Israel Finance Ministry, International Division

Excerpts from the
Annual State Revenue Report for 1997

VALUE ADDED TAX

	INTRODUCTION
	VAT REVENUES
	VAT-EXEMPT TRANSACTIONS
	ZERO-RATE VAT
	HOW VAT AFFECTS INCOME DISTRIBUTION
	HOW VAT AFFECTS PRICES
	EFFICIENCY IN RESOURCE ALLOCATION

1. INTRODUCTION

Value Added Tax (VAT) has become a main source of indirect-taxation revenue in Israel.

In 1997, VAT revenue was NIS31 billion, 21 percent of total state tax revenue and 9 percent of Gross Domestic Product (not including NIS4.2 billion from VAT on nonprofit organizations and financial institutions).

Israel, like most countries, imposes VAT on private and public consumption. The VAT tax base excludes investments and exports but includes imports meant for consumption. There are several exceptions to this rule, the most important of which are:

	Public-sector investments are liable to VAT.
	Housing services, although they come under private consumption, are exempt from VAT. However, VAT is imposed on the purchase of new dwellings, including their land component.
	Fresh farm produce is excluded from the tax base. (For a detailed description of transactions exempt from VAT or liable to VAT at a zero rate, see below.)

Value Added Tax acquired its name from the way it is collected: it is imposed on the value- added of every business transaction. For this purpose, value-added is defined as total sales less total purchases of inputs, intermediates, and investments of various types. Alternatively, the value-added of any business is its payroll plus profits.

VAT is collected-at point of import and at all phases of manufacture and retailing-on the value of sales to purchaser (including all taxes except for VAT itself). The VAT imposed on the previous phases-on intermediates and investments-is subtracted from the gross tax (i.e., the "input tax" is refunded).

Israel applies three types of VAT:

	Business VAT (17 percent), collected from all businesses on goods and services.
	VAT on nonprofit organizations (8.5 percent), collected from the public sector (including government ministries) on its payroll. (NPOs are not entitled to refund of input tax.)
	VAT on financial institutions (17 percent), imposed on payroll and profits of banks, insurance companies, and other providers of financial services. They, too, are not entitled to refund of input tax.

2. VAT REVENUES

In 1997, net collection of VAT from businesses was NIS31 billion, 29 percent of total state tax revenue and 9.1 percent of GDP. Additionally, NIS4.2 was collected on account of VAT on nonprofit organizations and financial institutions.

Table X-1 presents state revenues from business VAT in 1987-1997. The general trend during that period points to real growth in revenues. Some of this growth is attributable to increases in the rate of VAT in 1990 and 1991; the rest traces to the increase in consumption that occurred during those years. Although the VAT rate was reduced at the beginning of 1993 from 18 percent to 17 percent, collections did not decrease that year because economic activity was expanding at the time.

During the years reviewed, the share of business VAT in total taxes climbed from 24 percent to 29 percent and the fraction of VAT in Gross Domestic Product rose from 8.6 percent to 9.1 percent. The largest increase occurred in 1991, after the VAT rate was raised from 16 percent to 18 percent. In 1993, the share of VAT in GDP dipped from 9.6 to 9.2 percent because the VAT rate was lowered from 18 percent to 17 percent, where it has rested to this day.

3. VAT-EXEMPT TRANSACTIONS

Unlike many countries that charge different rates of VAT on different products, Israel applies a uniform rate to all products except for a small number of exemptions and several products liable to zero-rate VAT. The exempt transactions are those for which VAT is not paid and the business is not entitled to a refund of VAT paid on inputs (which are liable to VAT). These transactions include:

a.	Imports and exports of diamonds and gems between persons whose businesses deal in these commodities.
b.	Leasing of real estate for residential use, for a term not exceeding 25 years.
c.	Leasing transactions in real estate (including key money) and of land, to which the Protected Tenant Law, 5732-1972, applies.
d.	Sales of leased real estate under conditions of protected tenancy as aforesaid.
e.	Sales in Eilat-under the Eilat Law, sales of goods or services in the vicinity of this town, by businesses that is resident in Eilat and for consumption or use in the Eilat area.

The Eilat-area exemption does not apply to several types of durables, which are liable to VAT at full rate. Examples are private motor vehicles, color television sets, stereo sets, VCRs and video cameras, dishwashers, and dryers.

Most imported services are not liable to VAT.

4. ZERO-RATE VAT

A zero rate of VAT applies to transactions in which the business is not charged VAT but is entitled to a refund of VAT paid on inputs. There are several such activities:

a.	Exports of goods and services by a business whose main area of activity is in Israel.
b.	Sales of fresh (unprocessed) farm produce.
c.	Provision of service to a nonresident in Israel.
d.	Provision of tourism services in Israel to nonresidents, including hotel accommodations, car rental, outings in private vehicles and buses, etc.
e.	Exports of intellectual property-sales of intangible assets such as copyrights, patents, good will, and so on, to nonresidents outside of Israel or foreign-registered corporations.
f.	Sales of aircraft or sailing vessels to businesses whose field it is to transport passengers or cargo-by air or by sea-using regular air or shipping routes.
g.	International forwarding of cargo, by air or by sea, from Israel to abroad or vice versa.

