous tax reform committee headed by former treasury director-general Avi Ben-Bassat, which presented its recommendations two years ago, suggested another major source of financing. Namely, abolishing tax exemptions.

Yet another defunct reform, compiled by the Neeman Committee of 1998, made the same recommendation, but the Rabinovitch panel passed over this option.

According to Meir Kapota, the acting director of the treasury's State Revenues Administration and one of the architects of the Rabinovitch Committee: "We learned lessons from the failure of the two (previous) committees. We realized that a reform cannot be built on abolishing exemptions that the government and Knesset are unlikely to approve."

And what if the projected growth rate fails to materialize, as was the case last year and is again happening this year?

"Adjustments will be made," Kapota says, "through the state budget and/or budget deficit, and/or tax system." That is, the cost of financing the tax reform will become a factor in formulating the state budget each year.

The reform plan is slated to begin in 2003, with the cost of reducing the tax on labor next year assessed at NIS 2.5 billion. This cost will grow in subsequent years as the cost of the tax reduction increases to a sum of NIS 10.4 billion in 2008.

In 2003, the state budget will subsidize some NIS 1 billion of the reform. The additional NIS 1.5 billion required for the reform next year is expected to come from growth and taxes on the capital market. The budget subsidy will be reduced to NIS 500,000 over the next two years, before being eliminated completely in 2005. In subsequent years, economic growth and tax revenues from capital gains are expected to cover the cost of the tax reform.

"During the past 20 years, the tax burden on individuals has grown relative to gross domestic product... This situation cannot continue," Kapota says. Over the years, government spending has grown at a slower rate than that of the GDP. This differential will now be applied to reducing the tax burden.

The Rabinovitch panel knows well that its growth projections are far from sure.

"The level of certainty on this matter is not clear," Kapota says. The changes that have taken place in the economic reality over the past two years demonstrated the difficulty in formulating a finance program based on projections and assumptions about economic developments."