But this simple calculation overstates the true or effective tax rate of each company. It is necessary to factor back into the calculation two subsidies that the Government of Israel provides to each firm, which are quantified in the F20 reports or annual reports. These two subsidies are research and development (R & D) grants and exchange-rate insurance (a subsidy to exports in the form of compensating exporters for an overvalued exchange rate), which was phased out in 1993. (The phaseout of the exchange-rate subsidy does not change the overall picture much in that it is only one of a package of benefits that remains intact.)

Research and development grants receive peculiar treatment in company accounts. They are not treated as taxable income, but repayment of royalties up to a maximum value of the grants is regarded as deductible expenses. Repayments lag in value the grants, but over time the economic effect is a wash. It is not, however, a wash for tax purposes. Therefore, the value of the subsidy, taking one year with another, is the applicable tax rate multiplied by the value of the R & D grant. Most export-oriented firms enjoy a preferential tax rate under the Law for Encouragement of Investment, ranging from 15-25 percent, which is well below the standard corporate rate of about 41 percent that applied in 1991. In economic terms, the value of the R & D subsidy is the equivalent of a tax refund, which lowers a firm's effective tax rate.

The value of exchange-rate insurance, which is found in the notes segments of company annual reports, must also be incorporated in calculating effective tax rates. Exchange-rate insurance payments by the Government of Israel to exporting firms are added to company revenues and therefore show up in net income before taxes. The subsidy element is the after-tax portion of exchange-rate insurance payments, which is obtained by multiplying each firm's tax rate by the amount of the payments and subtracting that figure from the total payments. The value of both subsidies represents the equivalent of a refund of taxes, which reduces the effective corporate tax rate. (The notes to the data on Scitex identify these two adjustments to reported taxes and apply to the other seven firms as well.)

These adjustments to the determination of effective tax rates would be more accurate if it were possible to have an inside look at each company's accounts or annual tax returns. The calculations are, however, illustrative of the effective reduction in tax rates generated by cash subsidies to exporting firms.

But even these adjustments understate the effective corporate tax rate. There may be other subsidies, in cash or in kind, that are not reported in the annual reports or F20 forms. The Law for the Encouragement of Investment awards firms that receive the category of "approved enterprises" benefits in the form of accelerated depreciation, specified tax holidays, lower statutory rates for fixed periods and cash grants up to 38 percent of the value of their fixed investments. For the past several years, the Government has paid up to one-third of new payroll costs for firms that hire specified numbers of employees, and a new program of state guaranteed loans has an implicit subsidy value as well.

The tables in the appendix show the recalculation of tax rates for eight export-oriented firms. The tables exclude four firms: Electrochemical Industries (Frutarom), Oshap Technologies Ltd., Lannet Data Communications Ltd., and Aryt Optronics Industries Ltd. The first, Frutarom, has not paid taxes since 1979 owing to the benefits it has received as an approved enterprise. Someday one imagines that the firm will pay taxes, but for now collecting any taxes from Frutarom has proved to be a will-'o-the-wisp. The other three firms have not paid taxes in recent years, but they have received a combination of R & D grants and exchange-rate insurance payments. Bluntly put, these three firms have been consumers of taxes, not payers of taxers.

Examine the eight firms for which effective tax rates have been recalculated. A bracketed tax rate in parentheses (effective) means that the firm has received, on net, subsidies in excess of tax payments. Scitex was a net beneficiary of Government subsidies in 1988 and 1989, and paid an effective tax rate of 15-16 percent in 1990 and 1991. Elbit paid an average tax rate of 7-8 percent during 1987-1988, but was a net recipient of subsidies during 1989-1991 due largely to the tax loss carryforward of Elscint, in which Elbit acquired a controlling interest in 1989. This is seen more vividly in the third table, which reports the adjusted calculations for Elscint.

The only company which has paid serious taxes is Teva, but it exports only about half of its products and enjoys a commanding one-third position in the domestic Israeli market. Its effective high tax rate is due largely to its tax expenses on domestic sales.

ECI Telecom finally paid a positive effective tax rate in 1990, but this may be due to the fact that there was no entry in the ECI annual report for its receipt of exchange rate insurance (for which no data was entered in the table).