Notably, the zero rate of VAT on exports is typical of VAT laws worldwide. The principle that creates a VAT liability on imports also allows a zero rate on exports, in order to prevent double VAT. For this reason, exports are not included in the reckoning of exemptions. (Since one country's imports are another country's exports, VAT may not be applied to both.)

This also creates fair and non-discriminatory competition in international trade by equalizing VAT on domestic and imported products.

Therefore, Paragraph 2 of the VAT Law applies the tax to imports of goods in the manner of transactions, whereas Paragraph 30 of the same law applies zero-rate VAT to exports of assets and services. The result is that the product is taxed only in the destination country and not in the country of origin.

Countries that apply VAT charge a zero rate on exports of goods other than tourism services. Only Israel applies a zero rate to most tourism services, in order to encourage this industry.

Revenue Lost on Account of VAT Exemptions and Zero Rate
(NISmillions, 1997 prices)

1.	Zero rate on fresh fruits and vegetables	1,200
2.	Zero rate on tourism services	500
3.	VAT on customs and purchase-tax benefits	70
4.	Eilat Law	100
	Total	1,870

5. HOW VAT AFFECTS INCOME DISTRIBUTION

The most salient disadvantage of VAT is its regressiveness, which aggravates inequality in income distribution. This is because VAT is charged at a uniform rate on all consumption and because people in low income deciles spend a higher proportion of their income on consumption than people in the upper deciles.

Dr. Joseph Gabai found that the fraction of VAT in total gross income, including support and transfers, decreases commensurably with the increase in income-from 17.9 percent of income in the lowest decile to 7.7 percent of the income of the uppermost decile (findings based on Central Bureau of Statistics, Household Expenditures Survey 1992-1993). Gabai also found that the total effect of Value Added Tax intensifies inequality in income distribution in Israel by 5.1 percent relative to total gross income.

6. HOW VAT AFFECTS PRICES

Any increase in the VAT rate causes prices to rise in the short term, assuming that the entire tax increase is passed on to the consumer. A one-percent increase in the VAT rate creates a 0.8 percent increase in prices. Practically speaking, the effect depends on demand elasticity and the state of the economy (recession, indexation mechanisms, etc.).

The increase in VAT from 16 percent to 18 percent in January 1991 prompted a modest 1 percent upturn in prices, according to the Central Bureau of Statistics. When the VAT rate was lowered from 18 percent to 17 percent in January 1993, prices decreased by about 0.5 percent.

7. EFFICIENCY IN RESOURCE ALLOCATION

VAT is considered a very neutral tax in terms of resource allocation because it is applied at a uniform rate. The small number of exemptions and of products and services liable at a zero rate to VAT in Israel also brings about that the tax causes minimal distortions economic.

Momi Dahan and Michelle Stravaczynski found that while direct taxes correlate negatively with economic growth, indirect taxes on domestic manufacture have no effect on growth. This finding corresponds to conclusions in the theoretical literature about the effects of taxation on growth under conditions of rigid labor supply.

Value Added Tax has to some extent become a substitute for purchase taxes that had been applied at various rates. As stated, a uniform-rate VAT has a regressive effect on income distribution. To mitigate this effect, the introduction of VAT was accompanied by elimination and lowering of purchase taxes, especially on vital commodities, and continued steep taxation of durables and luxuries. As the VAT was raised from 8 percent to 17 percent, purchase-tax rates were reduced further, including those applying to durables and luxuries.

The VAT base is much broader than the base of purchase tax, which was applied to many products before VAT was introduced. Consequently, VAT can be charged at a lower tax rate than purchase tax for a given level of collection.

Table X-1
Share of Business VAT in Total Tax Revenue and in GDP
(NIS millions, 1997 prices, and percent)

Calendar year	VAT (net)	VAT as pct. of tax revenue	VAT as pct. of GDP
1987	17,655	24.0	8.6
1988	17,771	23.8	8.1
1989	17,621	26.2	7.9
1990	19,264	27.4	8.2
1991	23,208	30.6	9.2
1992	25,833	30.5	9.6
1993	25,912	28.8	9.2
1994	27,454	27.9	9.2
1995	29,372	28.8	9.3
1996	30,383	29.2	9.2
1997	30,899	28.5	9.1

Source: Customs and VAT Administration and Central Bureau of Statistics, processed by the State Revenue Administration

Table X-2
VAT Rates in Israel (1976-1998)
(Percent)

Incidence	Business VAT	VAT on financial institutions	VAT on NPOs
1 July 1976	8	6	3
1 November 1977	12	9	5
1 April 1979	12	12	5
27 July 1982	15	15	6.25
1 June 1985	17	17	6.25
1 July 1985	15	15	6.25
1 March 1990	16	16	6.70
1 January 1991	18	18	9
1 January 1993	17	17	8.50

