Tax Loopholes and Privatization.10.04.13

Tax Loopholes and Privatization 10.04.13

by

Howard Adelman

In the 1980s Israel began an aggressive program of liberal market reforms that included the privatization of many state-owned firms. I wrote about some of that privatization in yesterday’s blog on the energy sector. However, the reforms of its 1985 Economic Stabilization Plan went well beyond privatization of state owned-firms. First, the central bank independence in setting monetary policy was enhanced. Fiscal discipline was introduced. So was government intervention in the import and export of capital. Market competition was, at least for a time, increased by reducing monopolistic practices. Finally, Israel adopted a fixed exchange rate to halt runaway inflation and to stabilize the New Israeli Shekel (NIS).

Israeli credit exploded along with housing construction. Investment increased by leaps and bounds. So did consumption levels. From 1986 to 1992, GDP doubled per capita to $14,636. After coming through a severe recession between 2002 and 2004, the GDP more than doubled again by 2012 to $31,282 compared to Canada’s $50,436. How and why then did Israel slip up again in 2012 and develop a budget deficit of 4.6% (originally estimated at 4.2%), well beyond the target of 2-3%?

One explanation is the two year budget that Finance Minister Yuval Steinitz introduced in 2010 to the applause of International Monetary Fund and the OECD who lauded the longer range ability of government ministries to plan and the private sector, both corporations and individuals, to know what to expect for their financial planning. One severe critic was Avi Ben-Bassat, a Senior Fellow at the Israel Democracy Institute (IDI) where he heads the Economic Reform Project, is President of the Israeli Economic Association and was a former Director-General of the Finance Ministry from 1999-2001. Budget planning two-and-a-half years in advance is impossible because there will inevitably be too many intervening changes and unpredictable contingencies that will emerge. That is why no other country has adopted the model however appealing it might seem to armchair economists. The assumptions were just wrong.

Growth started to decline in the second quarter of that budget cycle. Instead of responding by introducing a mini-budget for the second year, policy makers were too wedded to the idea of predictability when unpredictability emerged as the governing pattern and predictability had proven to be a chimera. Along with a decline in growth, there was the correlated decline in tax revenues. Then Netanyahu, wedded to the ideological convictions of the right and the risk that raising taxes would pose for his own re-election, refused to raise taxes. What is more, he went on a bit of a pre-election spending spree rather than considering some drastic cuts in spending.

If the exercise in reducing the deficit is to follow Ben-Bassat’s proposal of one shekel of increased revenues for every two shekels in reduction in expenditures, where is the revenue to come from if income, corporate and consumption taxes are already at an optimum? Besides, consumption and value added taxes are regressive and increase the disparities between rich and poor. One source can be loopholes – raising tax revenues from those not paying their fair share of taxes. Even if the Haredim are put to work, this process will take a while to phase in and higher revenues cannot be expected from Haredim for the purposes of the forthcoming budget. The same is true if efforts to improve the economic earnings of the Arab sector work out. (See my future blog on disparities.)

Exemptions have to be targeted. The Israeli Treasury was already considering cutting tax breaks for exporters. (Meirav Arlosoroff, "Israel’s treasury mulls cutting tax breaks for exporters," Haaretz 17.02.13) Teva Pharmaceutical Industries paid just 0.3% taxes on $1.66 billion in profits in 2012 under the Encouragement of Capital Investments Law that allow companies which export more than 25% of the output special tax breaks. This means that most small and even medium size firms pay 25% of their profits in taxes while Teva benefitted from a very questionable additional 0% special rate for global companies. The corporate tax system was clearly skewed towards the large firms and the larger the firm was, the less tax it seemed to pay.

Further, there are additional tax reductions dependent on the region in which your facilities are located – 6% as opposed to 12% if the plant was in an outlying region. Global companies did even better since they were taxed a maximum of 5% and taxes on dividend distributions were taxed at only 15%. But the corporate tax rates cannot be changed because they were given to the companies as incentives to establish in Israel and have terms built in that do not allow increases for a number of years. The reality is that corporations such as Teva as well as Amdocs, Check Point, Iscar and Israel Chemicals, pay a disproportionately small amount of taxes as a result of the inter-state competition to lure exporters to each respective country.

Even with that competition, there is still room to cut exemptions without giving an incentive for large companies to relocate. Further, developed nations can work towards tax treaties that prevent large companies from escaping paying taxes by insisting on minimum taxes in any country where they locate and sell their goods and services. Further, taxes can be raised on dividends from 15% to 20%. The differential tax rates between regions can be maintained but doubled. One can expect a combination of these methods to be used to reduce the budget deficit and raise revenues.

However, export taxes are a mug’s game as all developed countries move towards broader and deeper free trade relations with other countries. There are other loopholes, however, for escaping or reducing VAT taxes, some of which discourage direct exports and encourage companies to initially export to a distributor in another country and eventually a subsidiary charged with distribution and located abroad. I am in no position to estimate whether a combination of reforms can raise an additional NIS5 billion shekels, but I am certain that this is where the focus will be on one main source of revenues.

