PLANNING PROPERTY TAX REFORM:

THE VOICE IS THE VOICE OF REFORM

BUT THE HANDS ARE THE HANDS OF EVIL DECREES

 

Udi Menirav

 

 

In 1998 a public debate took place in Israel on the issue of state property tax reform.  The property tax is one of the oldest and most anachronistic taxes in Israel, dating back to the days of Ottoman rule.  The need for reform of this tax has been clear for years, but the government continues to evade its responsibility to implement real reform. 

 

Review

 

The property tax in its present form is levied in accordance with the Property Tax and Compensation Fund Law passed in 1961.  This tax was first imposed on a wide variety of properties, including residential homes, office buildings, urban and agricultural land, equipment, “business stock,” and vehicles.  In April 1981, however, the property tax on most of these items was abolished, because of the difficulty in collecting it and the burden it imposed on Israelis.  Today it is only levied on vacant land.  Also, land defined as agricultural or utilized for agricultural business is exempt from the tax.

 

Officially, the tax is calculated according to the land’s value, but in practice it is the tax collector’s evaluation which is used.  The property tax rate is 2.5 percent annually, while contractors and land dealers holding property defined as “business stock” pay only 1.2 percent.  Property tax is unique among Israeli taxes in that some of its revenues are deposited into a government fund to compensate war and drought damages.  The following table presents the total property tax revenue in recent years, from which 25 percent was deducted for the state compensation fund.  In addition, the table shows payments made from the compensation fund to cover drought and war damages.  At the end of 1997 the compensation fund had a positive balance of $116 million.1

 

 

                                                                 Table 1

 

                                        Property Tax Collection and Payments

                                      From the Compensation Fund, 1994-1997

 

 

 Year

 

       Property tax                collected

       ($ millions)

 

         Drought                 compensation

       ($ millions)

 

            Total                         compensation

       ($ millions)

 

       Compensation              as percentage of               property tax                     revenues

 

 1994

 

             288

 

              2

 

               17

 

                5.9%

 

 1995

 

             326

 

              3

 

               17

 

                5.2%

 

 1996

 

             326

 

              2

 

               69

 

               21.2%

 

 1997

 

             330

 

              8

 

               24

 

                7.3%

 

 Total

 

           1,270

 

             15

 

              127

 

               10.0%

 

Source:   Internal report of the Central Bureau of Statistics and the Income Tax Authority for the years 1994-1997.

 

 

Property tax is not the only tax levied on various forms of real property in Israel.  In addition to the annual tax on vacant land, the central government also imposes a tax on the value of real estate at the time of purchase, as well as a property betterment tax levied on the real gain between the time of purchase and the time of sale.  In addition to these two additional central government property taxes, local authorities impose their own tax on property (arnona), which is an annual municipal tax on apartments and business assets, calculated according to property size and location.  Local authorities also levy a property betterment tax on land.2  In addition to these multiple taxes on real estate, an annual property tax is imposed on vehicles in the form of an annual vehicle registration fee.

 

The following diagram displays all of these multiple taxes on real property.  In 1997 the government collected approximately $3.65 billion in gross receipts from all kinds of property taxes combined.  This sum represented about 3.7 percent of GDP and 9.1 percent of all taxes.  This essay refers only to the central government’s imposition of “property tax” as defined in the 1961 law previously cited, which is a source of great economic distortion and hardship to the Israeli people.

 

As clearly demonstrated in Policy Studies No. 34, published in May 1998,3 property tax in its present form is an unjust and discriminatory tax.  It encourages economic distortions and is administered in a manner harmful to Israeli citizens.  It creates distortions because it is levied on a very narrow population base.  The tax is discriminatory and violates the principle of equality.  The tax’s high rates reduce the disposable income of Israeli citizens and bear no relation to the individual’s ability to pay.  In its present form the tax is not directed at any particular economic activity and causes countless disputes between the tax authorities and the taxpayer.  Furthermore, the tax increases building costs, driving up the prices of already expensive housing.  It distorts the allocation of  land and limits the availability of land for construction.  And if that is not enough, the tax falls disproportionately on  low income families.

 

An analysis of the situation suggests that the collection of property tax has become an end in itself for the tax authorities, whose own justifications for the tax in its present form are erroneous.  Property tax does not provide an incentive for building, it is not a tax on the rich, and there is no relation between property tax rates and income.  Furthermore, property taxes are not a significant source of revenue for the state.  Half of property tax revenues are collected at the expense of other taxes, and property tax actually decreases state revenues from the leasing of land.  Even without these offsets, central government revenues from property tax constitute less than 1 percent of total tax revenues and only 0.4 percent of the GDP.