Optrotech was a big recipient of subsidies for the past three years, which wiped out all tax expenses. IIS became, in 1990, a tax eater, rather than a taxpayer, and Laser Industries has had no tax liabilities against which subsidies can be offset.

A full study, along comparable lines, of exporting firms in Israel that trade solely on the Tel Aviv Stock Exchange or which are privately held, would reveal to what extent the analysis applies to the overall exporting sectors of electronics and textiles/fashion. But there is no reason to suppose that firms traded on U.S. stock exchanges are disproportionately greater recipients of subsidies than firms which trade on the TASE.

To put the story in perspective, the modern, high-tech export sector is virtually free from direct taxation. The equity bases of those firms that trade on the TASE are also free from capital gains taxation. This is the formula that gives Israel the modern sector of its otherwise moribund, socialist economy.

In 1991, Israel exported just over $11 billion of goods; of this, metals and electronics contributed $3.2 billion; diamonds, $3.1 billion; chemicals, $1.4 billion; textiles and fashion, $800 million; food, $500 million; and smaller amounts for rubber and plastics, mining, and wood and paper. Electronics are an important part of Israel's exports, but they were a very small part, about 5 percent, of Israel's $54 billion GDP in 1991. So, while the tax-free, high-tech sector flourishes, it is not large enough to drive the entire economy into high growth.

The tax-free status of Israeli corporations also extends to major foreign corporations that do business in Israel. Israeli officials boast of the massive investments made by such global giants as Motorola, Intel and IBM as proof of Israel's positive investment climate. But Intel's payment of NIS 30 million (about $11 million) of corporate income taxes in 1992 was the first year that the firm paid income taxes after 10 years of doing business in Israel .

Despite Intel's lack of contributions to state revenues, Israeli officials actively courted additional investment by Intel. In early January, the Government announced that it had approved in principle a seven-year grant to Intel of $380 million that would enable Intel to finance a $1 billion expansion in its Israeli activities. In late September, Intel executives announced that the firm would shortly submit its plan to expand its Jerusalem facility to the Investment Center of the Ministry of Industry and Trade. Intel's final decision to proceed, if positive, means that it will continue to operate on a virtual tax-free basis.

In addition to the lack of direct taxation on Israeli firms, profits from capital gains on the sale of shares listed on the TASE are free of taxation. Even in socialist Israel, no to low taxation produces profitable economic activity.

The Bureaucrats Respond: Tax The TASE (Or, they can't stand prosperity)

Every year, the Minister of Finance typically appoints a committee of "experts" to consider a variety of proposals to reform Israel's dreadful tax system. Taxation in Israel is heavy, uncertain, discriminatory, confiscatory, and complicated. The tax system, perhaps more so than any other area of economic policy, is a prime cause of low investment and slow growth. It drives thousands of would-be entrepreneurs underground or to greener pastures overseas, mainly in the United States.

This last statement may seem to contradict the previous section, but it does not. It is not easy to qualify for Government tax benefits. To do so requires running the gamut of bureaucratic obstacles imposed by the official "Investment Center," which has the authority to dispense capital grants, tax holidays, and other subsidies. None of these benefits are available to small entrepreneurs, who cannot invest the time and money to secure approved status or who are not big enough to go public on the TASE. Thousands of potential businessmen are cut off from these benefits. A low, neutral tax system would eliminate the high tax impediment to investment and work that obstructs the formation and growth of small business firms.

The year 1993 was no different in following the tradition of appointing yet another Government tax reform effort. The Minister of Finance, Avraham Shohat, appointed a committee of experts under the chairmanship of Yoram Gabbay, Director-General of State Revenues, to recommend changes in taxation. The members included Moshe Gavish, then Commissioner of Income Taxes, Professors Ephraim Sadka and Yitzhak Suary, two well-recognized tax specialists, Dr. Leora Meridor, director of research at the Bank of Israel, Aryeh Zeiff, Commissioner of Customs and Value Added Taxation, and three other "experts," Ben-Ami Zuckerman, Avi Alter and Yehudit Lifschitz. This list is a Who's Who of Israel's tax establishment.

