Budget deficits, elections, lack of economic freedom

A little over a year ago I predicted that the Trajtenberg Committee recommendations that were about to be enacted would stifle economic growth and lead to lower tax revenue. As a reminder, the Bill to Change the Tax Burden was implemented starting from January 12, with corporate, capital-gains and dividends tax rates increased. This was supposed to help generate more revenues and would offset the cost of Trajtenberg’s recommendations.

I received many emails from irate readers saying that I should “stop defending the rich,” and that “the government needs to give more to the middle class.” Well, the jury is in, and it looks like I may have been correct.

This week the Finance Ministry released a report on the much-larger-than-expected budget deficit, and it has made for good political fodder. Opponents of the prime minister have used the report to bash his economic policies, some even calling for more government spending, others calling for more middle-class relief and, of course, some calling for higher taxes.

If one actually takes the time to read the report, available on the Finance Ministry’s website, you will find out some fascinating data. It’s not that out-of-control spending was the culprit. The ministry’s budget makers actually did a heck of a job predicting spending. They were only NIS 2 billion short of estimates, and with expenditures of NIS 285b., that’s pretty impressive.

So what’s the culprit of the larger-than-expected budget? Shortfall in expected revenues.

Here is where someone at the ministry needs to fall on his sword and resign.

The utter irresponsibility in the revenue forecast borders on the scandalous. The fact is that tax revenues increased 3.4 percent in 2012 over the previous year. That’s pretty much equal to Israel’s GDP growth for the same period. The problem is that the Finance Ministry forecasted tax revenues that were supposed to be significantly higher.

According to their forecast, tax revenues should have increased by more than 8%.

Why was that so preposterous? Because in better economic years like 2010 and 2011 tax revenues increased by 6.5% and 4.3%, respectively, commensurate with GDP growth. No one in their right mind would have forecasted that the Israeli economy would grow by 8% in 2012. So what the heck were the Finance Ministry officials doing? I don’t like saying I told you so, but I told you so. If you look at the tax haul from those areas that had tax increases, you will see that the tax increases had an opposite effect: lower or steady revenues. Capitalgains tax revenue dropped by a staggering 30% over 2011 as foreigners bailed out from the Tel Aviv Stock Exchange, and smart investors booked their gains at the end of 2011 to pay the lower rate. Corporate tax revenues were flat, even as the economy grew over 3%. A note to all politicians considering raising taxes: No society has ever been taxed into prosperity.

In a ground-breaking paper published by the Adam Smith Institute titled “The Effect of Capital Gains Tax Rises on Revenues,” more than 50 years of data was collected, and it showed that increases in capital-gains tax rates actually lowered the revenues that governments took in. When will decision makers ever learn? In this election season how many times do we hear how a certain parliamentarian wrote this law, or a various party gave some goody to a certain constituency. Is this helpful for the economy? The answer is no.

What needs to be done to lower the deficit is to unshackle the economy and let it grow. Encourage investment, and incentivize job creators. This is the only way.

Required reading
I want to remind readers of something else I wrote last year. Before any more damage is done, I urge the local policy makers to read former Florida governor Jeb Bush’s defense of capitalism in a Wall Street Journal editorial titled “Capitalism and the Right to Rise.” In lamenting the current state of economic freedoms he says: “But when it comes to economic freedom, we are less forgiving of the cycles of growth and loss, of trial and error, and of failure and success that are part of the realities of the marketplace and life itself. Increasingly, we have let our elected officials abridge our own economic freedoms through the annual passage of thousands of laws and their associated regulations. We see human tragedy and we demand a regulation to prevent it. We see a criminal fraud and we demand more laws. We see an industry dying and we demand it be saved. Each time, we demand “Do something... anything.”

He continues: “We either can go down the road we are on, a road where the individual is allowed to succeed only so much before being punished with ruinous taxation, where commerce ignores government action at its own peril, and where the state decides how a massive share of the economy’s resources should be spent. Or we can return to the road we once knew and which has served us well: a road where individuals acting freely and with little restraint are able to pursue fortune and prosperity as they see fit, a road where the government’s role is not to shape the marketplace but to help prepare its citizens to prosper from it.”

Amen. Happy voting.

aaron@lighthousecapital.co.il

Aaron Katsman is a licensed financial adviser in Israel and the United States who helps people with US investment accounts.