The Effect of the 2003 Tax Reform on the Israeli Economy and Wealth Inequality

Introduction The Government of Israel has recently made many policy changes in respect to income and capital taxation. Two tax reforms in recent years, the first in 1996 and the second in 2003, led to major decreases in tax rates that stimulated economic growth. The first milestone was the implementation of a national health tax and the cancellation of the “parallel tax,” a levy on employers that had been used to finance healthcare services. This new policy was welcomed by employers, the main beneficiaries of this major tax cut. From then on, the government was expected to increase its expenditure significantly. Per-capita public expenditure for healthcare services had grown by more than 28% in 1990–1997. In the nine years after the elimination of the parallel tax (1998–2006), however, public expenditure for this purpose decreased by 13% (Figure 1). The compensating effect was an increase of more than 27% in private expenditure for healthcare services during the same period. The most recent major reform took place in 2003, when the government declared a massive tax cut that would be implemented over the subsequent seven years. At that time, some government representatives described the tax cut as essential for the regeneration of economic growth, which had slowed badly in the preceding years. Another argument was that a tax cut might increase government revenues, according to the Laffer curve theory. Five years later, one may say that this reform made a significant contribution to the positive growth rates over the past few years. However, there are also indications of growing poverty as well as inequality that cannot be underestimated. As noted above, public expenditure for social services has been reduced, forcing households to increase their share in national expenditure for social services. The implementation of an aggressive tax cut (pursuant to the decision in 2003) will most likely force the government to cut public expenditure further. This study attempts to determine whether this tax reduction will improve the welfare of the poor as well as the rich by simulating the effect of the 2003 tax policy. 8. Conclusion This study tried to measure the effect of Israel’s current tax policy on the welfare of three income groups. The simulations suggest that a tax decrease would benefit the higher income deciles and have an adverse effect on lower income deciles. If the government’s objective is to improve the welfare of the general public, then this current policy should be tested, five years after it has begun. One possible adjustment could be a negative income tax policy, which, according to the predictions in this study, would decrease inequality and also generate a 3.2% increase in GDP. The predictions in this study should be taken with caution for several reasons. One major factor that was excluded is that a tax cut would also motivate more individuals to report their total income and pay tax. Another central factor in trying to estimate the effectiveness of a tax decrease is the ability to work. Obviously, a negative tax program alone cannot decrease the unemployment rate or improve the social welfare of low-income individuals if they simply cannot work or prefer not to for various reasons.