 

In order to conduct an independent inquiry into problems related to property tax, Deputy Finance Minister David Magen appointed a public commission in May 1996 under the auspices of Dr.  Yoram Gabbay, the previous state budget director.  The commission was established following the publication of a State Comptroller Report listing the tax’s shortcomings, and in light of the numerous amendments made to the property tax regulations over the years.  In April 1997, the commission recommended cancellation of the tax.  In order to make up for lost revenue, the commission recommended levying a general sales tax on the public at a rate of 2.5 percent of all real estate value.4  The commission’s report stated the following:

 

Many serious defects exist in the Property Tax Law with regard to the tax base, tax rates, and manner of implementation.  The extent of these defects is such that the commission recommends against making do with minor adjustments to the law and recommends a comprehensive reform in which property tax in its present form will be replaced by a one-time property tax to be levied on the sale of land.5

 

For the first time, a public commission, independent of the tax authorities, confirmed what thousands of  Israeli landowners have been claiming:  There is no room for property tax in Israel and it should be abolished rather than amended.  The commission’s recommendation for a new tax, however, is unwarranted.  There are enough taxes on real estate in Israel, and according to the estimates of the Ministry of Housing and Construction, published in May 1998, the newly-recommended tax will create economic hardship for 100,000 young couples.6

 

 

Update for 1998

Lots of Newspaper Headlines, Few Results

 

In 1998  a consensus formed in the Knesset for comprehensive reform of the property tax, in order to relieve the burden on private Israeli landowners.  No less than four private bills have passed preliminary readings since the publication of the Gabbay Commission recommendations.  Knesset Member Avraham Poraz (Shinui) submitted a bill, which passed its preliminary reading in May 1997, to exempt from the tax land that cannot be used for construction.7  Today between 80-90 percent of the land which is assessed property tax is unavailable for construction, mainly because of various zoning restrictions.  If this bill becomes law, the exemption of these lands from the tax will constitute a significant reform.

 

In February 1998, the Knesset passed three bills in their first readings (most bills must pass the Knesset in three formal readings and, sometimes, a pre-reading):  Knesset Member Meir Sheetrit’s (Likud) bill would also exempt land unavailable for construction, and in addition would equalize the tax rate on “business stock” and other land;8 another bill which was approved was sponsored by Knesset Member Avraham Hirshson (Likud), David Magen (Likud), and Ofir Pines-Paz (Labor).  The bill adopts the Gabbay Commission recommendation to cancel the property tax and replace it with a sales tax; the third bill would also adopt the Gabbay Commission recommendations and was sponsored by 17 Knesset members from most of the parties represented in the Knesset, including the Arab parties, Labor, Likud, Communists, National Religious Party, Meretz, and Israel B’Aliya.9

 

In response to the possibility that the property tax may be canceled by the  Knesset, Finance Minister Ya’acov Neeman announced in March 1988 that “the Ministry of Finance will draw up a plan for implementing property tax reform within two weeks.”  In light of this promise, the chairman of the Knesset Finance Committee, Knesset Member Avraham Ravitz, decided to delay the bill calling for the cancellation of  the tax, stating:  “If the Ministry of Finance does not present its recommendations for changing the tax by the end of the present session, the committee will vote on the relevant bills.”11

 

Israeli legislative procedure requires that bills be debated in a Knesset committee.  A committee chairman can thus delay a bill by not listing it for a vote.  Similarly, bills that have passed preliminary hearings still have a long procedural way to go:  Finance Committee discussions, a first reading and vote, an additional discussion by the Finance Committee, and second and third readings and votes.  Only after successfully completing the entire procedure does a bill become law.

 

The Four Wonders of Economic Policy in Israel

 

1.  Promising reform or a vote means:  Everything can be changed but in the meantime I’ve achieved a time-out and a newspaper headline.  Not too bad, wouldn’t you say?

 

In March 1998, the Finance Committee was scheduled to discuss property tax alternatives.  But instead of discussing the reform which should have been presented at that time by the Ministry of Finance, Income Tax Commissioner Doron Levy discussed several possible directions for dealing with the issue of property tax.  No economic analysis of the various alternatives was presented, nor was there any discussion of the feasibility of their implementation.  Furthermore, most of the proposals were based on small adjustments to the tax, which would be compensated by increasing other real estate taxes; so that real reform was not included among the possible alternatives.  During the discussion it became clear that the Ministry of Finance had not yet  decided whether to institute a reform or how to implement such a reform.  The discussion was therefore theoretical and noncommittal.  In violation of his promise, the committee chairman did not put the bill to a vote.  A classic case of Israeli “Israbluff”:  the minister of finance promises to put together a reform within two weeks, following which a discussion takes place in the Knesset, where the finance minister’s reform is not presented.  During this discussion it is agreed that the ministry will plan a reform, following which another discussion will take place.  Meanwhile thousands of Israelis suffer at the hands of the tax authorities.

