How the Corporate Tax Negatively Impacts Israeli Investment
Last year, Israel canceled a scheduled phase-down of its top corporate income tax rate, and instead raised the rate one point to 25 percent. Now, some Israeli politicians are seeking to increase a preferential corporate rate that benefits export-oriented businesses. To be sure, Israel must make difficult choices to reduce its fiscal deficit, but attempting to do so by increasing the tax rate on business income-particularly mobile business activities such as export-oriented production-will discourage foreign direct investment (FDI) into Israel and may encourage Israeli firms to expand their businesses abroad instead of at home, causing diminished economic prosperity and further fiscal drag.
Israel's Corporate Rate Reversal
Israel was the only OECD country to raise its statutory rate in 2012. In fact, Canada, Finland, and the UK all cut their corporate rates. This tax rate hike was a policy reversal for Israel, whose top corporate rate declined steadily from 36 percent in 2003 to 24 percent by 2010. The scheduled rate phase-down that Israel canceled would have reduced it even further, to 18 percent.
On top of this, Israel is publicly debating the elimination or curtailment of pro-export tax benefits for some Israeli companies under the Law for the Encouragement of Capital Investment. This law provides a reduced corporate tax rate on all business income of firms exporting more than 25 percent of their domestic production. The reduced rate for qualifying companies-12.5 percent for production located in central Israel and 7 percent for activity located elsewhere in Israel-is currently scheduled to fall to 12 percent and 6 percent, respectively, in 2015. But if the proposed change is enacted, these highly mobile companies could lose this incentive to operate domestically and instead be required to pay the regular corporate rate of 25 percent.
Corporate Tax Rates and FDI
Globally, average corporate tax rates among developed nations have steadily declined over the past two decades. In 2012, the OECD average corporate rate was 25.4 percent. Ireland, which is in many instances Israel's direct competitor for FDI, went from a 40 percent rate in the mid-1990s to 12.5 percent by 2003.
These trends signify an increasing awareness of an important fact in public finance: businesses are more and more agile in their ability to move activities globally in response to differences in tax policies across jurisdictions. For example, Ireland's corporate rate cut triggered a massive influx of FDI and a surge in the Irish economy. In short, the rate reductions prevalent in developed countries in the last several decades reflect the degree to which international capital and investment are sensitive to corporate tax rates.
Academic studies have confirmed a statistically significant relationship between a country's corporate tax rate and FDI and have also shown an increase over time in the responsiveness of FDI to the tax rate. Economists Ruud De Mooij and Sjef Ederveen review empirical research on FDI and taxation across a range of countries and find that, on average, a one percentage point reduction in the corporate tax rate results in a 3.3 percent increase in FDI. Research I conducted with my colleague Kevin Hassett confirms that lowering high corporate tax rates tends to result in additional revenues by encouraging companies to report more profits in that country.
The Case of Israel
Corporate tax rates are particularly important for small countries to be globally competitive. Israel has the population of Virginia, an economy the size of Wisconsin or Tennessee, and land mass comparable to New Jersey. Israel's exports, $65 billion worth of goods in 2012, rank it 54th in the world. Because Israel is a small and open economy, it must have a competitive corporate tax structure to attract FDI.
Empirical evidence from cross-country analysis suggests that the one-point rate increase in 2012 may raise little or no revenue, but may do much to discourage both investment and repatriation of foreign-earned income back to Israel. The removal of the export incentives will only amplify the harm. The incentives are explicitly intended to encourage growth in the business sector and improve the global competitiveness of Israeli industries. The theoretical justification for Israel's preferential rate on a subset of business income is to target the benefit toward the most mobile capital.
But, the reduced tax rate may appear unfair to Israeli businesses that don't export. The solution is to extend the lower rates to all companies. That would effectively match Ireland's 12.5 percent corporate tax rate and would likely cause an investment boom.
If Israel were to remove the incentive currently in place, it would be reversing course on its previously aggressive strategy geared toward promoting investment and exports. If Israel instead adopts policies that attract new capital, its citizens will experience higher wages and greater employment opportunities.