Israel needs tax reform of biblical proportions

Flat taxes help achieve the key, and ever elusive objective of fairness.

By ALEX BENEDYK

OCTOBER 14, 2015 20:58

money (photo credit: REUTERS) — money

(photo credit: REUTERS)

Tax reform is a perennial part of the political rhetoric. Unfortunately, it is often the case that if any tax reform is achieved, the changes are only marginal. Yet, politicians usually tout any modifications as a major accomplishment that will boost productivity, overall economic performance and fairness.

Despite the recent tweaks to the tax system implemented by the new government, which were commendable for being in the right direction (lower taxes), Israel’s tax burden is still far too heavy according to a range of standard measures.

If the new government is serious about making substantial and truly beneficial changes, then the “flat tax” should be put back on the economic agenda.

In terms of income tax, there are basically two possibilities for a tax system: progressive or flat. Progressive taxation, the most prevalent system in the West, raises the rate of tax as income rises.

Taking Israel as an example, the first NIS 63,240 an individual earns is taxed at 10 percent, but the next NIS 63,240 to NIS 108,000 is taxed at 14%, with the trend continuing upward. So initially one keeps NIS 0.90 per shekel earned but for money earned after the threshold has been crossed only NIS .86 is pocketed for every shekel earned.

The cycle of increasingly lower returns continues as income passes higher thresholds. In short, an income raise into the next tax bracket is accompanied by a “punishment” of a higher percentage going to the government.

In the land of Israel, progressive income taxation was not always the norm. During biblical, or to be more precise, Temple times, a flat tax was imposed instead. Here, the tax remains the same regardless of how much is earned, so the 10% payment for the service of the priests in the Temple means that you always keep 90% of what you earn, and that remains independent of your income level.

Comparing the ancient tax system for priests and for government today is actually far more valid than one might initially assume. The priests during the Temple period kept the Temple in order, by partaking in a range of activities such as financial administration, security services, and supporting the high priest in his spiritual activities. These were all public goods at the time.

Similarly, government today keeps society in order by providing public goods such as a court system, a police force, roads and street lamps, flood protection and other social infrastructure. The crucial common feature then and now is that it would be difficult to stop people who do not pay from receiving benefit from these types of services.

The problem with relying on the market to supply public goods is that those who do not pay for the priests to look after the high priest nonetheless gain from his spiritual service given on behalf of the nation, just like those who do not pay for the flood barrier are saved from the flood.

As a result, individuals are not incentivized to pay but rather “free ride” and wait for others to pay.

This may result in the service being under-provided, or not being supplied at all. One of the main solutions to this public goods problem is to institute a compulsory payment on the population as a whole, known simply as a “tax.”

Estonia was the one of the first countries in the modern era to re-introduce the flat tax. This was implemented in 1994, soon after Estonia became free to re-design its economy after the fall of the Soviet Union. The Estonian transformation was remarkable.

Estonia overthrew a complicated progressive tax rate system and instead introduced a 26% flat tax rate on all personal income and corporate profits. Tax revenues did not fall and economic growth shot up to double digits a few years later. Economic growth has consistently reached 6% since the turn of the century.

Witnessing such impressive results in Estonia, Eastern European neighbors Latvia and Lithuania quickly followed suit. In total, eight Eastern European countries instituted a flat income tax system in a move that is credited with boosting their economies as they departed the Soviet Bloc and warmly embraced free market capitalism.

For those sceptical about whether such a tax system could work in larger, more diverse economies, the case of Russia provides evidence that it can. A year after Russia adopted a flat tax on personal income of 13% and on corporate income of 35% in 2001, economic growth was not harmed and income tax revenues increased by 25%.

In Russia, before the flat tax was introduced, individuals in the top two income brackets reported about half of their income to the tax authorities. Immediately after the new system was introduced, these individuals were reporting 68% of their income. Russian now stands as the fifth largest economy in the world.

Flat taxes thus have the potential to achieve a dual economic benefit: increased productivity and greater tax revenues for the state. In terms of productivity, workers are motivated to work harder and earn more knowing that they will get as much for each unit of currency earned as before.

Note that Israel’s productivity record is one of the worst in the OECD. This is very much out of place with its general performance relative to other member states. The flat tax could help overturn the productivity deficit by signaling to the workforce that one can keep the same amount per shekel as one pushes through to higher income levels.

When there is a uniform tax rate, as in a flat tax system, tax revenues can rise because administration and compliance is far easier and cheaper. Authorities can more quickly and easily clamp down on evaders, and law abiding citizens do not face complex tax calculations a barrier to payment.

Further, flat taxes help achieve the key, and ever elusive objective of fairness. The central idea is that people are treated equally regardless of how much they earn. Even though those with higher incomes pay more in absolute terms, they keep exactly the same amount for each unit of currency as everyone else. Higher earners will have less of a reason to feel that they are treated unfairly by the state.

The Second Temple was destroyed almost 2,000 years ago. Along with it went the flat tax for priests. Resurrecting the flat tax system from the lost relics of ancient Jewish history should be strongly considered today.

It would provide a timely boost to productivity, government finances, fairness, and social cohesion.

The author is a Research Fellow at the Jerusalem Institute for Market Studies.