 

2.  Two weeks equals three months.

 

Only three months later, in June 1998, did the Finance Ministry present a tax reform proposal to a meeting of the Finance Committee.  It would be more correct to call it a Peter Pan reform, since no official working paper was presented to the Knesset members.  The committee chairman requested that the ministry present a detailed document concerning the proposed reform.  The minister promised this would be done within “three weeks.” Once again the committee chairman decided not to put the alternate bills to a vote.

 

3.  “Three weeks” equals the five months that have now passed and there is still no reform of property tax.

 

The fact that the Ministry of Finance’s proposal was formulated by the Income Tax Authority, which collects the tax, explains why the tax has not been canceled.  The tax collectors are not about to cancel a tax which would reduce the Authority’s influence. 

 

On the assumption that the reform is one day carried out in accordance with the principles put by the minister of finance before the Finance Committee, it will contain four main points:  First is a reduction in the tax rate on land which is not “business stock,” from 2.5 percent to 1.2 percent.  As a result, the rate will be identical for both construction contractors and land dealers, as well as private landowners.

 

Second, is an increase in the minimum amount of land liable for taxation and some partial exemptions from property tax.  Under the present law, if the amount of tax owed by an individual in 1999 is less than $72, he is exempt from payment.  Under the ministry’s proposal, the amount of the exemption would be raised to $116.  If an individual owes between $116 and $347, he would be exempt from paying one half of the amount of the tax.  The Ministry of Finance has not revealed how many landowners will be eligible for this discount so that it is difficult to say whether this is a real benefit or just a gimmick. 

 

The third point deals with the possibility of deferring the payment of tax until the sale of the land.  An individual would be eligible for a deferral of tax payment until the sale of his land if the total value of  his (or his family’s) holdings of real estate do not exceed $120,500.  The deferment would be granted provided that his annual property tax exceeds 10 percent of his income.  Tax deferment would apply to 90 percent of the tax payment.  It should be noted that this is not an exemption from property tax but merely a deferment of payment, which is increased by changes in the consumer price index and related interest costs.

 

Unfortunately, any improvements stemming from the three above-mentioned points of the proposed reform, are wiped out by the fourth point:  a levying of additional taxes!  At present, landowners who acquired land between the years 1948-1960 pay an annual property betterment tax rate of between 12 percent and 24 percent of the real profit on their land.  According to the Finance Ministry’s proposal this rate would go up by 6 percent a year until it reaches 50 percent.  Even this, however, is not enough to satiate the ministry, which also proposes raising the purchase tax on homes for owners of more than one home.  The ministry again failed to present an economic analysis of its proposal.  It would clearly result in fewer people investing in second homes for purposes of renting them out on the free rental market.  Real estate experts claim that under present conditions, people are no longer purchasing homes for investment purposes.12  What will happen when the free rental market is reduced in size?

 

The government is not satisfied with collecting 42 percent of GDP in taxes.  When it decides to reduce the burden of the property tax, it immediately raises other taxes.  It is simply libelous to use the term “tax reform” to refer to these proposals. 

 

4.  Tax reform means increasing the tax burden.

 

In general we expect tax reforms to ease the tax burden.  The Ministry of Finance’s proposals would in fact achieve the exact opposite.  First of all, much of the planned reform is based on reducing the property tax rate for private landowners.  But as already shown in Policy Studies No. 34, the property tax paid is offset by the loss of future property betterment tax payments.  The more a landowner pays in property tax now, the less he will pay in property enhancement tax later.  Thus reductions in property tax payments now will increase future property enhancement tax payments.  What does this achieve?  As the Ministry of Finance is demanding that Israeli citizens pay more taxes today in order to fund the reduction, and more taxes to fund the deferment of property tax payments, Israelis will in the present pay more taxes.  In the future Israelis will pay the new tax and landowners will pay the property tax which was deferred.  Ultimately Israelis will pay higher betterment taxes, too.  The result is an increase in Israel’s tax burden.

 

What Should Be Done?

