Solutions to Israel's Social-Economic Distress: An Interview with Prof. Avi Ben-Bassat

In this interview, originally published in Hebrew in the Globes financial daily on August 8, 2011, IDI Senior Fellow Avi Ben-Bassat, former director general of the Ministry of Finance, reflects on the Netanyahu government's tax and expenditure policies, which he views as the cause of the economic protests of the summer of 2011. He calls for the immediate cancellation of the multi-year plan for reducing income tax and takes aim at the law for subsidizing capital investments. In addition, he points out that Israel's public services are deteriorating, and accuses Israel's current and past governments of causing the housing crisis by their policy of releasing state owned land for construction at a slow pace.

"The tax structure has two main goals," says Ben-Bassat. "One is to finance government expenditures and the other is to reduce inequality in the economy. On the one hand, we have income tax, which is progressive, while on the other, we have indirect taxes, which are regressive." As he sees it, "the main problem in Israel is that the burden of indirect taxes has increased substantially in recent years in comparison to other OECD member states, and these are the very taxes that increase inequality. This distortion should be corrected."

"Another problem is the proliferation of tax exemptions. There are many instances in which the taxpayer is exempt, and the sum total of these exemptions amounts to NIS 38 billion annually. A thorough examination of these exemptions must be conducted. In the past, I examined many of them while serving on a committee, but most are still around today, and some of them should be canceled; for example, the exemption given to "advanced training funds" (keren hishtalmut), which are not really used for advanced training, but serve as regular savings plans."

"Moreover, the well off are those who benefit most from this particular exemption. As a matter of fact, most of the exemptions benefit the top wage earners, since their marginal tax rate is higher. People who earn NIS 5,000 a month don't earn enough to take advantage of tax exemptions. The exemptions are regressive in nature, do not achieve any economic goal, and increase economic inequality."

Ben-Bassat points out another distortion: a reduced tax rate or tax exemption for exporters in the center of the country, which was given as part of the capital investment law. "This is a totally outdated incentive," he explains. "What products that replace imports contribute to improving the balance of payments and economic growth is identical to what export goods contribute. Therefore, it makes no sense to discriminate against products that replace imports. The problem has been compounded in recent years, as Israel has a surplus of foreign currency. This incentive for exporters only serves to increase Israel's balance of payments surplus and lower the exchange rate. This, in turn, forces the Governor of the Bank of Israel to intervene in the market in order to raise the exchange rate. This policy makes absolutely no sense and is inconsistent. We have far more important goals."

So what do we need to do?

"Prime Minister Benjamin Netanyahu's multi-year plan to reduce income and corporate tax should be cancelled. In addition, the composition of the tax structure must be altered so that the relative weight of indirect taxes is reduced. It is also necessary to review all tax exemptions and to cancel or limit those that do not contribute to worthy goals."

Ben-Bassat is convinced that this kind of change will not come easy. "The exemptions are enjoyed by people who are have an interest in their continuation," he says. "Accordingly, there will be a difficult struggle with those groups. Past experience has taught us, however, that approving controversial reforms is easiest when there is an appropriate window of opportunity. Studies show that it is easier to implement reforms that have a negative impact on special interest groups in a time of crisis, and that is the situation today. That was the case when the economic stabilization plan was initiated in 1985, when the pension fund reform plan was initiated in 2003, when the Bachar reform was initiated in 2005, and most recently with the Brodet reforms."

It is difficult to find a common denominator between the cottage cheese protests, the parents' protest against high cost of raising children, the housing protest, and the protest against the high cost of education, but Ben-Bassat says that Netanyahu's fiscal and tax policies are behind all of them.

"Netanyahu's banner is that lowering taxes and government expenditures leads to growth-a theory known as 'the fat man and the skinny man'. This principle, however, is problematic. First, there is no clear cut evidence that lowering public expenditure and a parallel cut in taxes at current tax levels accelerates economic growth. If we examine the weight of public expenditures as a percent of GDP and the average tax level in OECD member countries, we will find that there is great variance from country to country. There are the Scandinavian countries, with high levels of expenditure and high taxes; there are countries with an intermediate situation, such as France and Germany, and there are other countries, such as the United States and South Korea, with very low levels of public expenditure and tax relative to GDP. Nevertheless the economic growth rate of these OECD countries has been very similar over the past 40 years. There have not been real differences in their growth rates despite the substantial differences in their rates of public expenditure and tax levels."

"Note that the average public expenditure in Israel stands at 42%, which is similar to the OECD average, but defense expenditures in Israel are higher than in other OECD countries by about 5% of GDP. This places Israel at the bottom of the list of OECD countries with regard to public expenditure levels. In my opinion, this is one of the issues that stand in the background of the protests. Even if the protesters themselves are not completely familiar with the statistics and are not capable of analyzing them, they feel the results of the huge drop in public services and the low level of services provided to civilians. While the level of taxation in Israel is in line with the OECD, services are at a much lower level in many fields that are not directly connected to each other."

How do we get out of this situation?

"Israel's fiscal policy has to be changed, both in terms of expenditures and in terms of taxes, but it has to be planned carefully rather than done on the fly. It goes without saying that a small budget deficit must be safeguarded in order to prevent crises like we have seen in Greece. The way to do this is for the prime minister to issue guidelines for a new policy that would include a freeze on income tax cuts, a change in the composition of the tax structure, etc. But the actual economic measures must be carefully planned. Otherwise, we are liable to create a policy that causes more damage than good. We have to announce a change in direction."

