The discussion of the present tax system's problems given above and the description of the Ben Shahar and Sheshinski reforms in Appendix I lead us to several conclusions that will guide us in building our proposed system:

1. The progressive income tax with high marginal rates is not successful in fulfilling its function of redistributing income. Progressivity in taxation can be abandoned with little loss if the result is a system that functions significantly better in other respects.

2. Although simplification is an explicit or implicit goal in every tax reform, it is rarely achieved. The reason seems to be that the need to find solutions to other problems leads to complication piled on complication. The Ben Shahar reform introduced indexing to deal with inflation, and was then followed by the jungle known as the Steinberg Law. Our approach will be to simplify first; subsequently we will find that certain problems have disappeared and others have been substantially alleviated.

3. Both of the reforms described in Appendix I recommended a universal reporting requirement for individuals, in order to enhance compliance. We differ with regard to the value of universal reporting by individuals. First of all, most governments are inclined to throw low income households out of the reporting net by raising reporting thresholds, and Israel is no exception. This is done not for reasons of social justice but because of the questionable utility of processing these low income returns. Second, the contact between taxpayers and the tax authorities in Israel has become so corrosive, and the mutual suspicion and distrust so deep-seated, that it seems to us desirable to reduce the amount of direct contact. Third, we argue that our proposed system makes individual reporting redundant. Every item of personal income has a payer and a payee.

   There is already a universal requirement of reporting all payments by the payer. The tax authorities have available to them sufficient data processing capacity to separate all this data according to recipients, and they already do so. The information supplied in an individual return is already available to the government from the other side. The only problem lies in seeing to it that every business, however small, is known to the government, a problem that exists in every tax system. Furthermore, it will be seen that in our proposed system, withholding is exact and there are no payments or refunds to be made at the end of the year. If so, we would dispense with individual reporting.

   4. Our Plan - Business Income Tax

      The following changes are proposed in the handling of income and expense:

      1. Depreciation will no longer be recognized as an expense. Instead, capital expenditures such as equipment will be expensed as they are incurred, the way they are for VAT purposes. This provides an immediate tax incentive, equal to the business tax rate, for investments. In the long run, of course, this bonus is cancelled by the elimination of depreciation. It is more of a loan than a grant. Depreciation will thus no longer appear in income tax calculations, and the troublesome problems connected with the inflationary appreciation of depreciable assets will be resolved.

      2. Interest will no longer be taken into account, either as income or expense. At present, interest is wholly recognized as expense and as income in the business sector. (For individual taxpayers, interest is generally neither deductible nor taxable). But interest, especially in inflationary Israel, is mainly inflationary linkage and represents compensation for inflation rather than the classical cost of capital. If we can find a solution to the problem of taxation in an inflationary environment, and it will be seen that we do, we can drop interest as a factor, as expense or as income, in calculations of profit and loss.

         This will also remove the existing incentive for economic activity (such as leveraged buyouts, for example) that is based on the deductibility, as an expense, of interest. The problem of financial institutions, whose turnover is mainly interest, has to be dealt with separately, as it is to some extent today. 6 Excluding interest as an expense also solves the problem, from the government's point of view, that deductions of interest as an expense are typically taken by businesses at high tax rates, whereas interest income is typically received by individuals at zero (in Israel) tax rates.

      3. Inventory will not be taken into account when calculating income tax, just as it is not in the case of VAT. It may be that the tax authorities will want inventory declarations for enforcement reasons, but they will not be used in the tax calculation. This will save a lot of time and trouble that is now invested in doctoring inventories so as to extract the most tax benefit.

      By removing depreciation, interest, and inventory as factors we begin to approach a situation where the balance sheet is irrelevant to the income tax calculation. Let us go all the way and remove all capital and financial factors. Let us define INCOME as total revenue, and EXPENSES as all those recognized by VAT plus all payments to individuals (salaries, benefits, dividends, rents, etc.) on which personal tax is withheld and paid. The difference between income and expenses defined in this way will be subject to business income tax.

      The restriction of recognized expenses to those listed above will broaden the tax base, and consequently reduce the tax rate, assuming we intend to keep total tax revenues from this source constant. Suggesting a suitable tax rate for business income presents some difficulties. The problem lies in estimating what the income base would be, after removal of all capital and financial factors and their inflationary adjustments. In Appendix III we argue that a rate of 23.5 percent would be sufficient. It is worth rounding this up to 25 percent and eliminating some nuisance taxes. Such a low rate, comparable to that currently accorded approved enterprises, together with the immediate expensing of investment, would serve as a strong incentive for industrial and business activity, and would raise questions regarding the continuing need for the approved enterprise framework. It is especially worthwhile keeping this rate equal to the personal tax rate because of the resulting vast simplification. This point is elaborated further in Section VII.

      The definition of expenses given above excludes expenses (if they are not VAT-invoiced) such as trips to meetings abroad, car mileage expenses, part of home costs when used for business, and other items whose common characteristic is that their connection to the production of income is sometimes vague. These items also give rise to a disproportionate share of discussion, negotiation, and, occasionally, litigation between taxpayers and government. Our feeling is that setting the tax rate at 25 percent makes the possible inequity of disallowing these expenses small, and may encourage the taxpayers themselves to take a harder look at the necessity of these expenses, since the government no longer shares in them. There are other costs, such as municipal real estate taxes, that are excluded from our definition of expenses because they presently lie outside the VAT framework. Thought should be given to the possibility of bringing them inside and including them as recognized expenses.

      The simplification of the tax calculation that we have achieved would make it feasible to collect the business income tax on a monthly or bimonthly basis. The problem of inflation is now effectively eliminated, by reducing the time scale from one year to one or two months, and by eliminating capital and financial factors. We have thus succeeded in solving the problem of taxation in an inflationary environment, and we have done it through simplification, instead of through complication, as in the present system.

      We can now have simultaneous collection of business income tax, withheld personal tax and VAT on one monthly (or bimonthly) form. This would enable crediting of one item against another, and would reduce the number of cases in which a business goes into expensive overdraft in order to pay withholding while at the same time it is owed money on VAT, on which no interest is paid. This is an inequity in the present system which would be reduced in the proposed system. See Appendix IV for examples of such a form.

      The simple, single monthly form would be all that any business would be required to submit. There would be no annual report and balance sheet to prepare for the tax authorities. Companies that are publicly held (a very small percentage of the total) would probably have to submit an annual report to their shareholders. But the contents of this annual report would be prescribed by the securities authorities and not by the tax authorities, who would have no interest in them.

      Since business tax is now calculated and collected monthly, the present system of monthly estimated payments can be dropped. The current system of separate withholding on payments for goods and services can also be eliminated, since all payments are either covered by VAT invoices or have 25 percent withheld automatically, and taxes due are collected every month.

      The elimination of financial and capital factors from income tax calculations obviates the present system of final discussion (generally lengthy and acrimonious) and acceptance by the tax authorities of yearly returns. These discussions tend to center around financial and capital factors and often take place five or six years after the tax year in question. The tax officials who conduct these discussions seem to have unlimited authority to ignore common sense, to contradict basic ideas of equity, to reinterpret the rules according to their needs, and to disallow bona fide expenses on the basis of questionable technicalities, while accompanying it all with threats to the effect that "you have the right to appeal but you'll get into trouble." For a small businessman these discussions become a nightmare of casting about for documents and explanations that finally ends in unsatisfactory compromise, to which he consents partly from fear and partly from fatigue.

   Part IV