This article examines, by means of an investment-portfolio model, how a tax reform - the elimination of tax discrimination between Israeli and foreign securities - may affect the composition of the public's portfolio of financial assets and, in particular, the proportion of the portfolio that is invested in foreign securities. The purpose of the analysis is to examine how severely the tax reform may threaten the stability of Israel's capital and forex markets. The effect of the reform is tested from the points of view of institutional and private investors separately.

First we examined the actual investment patterns of investors in Israel and found a strong predisposition, among both private and institutional investors, to invest in domestic stocks even though external investment is highly advantageous. A similar predisposition in the composition of the investors' bond portfolio was not found. Before we tested the effect of the tax reform on the public's investment patterns, we estimated, using the Tobin and Markowitz portfolio-selection model, the effect of the predisposition to domestic investment ("home bias") on the composition of the securities portfolio. By applying the model, we were able to isolate the effect of the tax reform from other factors unrelated to tax discrimination.

The findings show that the main effect of the tax reform will probably be an increase in institutional and private investments in foreign bonds. The difference in the intensity of the effect of the reform will be related to investors' strong predisposition to invest in domestic stocks and a significant increase in the relative advantageousness of investing in foreign bonds after the reform. The findings also show that the reform should have a more significant effect (in both relative and financial terms) on institutional investors than on private ones, mainly because the current tax discrimination is more significant for institutional investors.

Keywords: Counterterrorism, Stock Market

JEL Classifications: G14, H56

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