The committee and the TASE wrestled with each other throughout the year. On January 27, 1993, a week before the committee was scheduled to hold its first meeting, the stock market closed down sharply, losing 1.42 percent of its value, in response to a rumor that the Ministry of Finance was planning to levy a 25 percent capital gains tax on stock market profits. The absence of any capital gains taxation imposed on financial transactions on the TASE is one of the glaring exceptions to Israel's overall high tax policy. That night Minister Shohat categorically denied the rumor.

But the rumor would not go away. One reason was that the chairman of the tax reform committee, Yoram Gabbay, who also works for Minister Shohat, stated on the record that: "There are billions of tax-free shekels in the capital market -- about NIS 4 billion. If some of this money were taxed, it would enable us to lower income taxes." Israel's egalitarian, socialist mindset breeds a mentality which holds that it is unfair to let stock exchange profits escape taxation. Besides, a genuine private sector would reduce the power and control of these bureaucrats, who seem determined to frustrate efforts by elected politicians, especially the Minister of Finance, to set policy.

Next, Bank of Israel Governor Dr. Jacob Frenkel fueled anxiety over a possible capital gains tax when he warned that cash flowing into the TASE, whose index had risen from 100 in 1988 to 386 in 1992, was at the expense of money invested in private sector investments in buildings and equipment, whose index had risen only from 100 to 158 during 1988-1992. On February 9, Frenkel fretted that the TASE was becoming a "bubble," which might burst. Did Dr. Frenkel learn this logic for his view of economic processes during his many years at the free-market University of Chicago economics department?

Rumors of a capital gains tax resurfaced in early March, again driving down share prices. To halt the mischief of his State Revenue Director-General and Income Tax Commissioner, Messrs. Gabbay and Gavish, Shohat temporarily postponed deliberations of the tax reform's subcommittee on capital market taxation.

On May 4, Israel's daily financial newspaper, Globes, reported that the subcommittee on capital market taxation, under the leadership of Gavish, was preparing to recommend a 25 percent tax on capital gains. A week later, on May 12, Shohat told the Knesset that he had not yet decided the issue, and that he was not obligated to accept the recommendations of his tax reform committee.

Gavish could not restrain himself. On June 8, he told the Accountants' Association that the failure to tax the stock exchange amounted to favoring the financial sector over the real investment sector. Globes reported on June 14 that Gavish told Shohat he favored a 25 percent capital gains tax. He was reportedly joined in this recommendation by Aharon Fogel, the Director-Geneal or number one staff person in the Ministry of Finance. In an editorial published in The Jerusalem Report on June 18, columnist Neil Cohen correctly asked: "Who's in charge of the Treasury anyway?" The situation was clearly out of hand.

Israeli prime ministers rarely, if ever, join the fray over economic policy disputes. But continued volatility in the TASE prompted Prime Minister Yitzhak Rabin to quell expectations about imposing a capital gains tax. Declines on the exchange in mid-June were dramatically corrected, when stocks rose 3 percent in response to Rabin's promise not to tax capital gains. Speaking to reporters on a visit to the north on June 15, Rabin stated: "I want to make it categorically clear that I view the bourse as a major source for raising money for investment in the future. I don't foresee any taxes on the bourse in the near future."
Three days later, on June 18, Rabin told a forum of economic policy makers and businessmen that he would not tax the TASE because it was the only alternative to taxpayer-financed, state aid. Denouncing his own bureaucrats, he stated: "It is unacceptable that shock waves [routinely] unsettle the capital market every Monday and Thursday." Rabin's statement followed months of press leaks that the Finance Ministry's subcommittee on capital market taxation would recommend a capital gains tax. Even this did not silence the bureaucrats. The Post reporters noted that both Aharon Fogel, the Finance Ministry's Director-General, and Moshe Gavish, Commissioner of Income Taxes, supported taxing capital gains. Despite repeated denials by the Minister of Finance and the Prime Minister himself, Israel's senior bureaucrats continued their assault.

