Tax Composition and its Impact on Growth in Israel: A Narrative Approach

Abstract

This study is unique in using a narrative approach framework to examine whether the very high ratio of indirect to direct taxes in Israel has affected growth in the short term. Indeed, the results suggest that a high ratio of indirect to direct taxes can create a unique environment in which the negative effect of indirect tax increase reaches the negative effect of direct tax increase. The results were stable and robust for both OLS and 2SLS analysis and numerous control variables. Furthermore, the negative effect of indirect tax was achieved in full in the short term, almost exactly as the well-known effect of direct tax documented in many studies. Our interactions analysis suggests that the negative effect of the direct tax is transmitted through both the labor and the capital channels while the negative effect of the indirect tax is transmitted mainly through the capital channel. The results contradict findings on developing countries as well as older results reported in papers on developed countries. Therefore, questions may arise regarding the aims of tax policy in developed countries which usually prefer to raise indirect taxes in order to minimize the negative effects of contractionary fiscal policy.