"This is also the opportunity to do away with the two year budgets. A different budget will be needed for 2012. One of the central problems of the two year budget process is the lack of flexibility in response to changing situations. The events of the summer of 2011 prove once again that it was a mistake to go over to a two year budget process. Indeed, in all countries and corporations in the world budgets are set for one year at a time."

A Passive Approach by the Anti-Trust Commissioner

Despite the above, Ben-Bassat has some reservations and notes that the solutions for the crisis cannot all be found in change in fiscal and tax policies. "There are many problems, especially when it comes to prices. The solution in these cases can be found in changing the monopolistic structure of many branches of the economy and in reducing the power of the business pyramids in Israel substantially," he explains. "For example, government intervention is necessary where monopolies and oligopolies exist, such as in cement production, the cellular industry, insurance providers, and the banking sector. Government intervention is necessary in these areas, since there is a failure of the market and instead of widespread competition, there is competition among very few players. Ongoing government efforts to increase competition are necessary in these sectors, which in effect suffer from excess concentration."

"The basic approach of the antitrust commissioner has to be changed. In Israel, the commissioner takes a passive stance; that is, if a certain company wants to merge with another, it must request permission. When there is a complaint over a merger stifling competition, as happened recently in the book market, then the commissioner enters the picture and assesses the legality of the move. I think that an activist approach must be adopted, as in several other countries and as is the case with financial regulators in Israel."

"The bank supervisor, the capital markets director, and the chairman of the Securities Authority in Israel all closely oversee corporations, and demand regular statistics and reports, including data on profitability. When they see actions that are undesirable, they intervene. The antitrust commissioner must change his approach. When all steps taken to foster competition in a certain sector fail, prices themselves can be supervised, just as the bank supervisor occasionally limits the level of bank commissions. This, however, should only be used only as a last resort."

Is the recently approved law dealing with the concentration of business groups likely to increase the power of the anti-trust commissioner?

"The new law does not even mention what I have been talking about. The approach must be changed and supervision by the antitrust commissioner must be put on par with that of financial regulators."

What about the over concentration in the economy?

"The corporate pyramids, by their very nature, have a number of problems that must be resolved. First, the pyramid controls a huge amount of capital through a relatively small investment, and that is not fair. In actual fact, this circumvents the 1990 law that prevented issuing shares with reduced voting rights. In addition, the head of the pyramid or the controlling shareholder primarily endangers the capital of others and therefore is susceptible to taking risks that are too large. Studies show a correlation between lower investment by the controlling shareholder and poorer performance by the company."

"There is another problem dubbed 'tunneling.' Since the stake of the head of a pyramid is larger in companies at the top, there is a tendency to transfer profits from the bottom of the pyramid to the top. The over concentration of the economy has also led to a situation in which economic decisions are concentrated in the hands of very few decision makers. As is the case in the handling of financial portfolios, there is far less risk when decision-making is distributed among a larger number of people."

"Another serious problem involves conglomerates that include a financial institution. The intertwining of a financial institution with a conglomerate could lead to preferential treatment in granting credit to companies controlled by the owners of the conglomerate. Even worse, this could lead to the taking advantage of insider information known to banks about companies that are competing with companies owned by the conglomerate. Evidence of this was heard at the President's Conference, in remarks by David Wiessman, one of the owners of the Dor Alon fuel company."

Finance Ministry Director General Haim Shani resigned yesterday. The ministry is going through difficult times and its position has weakened. What price is the economy paying for this during these stormy times?

"Changing so many positions in such a short span of time is not positive, since everyone has to learn his or her job and formulate policy. When change occurs gradually, it is easier. These latest changes could slow down economic initiatives. A situation has been created in which there have been a lot of personnel changes in a very short period of time. It is possible to compensate for this through very intensive work."

The Housing Crisis: Free Up Land, Not in Bits and Pieces

"The main problem in the area of housing was the lack of a quick response regarding the supply of land," explains Ben-Bassat in reference to the tent protests. "The reason for this is that the government controls 93% of the land in Israel and releases far too little annually. The government's approach to releasing land for construction must undergo a fundamental change. The government is releasing land to the market in bits and pieces, in line with the growth of the number of households, but failed to align its response to the increase in demand. Therefore, there is a need for a massive release of land in order to make an ample supply of land available for building at all times. This will translate into a much quicker response on the supply side whenever demand increases."

"There is certainly a problem of efficiency at the Israel Lands Authority, but the more fundamental problem is the approach of all of Israel's governments, which must control state land in order to prevent takeover by hostile elements. This has led to the policy of the slow release of land. Unless this approach is abandoned, the future will be fraught with waves of price increases in the housing market."

What about the bank of Israel? Isn't it responsible for the crisis?

"In light of the economic crisis, interest rates were lowered all around the world. The cut in interest led to an increase in demand for housing, as a result of a drop in the cost of mortgages. But since supply didn't increase quickly enough, prices rose. Once prices rose, savers, who had witnessed a drop in their returns in the capital market and expected to benefit from gains in the housing market, subsequently increased demand. When the demand increased, prices rose even more. Is there a bubble? I don't know, since I haven't examined it. However, if the supply side would have responded more quickly, the problem would clearly be much less severe than it is today." 

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This interview from Globes was conducted by Adrian Filot and was first published on August 8, 2011. It has been reprinted with permission.

Professor Avi Ben-Bassat is a Senior Fellow at the Israel Democracy Institute, a lecturer in economics at the Hebrew University, and the former Director General of the Finance Ministry.