Investors lacked confidence that Rabin's pronouncement would silence the bureaucrats once and for all. Investors phoned in sell orders, and the market began a five-day plunge on June 20, losing 8.6 percent of its value. Investors also evidently did not believe Shohat's remarks of June 21 at the Jerusalem Economic Forum that he was in no rush to accept any recommendation of his reform committee to tax capital gains. Finally, on the afternoon of June 28, Shohat unequivocally announced that the Ministry of Finance would not tax stock market profits. The announcement forced the TASE to halt trading in the afternoon. Opening the next morning, the market recovered most of its previous losses, rising 6.7 percent. Leftist members of the Knesset were upset, believing that capital gains taxation was "socially just."

The verdict on 1993's exercise in tax reform? Yedioth Ahronoth, the Hebrew daily that commands nearly 80 percent of the market, ran a feature story on June 29 on the tax reform committee. Its conclusion was on target: "one big foul-up." No reform was executed, only unimportant cosmetic changes were proposed, and some of these were negative or superfluous. These are not kind words about Israel's "tax experts." The newspaper criticized the committee's proposal to raise the top marginal rate of tax from 48 percent to 50 percent, as this would encourage high-rate taxpayers to engage in a variety of tax avoidance schemes. The newspaper also accused the committee of failing to deal with issues of simplification that might benefit tens of thousands of self-employed persons, who are routinely harassed by the tax authorities.

Coincidentally, The Jerusalem Post reported in its June 29 edition that Income Tax Commissioner Moshe Gavish announced his intention to resign at the end of September. Gavish denied that his decision to resign was influenced by Shohat's refusal to impose a tax on capital gains.

Yedioth Ahronoth reported on July 2 remarks of Gavish that all the members of the subcommittee on capital market taxation -- Aharon Fogel, Leora Meridor, Yitzhak Suary, Ben-Ami Zuckerman, and Yoram Gabbay -- unanimously supported taxing the TASE. A few days later, Gabbay, still in his job as Director-General of State Revenues, stated that he opposed taxing the TASE because the imposition of universal filing requirements would deter investors, thereby causing economic damage to the nation. A reporter for Yedioth Ahronoth claimed in a story dated July 2 that Gavish charged Gabbay with seeking to curry favor with his boss, Minister of Finance Shohat, thus explaining Gabbay's apparent reversal.

So what did the committee on tax reform ultimately produce? A reform so incremental that it can scarcely be recognized in the budget. Shohat proposed to the cabinet in early August that individual income taxes be reduced in the aggregate by NIS 800 million over two years, which is on the order of one-half of one percent of annual state revenues. This does not justify the name "reform" or the expenditure of energeies that went into producing it. Most of all, it does not do justice to the magnitude of problems associated with the tax system. Note well that the axis upon which all discussion of reform turned was controlled by the experts -- and their idea of reform was to add new taxes.

The supposed "reform" would broaden tax brackets slightly, giving middle-income taxpayers with monthly incomes in the range of NIS 4,000 to NIS 10,000 a slight reduction in monthly tax payments ranging from NIS 40 to NIS 120 (about $14 to $42). However, incentives at the top would be harmed by a proposed rise in the top marginal rate of tax from 48 to 50 percent. Previous legislation would reduce the corporate tax rate one percentage point from 39 to 38 percent in 1994, with a planned annual one percentage point cut to 36 percent by 1996.

But there is some credit to award in all of this -- to the man who resisted the bureaucrats. The intellectual and bureaucratic establishments did everything they could to browbeat the Minister of Finance to impose a 25 percent tax on stock market gains. Minister of Finance Shohat, with the support of the Prime Minister, showed the courage to overrule an apparently unanimous recommendation of "tax experts" he himself appointed. In so doing, the two men kept alive the one sector of the Israeli economy that truly works, the Tel Aviv Stock Exchange, and earned Shohat Man of the Year honors.

Don't expect the bureaucrats and experts to give up so quickly. They will resurface every year, clamoring for a "just" capital gains tax. Eternal vigilance by Shohat and a succession of Ministers of Finance is required to insure the survival of a vibrant stock market, and the development of genuine capitalism in Israel.

There are sound reasons not to tax capital gains. Capital gains are not recorded in any country's national income accounts. Capital gains are not counted in GDP, but simply represent a transfer of assets among individuals or firms. A well-design tax system should strive to levy the lowest possible rate of tax on the broadest possible base of income, which is the GDP. Since capital gains are not counted as part of the GDP, there is no justification for taxing them.

