Study: Lack of competitive tax system costs foreign investment

Compliance costs take into account the time spent in accounting, reporting, audits, appeals and negotiations with the tax authorities.

Israel is being urged to overhaul its "outdated and complex" tax system and replace it with a simpler, more efficient "flat tax" system that will boost economic growth, increase state income and lead to a rise in direct foreign investment. "Israel cannot afford to be without an efficient, fair and simple tax system," said economist Shahar Shlush, a "Koret Fellow" and the author of an international tax study released by the Koret-Milken Fellowship Program ahead of next week's Koret-Milken Conference on Economic Development. "Considering the rate of acceptance of the flat tax around the world, reform may be unavoidable. The timing however, is still in question, and the timing will determine the amount of foreign investment Israel will lose if it delays in adopting a competitive tax system, and how many hundreds of billions of shekels the economy will lose because of sunken compliance costs and the loss of productive individuals who emigrate as a result of the tax system here." The flat-tax or one-rate, system has already been adopted by at least 15 countries around the world, mainly by Central and Eastern European nations, all of which, said the report, have seen their economies grow as a result of adopting the system. A flat-tax system taxes everyone at just one rate and in place of a complex set of income tax brackets, the state declares a threshold above which all parties pay a fixed-rate on all their income. This threshold is normally low enough to provide an "incentive" for the citizens to prefer payment to dodging their taxes. According to the report, when Russia instituted a flat-tax system about seven years ago, revenue from personal income tax rose 25.2 percent in 2001 and 24.6% in 2002, an increase of 56% in two years, while Lithuania enjoyed a 182% increase in tax income over the first two years after introducing a flat-tax. Meanwhile, the GDP growth rate of the countries examined in the report rose an average of 8.45% in the two years following the implementation of the reforms. "If Israel were to enjoy similar success as Russia, we might say that such an effect would mean an increase of NIS 55 billion in state income from direct taxes and GDP growth of 13.55% by 2009," noted Shlush. Additionally, in 1998, when compliance costs were last calculated, the Israeli government collected NIS 64 billion in taxes, while compliance costs reached NIS 31.5b., equaling 7.67% of the GDP at the time. Compliance costs take into account the time spent in accounting, reporting, audits, appeals and negotiations with the tax authorities. "It cannot be that a tax system which throws away half of what it collects, is the best that it can be," Shlush said. Moreover, said the report, Israel's high tax rates are disincentives to entrepreneurship and investment, as a 5% increase in a marginal tax rate leads to a 10.4% drop in the number of entrepreneurs making new capital investments and a 9.9% drop in the total invested sum. In 2006, Israel's foreign direct investment was $13.2b., while Israelis invested $12.3b. abroad, leaving the country with only $900 million in net foreign direct investment. "The adoption of the flat tax rate would likely both encourage foreigners to invest in Israel and encourage Israelis to invest at home rather than abroad," the report said. The Koret Fellows Program, established in 1994, provides annual fellowships to exemplary students to serve as economic research assistants and to complete independent economic research on issues impeding small business development, employment expansion and private-sector economic growth in Israel.