 

1.  Cancellation of state property tax.

 

State property tax should be canceled and collections halted.  The bureaucracy for property tax collection should be abolished once the issue of past debts and other transition arrangements have been dealt with.

 

2.  Cancellation of free state insurance for drought damage.

 

Payments for drought damage from the Compensation Fund should cease.  Compensation for drought damage is distributed to farmers free of charge and constitutes a non-budget subsidy.  Drought damage compensation results in economic waste and inefficient allocation of the factors of production.  Farmers can insure themselves against drought through regular commercial insurance as is the practice abroad.

 

3.  Transfer of the Compensation Fund to the state budget.

 

The state budget is meant to fully disclose government revenues and expenditures, both expected and unexpected.  Compensation paid from the Compensation Fund is direct government aid that does not appear in the state budget.  Furthermore the sum accumulated in the Compensation Fund is relatively small and could not compensate for damages in the case of an all-out war.  Similarly, the Ministry of Finance’s proposal to reduce property tax without finding alternative funding for war damage compensation constitutes neglect of a most sensitive issue.

 

Contrary to the claim that canceling the property tax will reduce state revenues by $300 million, in practice the tax-offset reduces the amount collected by half.  In other words the actual revenues from property tax are only $150 million.  In addition, the cancellation of property tax will save the cost of the collection bureaucracy, reduce legal expenses resulting from the endless legal disputes over property tax, increase state revenues from the leasing of land by the Israel Lands Authority, and increase state revenues from property tax due to an increased number of real-estate transactions.  And since property tax increases housing prices, its cancellation would allow government subsidization of housing to be ended without any harm to Israeli home buyers.

 

Grade

 

Following the recommendations of the Gabbay Commission in May 1997, the Ministry of Finance could have formulated a property tax reform which would have already gone into effect in 1998.  However, the ministry chose not to act, thus prolonging the suffering of private landowners. 

 

Moreover, in 1998 the Ministry of Finance continued to evade implementation of real property tax reform and, despite repeated promises, still has not produced an official document which presents its position.  The minister of finance has decided that any property tax reform will involve the increase of other taxes.  The minister has ignored the opportunity to bring about renewed growth and enhance the freedom of Israeli citizens by reducing the tax burden.  Furthermore, the proposed reform will actually increase the tax burden.  Even though the property tax should clearly be canceled, the Ministry of Finance has so far failed to cancel it and in fact has no intention of canceling it.  The chairman of the Knesset Finance Committee is also delaying the passage of bills that would initiate property tax reform and is thus one of the major obstacles to achieving a real tax reform.  The performance of the Ministry of Finance and the government on the issue of property tax reform together with the performance of the chairman of the Knesset Finance Committee earn a grade of Unsatisfactory. 

 

Ehud Menirav is an IASPS Koret Fellow at the Institute for Advanced Strategic and Political Studies in Jerusalem and Washington, D.C.  He is the author of IASPS Policy Studies No. 34, "Israel's Property Tax and Compensation Fund"

 

 

Notes

 

1.  According to data from the Central Bureau of Statistics, the balance at the end of 1997 stood at approximately NIS 587 million.  This amount was translated into dollars according to the exchange rate at the end of December 1997CNIS 3.5360 ‘ US$1.

 

2.  The property betterment tax is collected by local authorities on increases in land values, at a rate of 50 percent, which result from the approval of municipal building plans.  For example, tax is collected on the increase in value of agricultural land following the granting of building permits.

 

3.  Ehud Menirav, “Property Tax and the Compensation Fund in Israel,” Policy Studies No. 34 (Jerusalem:  Institute for Advanced Strategic and Political Studies, May 1998).

 

4.  The committee’s report was published in the Israel Tax Quarterly 25, no. 99 (Jerusalem:  The Jerusalem Tax Museum, May, 1998).  [Hebrew]

 

5.  The Ministry of Finance, The Public Committee for Investigating the Property Tax Law, “Summary,” April, 1997, p.  1.

 

6.  Yediot Aharonot, May 20, 1998.

 

7.  Proposed Property Tax and Compensation Fund Bill (amendment: exemption for land that is not available for construction), 1996.  Bill no. p/641.

 

8.  Proposed Property Tax and Compensation Fund Bill (amendment: exemption for land that is not available for construction and equalization with commercial land) 1996.  Bill no. p/835.

 

9.  Proposed Sales Tax Bill 1997.  Bill no. p/1808.

 

10.  Yediot Aharonot, March 11, 1998.

 

11.  Ibid.

 

12.  Yediot Aharonot, July 19, 1998.

 

 

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