Source: Customs and VAT Administration

Table X-3
VAT Data¹ by Types of Businesses, 1997
(NIS millions and percent)

	Total	Private firms	Public firms	Cooperative associations	Self-employed	VAT partnership	Other
Active files (qty.)	324,914	72,084	672	1,165	226,615	21,959	2,419
Total sales (NIS millions)	602,912	289,976	76,121	23,075	67,702	131,975	14,063
Sales at full rate	496,997	245,640	53,068	16,186	63,898	107,375	10,839
Sales at zero rate	105,915	44,335	23,053	6,889	3,804	24,599	3,233
Value added and taxable value added (NIS millions)
Total purchases (excl. investments in equipment and assets)	405,848	201,649	53,479	15,987	42,148	84,515	8,070
Value added (sales less purchases)	197,064	88,327	22,643	7,088	25,553	47,460	5,993
Taxable value added	91,150	43,991	-410	199	21,750	22,860	2,760
Pct. of value added (value added as pct. of total sales)
Pct. of value added	32.69	30.46	29.75	30.72	37.74	35.96	42.62
Pct. of taxable value added	15.12	15.17	-0.54	0.86	32.13	17.32	19.63
Distribution of active files vs. distribution of sales
Pct. of active files	100.00	22.18	0.21	0.36	69.75	6.76	0.74
Pct. of total sales	100.00	48.10	12.63	3.83	11.23	21.89	2.33

Source: Customs and VAT Administration, Planning and Economics Department, March 1998

Note to the table:

1. The data include VAT remittances and refunds on account of local manufacture and only VAT refunds on account of imports.

Table X-4
VAT Data¹ by Economic Branch, 1997

(NIS millions and percent)

	Total	Agriculture	Industry	Electricity and water	Construction	Trade, hospitality, and repairs	Transport, storage, and communications	Finance and business services	Public and other services
Active files (qty.)	324,914	13,864	27,510	336	38,047	88,087	31,544	80,184	45,341
Total sales (NIS millions)	602,912	26,049	157,804	11,141	66,607	198,311	47,462	76,848	18,690
Sales at full rate	496,997	17,681	106,565	11,124	65,582	178,444	32,919	66,617	18,065
Sales at zero rate	105,915	8,368	51,239	17	1,025	19,867	14,543	10,231	625
Value added and taxable value added (NIS millions)
Total purchases (excl. investments in equipment and assets)	405,848	17,859	105,878	8,931	49,687	152,801	22,872	38,837	8,983
Value added (sales less purchases)	197,064	8,190	51,926	2,210	16,921	45,510	24,590	38,011	9,707
Taxable value added	91,150	-178	687	2,193	15,896	25,643	10,047	27,780	9,083
Pct. of value added (value added as pct. of total sales)
Pct. of value added	32.69	31.44	32.91	19.84	25.40	22.95	51.81	49.46	51.94
Pct. of taxable value added	15.12	-0.68	0.44	19.68	23.87	12.93	0.00	36.15	43.60
Distribution of active files vs. distribution of sales
Pct. of active files	100.00	4.27	8.47	0.10	12.71	27.11	9.71	24.68	13.95
Pct. of total sales	100.00	4.32	26.17	1.85	11.05	32.89	7.87	12.75	3.10

Source: Customs and VAT Administration, Planning and Economics Department, March 1998

Note to the table:

1. The data include VAT remittances and refunds on account of local manufacture and only VAT refunds on account of imports.

Table X-5
VAT Data¹ by Percent of Value Added from Sales, 1997

(NIS millions and percent)

	Total	>0	0-1	1-20	21-40	41-60	61-80	81-99	99-100
Active files (qty.)	324,914	45,065	2,458	49,100	53,220	52,537	58,119	51,840	12,575
Total sales (NIS millions)	602,912	27,027	3,600	177,910	188,119	106,549	48,347	43,759	7,601
Sales at full rate	496,997	23,183	3,541	168,795	157,280	79,102	35,587	28,068	1,441
Sales at zero rate	105,915	3,845	59	9,115	30,839	27,446	12,750	15,691	6,161
Value added and taxable value added (NIS millions)
Total purchases (excl. investments in equipment and assets)	405,848	38,766	3,583	157,963	132,219	53,636	14,949	4,718	13
Value added (sales less purchases)	197,064	-11,739	17	19,947	55,900	52,912	33,397	39,040	7,589
Taxable value added	91,150	-15,583	-42	10,832	25,061	25,466	20,638	23,350	1,428
Pct. of value added (value added as pct. of total sales)
Pct. of value added	32.69	-43.43	0.47	11.21	29.72	49.66	69.08	89.22	99.84
Pct. of taxable value added	15.12	-57.66	-1.17	6.09	13.32	23.90	42.69	53.36	18.79
Distribution of active files vs. distribution of sales
Pct. of active files	100.00	13.87	0.76	15.11	16.38	16.17	17.89	15.95	3.87
Pct. of total sales	100.00	4.48	0.60	29.51	31.20	17.67	8.04	7.26	1.26