The Effect of Legislated Tax Changes on Tax Revenues in Israel

We estimate the extent to which tax revenues in Israel are influenced by legislated tax changes, using a database that includes all such changes during the period 1991–2012. We use the tax revenue forecasts, which are presented to the Knesset each year alongside the proposed changes in taxation, as a proxy for the information possessed by policy makers at the time tax policy changes were legislated (after verifying that these forecasts are not manipulated). This makes it possible to overcome the endogeneity problem which makes it difficult to identify the effect of legislated tax changes on tax revenue and economic activity. We find that the effect of legislated tax changes on actual tax revenue is about 70 percent of the amount predicted by a static calculation based on multiplying the tax revenues in the previous year by the change in the tax rate. The offset is a result of the effect of the tax change on economic activity, which peaks in the second year following the implementation of the tax change and declines subsequently. This finding implies that policy makers should be aware during periods of tax rate changes that the effect of the changes on revenue stabilizes at its peak only about two years after being affected. The results disprove the claim that the Israeli economy was located during the sample period on the “wrong side” of the Laffer curve where reducing tax rates leads to higher tax revenue. We find that after a transition period of two years, a change in the corporate income tax rate yields 90 percent of the revenue expected by a static prediction—a greater share than that of revenue collected from a change in the personal income tax (65 percent), or in indirect taxes (53 percent).This order is in contrast with the short term, where changes in corporate income taxes have the lowest actual effect on revenues. We also find that reducing personal income tax rates has a negative effect on the average gross wage in the economy. Thus net wages increase by about 65 percent of the benefit, and the employers' labor costs decrease by the rest of the expected revenue loss.