Capital gains tax on financial transactions constitutes a form of double taxation. The reason is that rising profits in any firm are taxed by the corporate income tax. A share of stock is the residual claim on the firm's after-tax earnings. Rising stock prices signal rising after-tax earnings. To tax capital gains would amount to double taxation -- first on the rising earnings and then again on after-tax proceeds received by individuals in the form of capital gains. Intuitively, if not objectively, both Shohat and Rabin deserve praise for getting these basic principles of tax policy correct.

To summarize, the modern high-tech sector works in Israel for two reasons: firms pay little or no direct taxes and shareholders pay no taxes on capital gains. If Israel had a well-designed system of low tax rates, subsidies and tax breaks for firms would not be required. But the principle of low effective rates of taxation is a recipe for success, even when it is accomplished in a second-best manner. Pity that the Government does not apply this lesson to the whole of the Israeli economy.

Some Concerns

All is not roses on the TASE. There are two worrying trends. The first is the inept use of the TASE by the Government to sell portions of state-owned banks and firms, which amounts to nationalizing savings while retaining Government control. This non-privatization privatization, or non-investment investment, diverts private savings away from private enterprises into Government hands, where it is mainly spent on consumption. The second worrying trend is the growing discrimination practiced by the TASE against small firms. The first trend is dissected in Chapter 2; here the second is examined.

The TASE no longer permits very small start-up operations to be listed. At the beginning of 1993, a new firm was required to have an equity of $1 million to list its shares for trading. This level was increased in mid-year to $2 million. In November, the TASE issued new regulations, which raised the level to $3 million. In addition, firms can no longer offer pro forma balance sheets for a business year, but must have been actually operating for a year prior to an initial public offering (IPO). Research and development firms are now required to show equity of $750,000, an increase over the prior minimum of $500,000.
The chairman of the TASE, Haim Stoessel, said that the tougher requirements were directed at improving the quality of new issues, and also noted at year's end that the higher conditions were not slowing the pace of new IPOs. In fact, at the pace of 1993, the TASE would list more shares than are traded on either the German or French markets sometime in 1994.

Nonetheless, the greater capital requirements crowd out firms that readily qualified for an IPO in early 1993 and the TASE has not yet published any research that demonstrates a higher than average failure rate for smaller capitalization issues. The higher capital standards and length of time required to have been in business will reduce the ability of start-up firms to go public. The consequence of these measures is to restrict the benefits of being listed on the TASE to a smaller group than would be permitted under the 1992 TASE regulations and those in effect for most of 1993, when the stock market became an important source of capital for new enterprises. It behooves the TASE to demonstrate on firm grounds of evidence that investors are at greater risk in acquiring newly-listed shares of small-capitalization firms before increasing the requirements for an IPO.

Nasdaq for Israel

Small business is the primary engine that drives economic growth all over the world. The TASE has played a critical role in bringing to market several hundred new firms in the past two years. The higher capital requirements for IPOs on the TASE have not stalled the flow of new firms seeking equity capital, but it has eliminated smallcap, start-up companies. One way to resolve this problem is to establish smallcap stock markets, perhaps in Jerusalem, Haifa or Beersheva.

Listing requirements in the United States depend on the particular exchange. The New York Stock Exchange imposes the toughest requirements. The American Stock Exchange only requires $750,000 in pretax income in the latest fiscal year, a minimum share price of $3.00, at least 800 stockholders, and an initial public float of $500,000 out of total stockholders' equity of $4 million. Nasdaq has two sets of quantitative and qualitative standards, one for its national market and the other for its smallcap market. The market value of the public float must be $3 million for listing on the national market, but only $1 million on the smallcap market. Exchanges in other countries, both in developed and emerging markets, have different minimum listing requirements.

The easy solution for Israel is to establish a Nasdaq-type market in Jerusalem or some other location that imposes the 1992 TASE minimum requirement of $1 million, or less, for original listing of common stocks. The establishment of one or more smallcap markets would permit the TASE to maintain or even raise its minimum listing requirements without closing the equity door to smaller start-up firms. The existence of other stock exchanges would also prevent the TASE from becoming a monopoly, which is a particularly insidious feature of Israel's economy. The benefits of competition in the economy should also extend to stock markets themselves.

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