(photo credit: REUTERS)
In justifying a one-percentage-point cut in value-added tax from 18% to 17% Prime Minister Benjamin Netanyahu resorted to a bit of populism.
"An economy that grows, does it with low taxes," Netanyahu said during a joint press conference with Finance Minister Moshe Kahlon last week.
"We can do that, because an excess of billions in taxes has come to the state coffers, and instead of holding onto them we decided to return them to you, the citizens of Israel." In July, the Finance Ministry found itself with an unexpected NIS 3.1 billion monthly budgetary surplus, which reduced the running 12-month deficit from 2.6% of GDP to 2.1%. The 2015 budget deficit goal is 2.9% of GDP.
Essentially, Netanyahu was saying that the state had collected too many taxes from the public and now the state was giving that money back.
But the truth is that the state has other obligations, particularly to foreign investors who fund Israeli debt in the form of bonds. Interest payments on that debt amount to about NIS 40b. a year. Netanyahu and Kahlon could have and should have used the unexpected windfall in tax revenues to pay off some of that debt and lower the annual cost of servicing it.
"Imprudent" was the adjective used by Bank of Israel Governor Karnit Flug to describe the decision to cut VAT. Neither Netanyahu nor Kahlon bothered to even notify Flug of their decision, let alone ask her advice, though technically she is the senior economic adviser to the government.
Left out of the loop, Flug had no choice but to issue a statement of her own – and she did it at the same time as Netanyahu and Kahlon were presenting their tax cut to reporters.
Noting that the unexpected tax revenue increase may have been a result of temporary upswing in real-estate transactions, fueled by Kahlon's warning that he intends to increase property taxes on investments, Flug warned that "it would therefore be imprudent to regard the surpluses recorded in recent months as an ongoing development and use it as a basis for revising expected tax revenues upward for the next year." Better to use that extra revenue to lower the budget deficit so as to prevent a rise in the debt to GDP ratio, advised Flug. What is the most senior economic adviser to the government to do when her advice is ignored? Is she considering tendering her resignation? Meanwhile, Netanyahu and Kahlon argue that tax cuts spur economic growth. This might be true with regard to the cut in corporate tax from 26.5% to 25% which was announced along with the cut in VAT. Cutting corporate taxes could very well prompt businesses to take steps that lead to economic growth. Investing more in R&D, employing more workers, expanding production or opening new factories are all possibilities.
However, lowering VAT will probably not have much of an impact on private consumption for a number of reasons. First, a cut in VAT does not necessarily translate into lower retail prices. Often suppliers prefer pocketing the extra profits themselves or delaying passing on the tax cut to consumers until they replenish their inventory.
Also, because VAT is an indirect tax, it does not focus on a particular segment of the population. Purchasers of expensive sports cars and high-rise apartments will benefit more in terms of the amount of money they save than the average person at the supermarket.
VAT also nets revenues from chronic tax evaders who do not pay their share in income tax or other direct taxes.
Everyone pays VAT, which makes it a highly effective tool for keeping tax revenues on par.
Every 1 percent of VAT increases tax revenues by NIS 4.5b. This money could have been invested in infrastructure, particularly transportation, which leads to greater efficiency and higher labor productivity. Marginal income taxes of nearly 50% could have been lowered.
Negative income tax could have been raised to encourage more people to enter the labor market.
What were Netanyahu and Kahlon thinking when they took the populist step of lowering VAT, snubbing in the process good economic sense represented by Flug? Perhaps they were thinking that the present government's life expectancy is short and now is the time for policy decisions that make good election propaganda.