The Knesset today approved the second and third readings of the tax reform, by a majority of 61 to 13, with ten abstentions.
The reform comes into effect on January 1, 2003.
Its clauses include imposing tax on capital gains and inflation-adjusted profits on savings. Israelis will also be liable for tax in Israel on earnings made abroad.
Tax on labor will gradually be reduced, from the start of 2003 to 2008.
"Israel is the only Western country where there is no capital gains tax," Finance Minister Silvan Shalom told reporters. "This will now change and make us a modern country."
Israel will impose a capital gains tax of 15%, while the plan also levies tax on interest earned on savings deposits and brings down income tax rates through 2008. The bill brings the highest tax margin to 49% from 60%.
The government said lowering income taxes will cost NIS 2.5 billion in each of the first two years. Capital gains taxes are expected to bring in NIS 1.5 billion a year meaning the government will have to cover the other NIS 1 billion.
"It's a good sign for the middle class that for the first time we will have taxes on capital gains and a cut in income taxes," Shalom said. "This will help the economy and promote growth."
The tax plan, he said, will be part of the 2003 budget and economic plans that will be sent to parliament next week.
This was the sixth attempt to restructure a system that saddles Israel with one of the highest tax burdens in the world.
Previous tax reform proposals had been killed, partly due to stiff opposition to a capital gains tax.
Shalom rejected arguments that the taxes will discourage investments in the Tel Aviv Stock Exchange. He said when the market was booming, people did not want a tax because it would hurt the market while in bad times it would weigh further.