Today, July 26, the citizens of the State of Israel can, despite the situation, indulge in a mild celebration. Why? Tax Freedom Day (TFD) 2006 will have finally arrived.
TFD is the day in the year when the average Israeli stops working to pay off his or her tax obligations, and starts earning money for his or her own personal consumption.
For the first 207 days of 2006 the tax authorities snatch away every shekel earned by the average Israeli, but, for the remaining 43% of the year, Israelis will be able to spend their hard-earned money as they see fit.
There is even more good news. Not only has TFD finally arrived, but it is actually falling nine days earlier this year than it did in 2005. TFD 2006 moving backwards by nine days translates into an extra NIS 2,637 of disposable income per family.
For this extra money, and the relatively earlier arrival of TFD, we should thank our politicians for allowing the implementation of new income tax reforms introduced in 2005, and the reduction in the VAT rate from 17% to 16.5%.
Although we should certainly rejoice at the good news of positive economic developments, we must also keep in mind that there is still a very long way to go. In other words, many more tax reforms will need to be implemented for Israel to celebrate TFD closer in time to most "economically normal" countries.
For example, the citizens of OECD countries, on average, celebrated TFD this year on May 29, almost two months before Israel. In Ireland, a country often compared to Israel for its reliance on the hi-tech sector, TFD was on May 5, 82 days before Israel.
SO HOW CAN we move Israel's TFD closer to the beginning of the year (or at least to the beginning of the summer)? Reducing the VAT rate even further, as has been recently proposed, is praiseworthy, but is probably not the most efficient way to achieve the goal. VAT reductions may boost the economy in the short term, but they usually fail to sustain higher rates of economic growth in the long run.
In order to understand this, note that sustainable economic growth occurs only when individuals work more and firms increase their capital investments that enhance worker productivity. Unfortunately, a reduction in the VAT rate usually does not lead to these two outcomes. By making immediate consumption relatively more attractive than savings, a lower VAT rate discourages individual savings, which renders firm capital investments more expensive. In addition, a lower VAT rate fails to substantially increase work incentives for individuals.
In order to achieve sustainable economic growth it would probably be better to "fund" a reduction in income tax rates and capital tax rates with an increase in the VAT, rather than a further decrease. This shift from direct to indirect taxation works better because it encourages entrepreneurs to invest in capital, enabling productivity, output and wages to increase.
A lower cost of capital, combined with lower income tax rates, translates into more job opportunities and higher earnings for workers as well as higher profits for entrepreneurs. In contrast, VAT reductions can even hurt the economy when they substantially lower the level of personal savings and contract the supply of funds needed for capital formation.
The government of Israel should, therefore, not focus on further lowering the VAT rate, but rather on more significant reductions in income and savings tax rates. Personal consumption may decline in the short run through this alternative strategy, but as Israelis start working and saving more, the economy will grow at a higher rate, leading to higher wages and more disposable income and consumption in the future.
IT IS IMPORTANT to acknowledge that the proponents of the current VAT-cut strategy often claim that they prefer reductions in VAT, as opposed to reductions in income and savings tax rates, on the grounds of social equity. Since the poorest do not pay income tax and have little savings, they never benefit from income and savings tax reductions.
But this argument is rather shallow. The wealthy consume more than the indigent, so the wealthy also benefit more from VAT rate reductions than do lower income families.
VAT reductions will likely not improve social equity, nor will they help the poor become economically independent. The best way to help the poor is to give them incentives and opportunities to join the labor force.
This is far from being a new idea. It can also be claimed that this is an especially relevant idea for the State of Israel since it is closer to the traditional Jewish approach to poverty reduction.
We should not forget that Maimonides, the great medieval Jewish philosopher and codifier of Jewish law, holds that the most praiseworthy and effective means of fulfilling the commandment of tzedaka (giving charity) is through offering an impoverished person a business partnership, a business loan or a job. Only through productive economic behavior will the poor be able to break out of the cycle of poverty and become financially independent. Direct or indirect monetary handouts in the form of welfare checks or reductions in VAT may give partial temporary relief, but they will not solve the national poverty problem in the long run.
Happy Tax Freedom Day!
The writer is director of the Jerusalem Institute for Market Studies.