From the forthcoming Recent Economic Developments: The Cyclically Adjusted Deficit in Israel

07/02/2012
29.12.2011
 
From the forthcoming Recent Economic Developments: The Cyclically Adjusted Deficit in Israel
 
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  The government’s tax revenues in Israel are more sensitive to the business cycle than in other OECD countries and South America.
  The high sensitivity of tax revenues in Israel is primarily due to the high sensitivity of taxes on wages, which is a result of the high progressivity of the income tax in Israel and the high elasticity of total wage payments in the economy with respect to changes in the output gap relative to the OECD countries.
  The high elasticity of total wage payments in the economy to the output gap reduces the sensitivity of corporate profits in Israel to changes in the business cycle, which has contributed to the resilience of the economy in recent crises.
  An increase in the output gap of one percent increases the deficit of the public sector in Israel by 0.46 percent of GDP, which is similar to the average for other OECD countries. This similarity, despite the higher elasticity of taxes, reflects the low level of unemployment benefits in Israel and the relatively low elasticity of unemployment with respect to the business cycle.
  After neutralizing the effect of the business cycle according to the estimated elasticities, it appears that the consolidation measures adopted by the government between 2003 and 2007 accounted for about two-thirds of the reduction in the deficit during that period. The remainder was due to growth in economic activity, as the economy recovered from the recession. In contrast, the increase in the deficit from the end of 2007 until 2010 is explained almost completely by the reductions in tax rates, while the business cycle had only a minor effect.
A study carried out by the Bank of Israel Research Department has found that the influence of the business cycle on the deficit of the public sector in Israel is similar to that calculated for the other OECD countries using an identical method. The study found that the influence of changes in the output gap on tax revenues in Israel is large relative to the OECD countries but that they have only a small effect on government expenditure. The estimates indicate that the large increase in the general government deficit from 2007 until 2010 was a result of the government’s policy measures, primarily the major reduction in tax rates in 2007 and 2008, and to a lesser extent macroeconomic developments. In contrast, the decline in the deficit from 2003 until 2007 was the result of government measures to limit the increase in government expenditure as well as the increase in tax revenues as a result of the economy’s accelerated growth. The graph below presents the total change in the deficit (measured in percent of GDP) for various sub-periods between 1993 and 2010 and the contribution of government policy measures and the business cycle to these changes.
 

 
The OECD’s method of calculation divides the effect of the business cycle on the government deficit into five parts: the income tax on wages, social security contributions, the corporate income tax, indirect taxes and unemployment benefits. For each of them, two components are calculated: 1) the percentage change in the tax base (for example, corporate profits constitute the base for the corporate income tax) relative to a change of one percent in the output gap (which is the difference between actual GDP and an estimate of the economy’s productive potential in a particular period); and 2) the percentage change in tax revenues relative to a change of one percent in the tax base. The calculation of these elasticities using the same method for a number of countries enables a comparison of both the overall elasticity of taxes with respect to the output gap and the elasticities of tax components.
The comparison shows that a change of one percent in the output gap brings about a change of 1.25 percent in the same direction in tax revenues. This elasticity is larger than that in other OECD countries (1.05 on average), primarily due to the high elasticity of taxes on wages in Israel with respect to the output gap. This is a result of both the high progressivity of taxes, which increases the elasticity of tax revenues with respect to wages, and the higher sensitivity of wage payments in the economy (the tax base) to the output gap. The latter is an indicator of the flexibility of the labor market in Israel, which has helped the Israeli economy cope with crises during the last decade. In contrast to the relatively strong reaction of tax revenues to the output gap, the elasticity of unemployment benefits with respect to the output gap in Israel is very low, while in the OECD countries it is significant. As a result, the change in the deficit of the public sector in Israel with respect to a one-percent change in the output gap is similar to that in the OECD countries.
The OECD’s method of calculation has some limitations, which are the result of the need to maintain uniformity between a large number of countries. In order to test the significance of these limitations, the study included a more disaggregated estimate for Israel, which is based on data that the OECD researchers did not use. According to the main findings, the overall effect of the output gap on tax revenues and the government deficit is smaller than the disaggregated estimate; however, the differences relative to the OECD estimates are not large. With regard to specific elasticities, it was found that the elasticity of indirect taxes with respect to the output gap (0.76) is significantly lower than the unitary elasticity assumed by the OECD and that the elasticity of taxes on wages in the disaggregated calculation (1.54) is significantly lower than the estimate which is based on the OECD methodology (1.81). On the other hand, it was found that the tax revenues from self-employed income grow by about three percent relative to each one-percent increase in the output gap. This is much higher than what was obtained by the OECD method, which assumes that it is identical to that of taxes on wages.