There is another source that may not increase state revenues but which is certain to reduce consumer expenditures. Ten years ago, the Israeli Ministry of Finance undertook a study that showed that monopolies cost the Israeli economy NIS5 billion per year that is paid by both consumers and manufacturers. Many of these were government companies. Thus, a source of revenue can come from selling off even more government monopolies raising money from the sale of capital while guaranteeing economic benefits for both consumers and corporations as well as further future tax revenues for the government. This will have to de done on a company by company basis rather than across the board. Will the Israeli Electric Corporation be sold off or subjected to competition? What about the ports?

One exception will be Better Place. The government granted Better Place an effective monopoly on electric cars, but it is hard to envision how this sector could be developed without such a monopoly. I had the pleasure of driving one of the first versions of the electric car and produced and hosted the first television special on Better Place outside of Israel. However, Better Place is now in deep financial trouble. Shair Agassi, who conceived and founded the company in 2007, introduced the revolutionary idea of the swappable battery, and invested a good part of the fortune he made in the computer software business, was driven out of the company last October along with Moshe Kaplinsky and three other top executives, the VPs of marketing, infrastructure and public relations. Over 200 staff were laid off.

The company had established 38 of the planned 45 battery switching stations, and 2000 recharging stations, but only sold about 500 cars in Israel. The company was haemorrhaging money (a half billion in losses thus far) with little insight into how one could both develop a capital intensive infrastructure yet wait for income as public confidence in the car and the integrated system grew slowly. Idan Ofer, head of the Israel Corporation, and both the largest individual shareholder (8%) and largest corporate shareholder (28%) respectively has taken over, invested more money, but it is unclear whether he will pull the plug or even can or wants to shoulder on. Monopolies may be needed to develop some concepts but the risks are much larger.

In other areas, the matter is simpler. One of the sources of the protest movement in Israel last year was the report by the trade ministry that monopolistic pricing in the food industry resulted in Israelis paying among the highest food prices in the developed world whereas in 2005 those prices had been 10-20% cheaper than in other OECD countries. Monopolistic pricing is not just a problem of government owned firms but permeates the private sector. For example, Shufersal and Mega between them control two-thirds of the market share of the sale of groceries. Thus, in spite of the anti-monopolistic laws of the Israeli Antitrust Authority and the Monopoly Chapter that prohibits the abuse by a firm of its dominant position that might harm competition or the public, the present implementation of the law has been ineffective. The effect of the May 2012 amendment to the law authorizing the Director-General to impose monetary sanctions on both corporations and individuals in lieu of criminal prosecution for violations has yet to be examined to assess the results. The Tamar gas field, that came on line at the end of last month and that I wrote about yesterday, is and has been declared by the government to be a monopoly. (Announcement, David Gilo, General-Director Antitrust Authority, 13.11.13) What significance this has I have yet to determine.

I will deal with the issue of Tycoons in a separate blog. In Israel, 20 families own and control most of the country’s resources, including Idan Ofer whom I discussed above. As in the break up of the Soviet Union, they obtained from the state and the labour unions in the process of privatization companies at bargain prices, for they were the only groups with enough wealth to buy the companies. Cross-sectoral and multi-layered conglomerates with ownerships of banks that supply the financing to vertically integrated groups distort the Israeli economy, push up prices for consumers and, through transfers and other means to subsidiaries, reduce revenues to the state. Private sector monopolization may possibly be preferable to state monopolization, though that is debatable, but monopolization has repeatedly been demonstrated as a drag on an economy while, surprisingly, incurring greater risks. These large conglomerates have higher levels of financial leverage and hence higher risks than small to medium-sized stand alone companies.

If the state revenues are affected, so is the private sector. Restraint on competition inhibits the ability of small and medium firms to expand, especially given many of the tax advantages granted to the large firms. The largest cost to consumers has been in the housing sector. But that is largely a result of the state control of land and the way land is released for development to the private sector.

The Israel Lands Authority (ILA) controls almost all the land in Israel. If more land is freed up and released with fewer bureaucratic obstacles, this could accomplish two goals – increased revenues for the state as well as reduced prices for home buyers primarily by increasing the land available for construction. Further, if the land is sold and not just leased (usually two terms of 49 years), revenues could rise much faster but at the expense of long term income that could be offset from gas royalties. Further, if the Israeli government sold off the exiting leases to the existing owners on a right of first refusal, as recommended by an April 2009 Ministry of Finance Report, significant additional revenues could be created. As well, bureaucratic government costs will be reduced while other steps could be taken to protect the environment and set aside open lands for permanent benefit to Israelis. The laws are already in place. In August 2009, the Knesset passed the Israel Land Authority Law allowing Israeli citizens to own property in Israel and not just lease it. On 21 January 2013, Netanyahu appointed Moshe Kahlon as the new ILA chairman. As the former Communications and Welfare Minister, he earned a stellar reputation for slashing the very high cell phone prices in Israel. Concerted action can be expected to implement the law, bring land prices down and enhance revenues for the state.

I, of course, do not know what combination of sources of revenues from closing tax loopholes to selling off monopolies, breaking up or imposing rules on existing private monopolies and selling leases and land to bring in a target of NIS5 billion, but this outline should indicate that there are enough sources of potential additional revenues without needing to raise corporate, income or consumer taxes.

Tax Loopholes and Privatization10.04.13.doc

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