Israel Weighs Tax Reforms Amid Budget Pressures

Israel's government is considering significant tax reforms to boost state revenue, driven by increased war spending and high debt servicing costs. The debt-to-GDP ratio rose to 68.5% by the end of last year and is expected to remain elevated despite potential deficit reductions. To address this, joint teams from the Finance Ministry and the Tax Authority are developing proposals.

One major proposal involves reducing marginal tax rates for employees while simultaneously eliminating tax credits. This could include widening income tax brackets, but might be coupled with less popular measures like removing credits for parents, which cost the state NIS 14.4 billion annually. This structural reform aims to benefit a broad segment of the population but is expected to face opposition from interest groups currently enjoying tax benefits.

Another area of focus is adapting the tax system to the AI era, anticipating a potential decrease in revenue from labor taxes. Recommendations include increasing the proportion of capital taxation relative to labor taxation. Proposals include reinstating a property tax on vacant land, which was previously estimated to generate NIS 9.5 billion annually but was removed from legislation due to political opposition. A "Netflix tax" on international companies charging VAT to Israeli consumers, estimated to yield NIS 500 million annually, is also being considered, though it may face U.S. opposition.

The high-tech sector is also under scrutiny, with a proposal to increase the tax on unexercised stock options from 25% to 30% upon share sale. This initiative faces internal opposition within the Finance Ministry and from the industry itself. Finance Minister Bezalel Smotrich has stated his opposition, suggesting the decision will fall to the next government. Additionally, tax authorities are exploring arrangements for intellectual property transfers and secondary share transactions to ensure appropriate tax collection.

Significant changes are also being discussed for pensions and savings. The current tax benefit on pensions is estimated to cost nearly NIS 31 billion annually. Some officials advocate for reducing or eliminating mandatory pension contributions up to age 40 to encourage consumption, while others propose significantly reducing tax benefits on mandatory contributions. The current Finance Minister has blocked previous attempts to reduce pension exemptions, leaving the decision for the next government. The taxation of study funds, costing about NIS 10 billion annually, is also on the table but considered a difficult political hurdle. A reform to equalize tax treatment across savings products like provident funds, savings policies, and mutual funds, with a general exemption up to NIS 200,000, is also ready but its impact on consumer prices is debated.

Implementing such a wide array of reforms presents challenges, including potential legal hurdles for broad budget-supporting legislation and political opposition depending on the next government's composition. The effectiveness of the Budget Director, Mehran Prozenfer, may also be tested depending on the new political leadership.