Higher VAT hurts poor and fuels inequality, Treasury report shows ahead of tax hike

Value Added Tax, levied on goods and services, is set to rise from 17% to 18% in January 2025 to help the government rein in a ballooning budget deficit amid growing war costs

Sharon Wrobel

Sharon Wrobel is a tech reporter for The Times of Israel.

People shop at the Mahane Yehuda Market in central Jerusalem on July 7, 2023 (Chaim Goldberg/Flash90)
People shop at the Mahane Yehuda Market in central Jerusalem on July 7, 2023 (Chaim Goldberg/Flash90)

A planned hike in value-added-tax (VAT) is likely to mainly hurt the poor and worsen inequality in Israeli society, a new report by the Finance Ministry’s chief economist showed.

In less than six months, Israel’s VAT rate is slated to rise from the current 17 percent to 18% as the government is grappling to close a fiscal shortfall of an estimated NIS 70 billion ($19 billion) after almost nine months of war with the Hamas terror group is denting the country’s finances.

VAT is an indirect tax that is collected through the purchase of goods and services, and is not paid directly like income taxes, which are part of direct taxes. VAT in Israel, which is levied on most consumer goods and services, is a regressive tax, meaning that a higher rate harms the lower-income population more than higher earners, and contributes to increasing the already high cost of living in Israel.

In Israel, the bottom decile, the lowest income group of the population, spends 28% of its gross salary on VAT, the second decile spends 18%, and the top decile, or highest earners only 5%, according to the report by the Finance Ministry’s chief economist division published earlier this week.

That is because the lower deciles of the population spend a higher percentage of their salary to buy immediate and basic needs, which in turn reduces their disposable income. In practice, it means that for a similar basket of goods and services, someone with a high income pays less VAT as a percentage of income, than someone from a lower income group.

The chief economist’s report concluded that indirect taxes, such as VAT, increase inequality, but do less harm to economic growth.

Finance Minister Bezalel Smotrich in Jerusalem, April 21, 2024. (Chaim Goldberg/Flash90)

VAT is not just a source of income inequality, it is a factor increasing the cost of living in Israel. That’s as almost everywhere you look, the cost of living is rising, with food and energy prices going up. Food and beverage prices in Israel are 52% higher than the average among developed countries, second only to South Korea.

From the Finance Ministry’s perspective raising VAT is advantageous as it increases tax revenues for the government and will help finance the state’s coffers following massive military expenditures since October 2023. The 1% increase in VAT, which is expected to come into effect in January 2025, is estimated to add about NIS 7 billion ($1.9  billion) to government revenue.

A rise in taxation has become inevitable as the war’s soaring defense and civilian costs are leading to a sharp and swift increase in the government’s financing needs. With the budget deficit in May already at 7.2% of GDP, over half a point above the 6.6% target set for 2024, and rating agencies downgrading Israel’s credit rating, the Bank of Israel and senior economists have urged “significant” fiscal adjustments on the spending side and tax increases on the revenue side to prevent the deficit from spiraling out of control.

War in Gaza erupted with Hamas’s October 7 massacre, which saw thousands of terrorists burst across the border into Israel, killing some 1,200 people and seizing over 250 hostages. The fighting is slated to incur NIS 253 billion ($68 billion) in defense outlays, expenditures for civilian needs, and lost tax income between the years 2023 and 2025, according to Bank of Israel estimates.

To partially offset the increase in wartime expenditure needs, and bring down the budget deficit in 2025 to avert further rating downgrades, the Finance Ministry and Israel Tax Authority have proposed a package of fiscal cuts and tax measures, which for the most part have been rejected by lawmakers, including Finance Minister Bezalel Smotrich.

Smotrich has been harshly criticized for failing to adjust fiscal priorities to address wartime needs and support the economy’s recovery. Despite making moderate spending cuts in the 2024 revised budget, Israel’s right-wing coalition has left in place billions of shekels in discretionary funds made available to political allies under deals reached in coalition talks over a year ago.

Prime Minister Benjamin Netanyahu, right, and Finance Minister Bezalel Smotrich attend a vote on the state budget at the Knesset, in Jerusalem, March 13, 2024. (Yonatan Sindel/Flash90)

Treasury officials have proposed to dismantle 10 unnecessary ministries – including the Settlements and National Projects Ministry, the Jerusalem and Jewish Tradition Ministry and the Intelligence Ministry – to free up funds to help cover the wartime budget shortfall. Meanwhile, the Knesset Finance Committee on Tuesday allocated hundreds of millions of shekels in “surplus” coalition funds to government ministries such as the Settlements and National Projects Ministry.

As the Finance Ministry is now working on the 2025 budget outline, Treasury officials are reportedly proposing cuts and taxes to raise an extra NIS 30 billion to 50 billion to fund war costs. The proposed measures include raising the current VAT tax by two percentage points to 19%; cutting child allowances; freezing public sector wages; curbing tax breaks on workers’ saving funds that are primarily funded by employers; and slicing coalition spending.

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