A taxing dilemma

In its customs union with the PA, Israel holds vast economic leverage over Hamas. Is it time to use it? If the decision was made to unilaterally abdicate the Paris Protocols and break the customs union, the effect would likely be far-reaching across the Palestinian economy.

Analysis

By Rafael D. Frankel

Through five years of fighting, Israel has tried numerous tactics to prevent, punish and dissuade attacks on its citizens. Extensive ground-based operations, targeted killings from helicopters and jets, home demolitions, mass arrests, road blocks, checkpoints and other means have all been employed against the Palestinians.

The results are mixed. Terrorist attacks are much lower than they were at the height of the intifada, but, as The Jerusalem Post reported on Thursday, 14 suicide bombers were intercepted and arrested by the IDF and Shin Bet (Israel Security Agency) in the past three weeks alone, indicating that the relative calm is not for lack of trying by Palestinian militants who have stepped up their operations in the wake of the Hamas victory at the polls.

In the varied success of these strategies, one common thread woven among them is their physical nature. (On only one occasion, when terror was at its height in 2002 and Arafat was caught red- handed smuggling in weapons on the Karine A, did Israel withhold funding for the Palestinian Authority.)

So while it is clear that physical measures have worked to prevent hundreds, if not thousands of terrorist attacks, the strategy has not managed to dissuade them with the same degree of effectiveness. And in the long-run, if the will remains to attack Israelis, casualties will inevitably follow.

But physical tactics, though clearly the preferred choice of the government to this point, are only one set of a vast array of tools which Israel has at its disposal to fight terror.

For some time, calls have been growing to employ not only non- violent, but entirely non-physical means against the Palestinians which could nonetheless prove exceedingly effective at dissuading terrorists from even attempting attacks. Now, with the Hamas ascendancy, those calls have translated into an indefinite cessation of transferring tax revenues to the PA and an examination by the government of other tactics which follow the same line.

Cutting off electricity to the Palestinians in Gaza after rockets are fired is one such idea. Closing off Israel to Palestinian workers is another. Both have been floated as possible counter-measures to terror for some time, the latter having been periodically used. But at a moment where Israel is walking a tight- rope in trying to maintain an international coalition against Hamas, those measures, branded by many in the West as a form of "collective punishment," could backfire.

Thus, attention is slowly turning to the long taken- for- granted economic relationship between Israel and the PA. This has more or less maintained the same shape since the 1994 Paris Protocols which, in essence, amalgamated the two into a single economic entity.

"We've always been reluctant to use the economic weapon in our struggle with the Palestinians. At least partly, we were apprehensive about what the Americans would say if we applied economic pressure," said Yakir Plefner, a former deputy governor of the Bank of Israel. "But we've been supplying the Palestinians the whole time with the electricity, the fuel and the fertilizer to make bombs. I don't think there's been anything like that in history. It's us who make it possible for the Palestinians to keep functioning militarily."

UNTIL NOW, the one aspect of the Paris Protocols which has made its way into the news is the revenue clearance mechanism, in which Israel collects the revenue for PA import and export duties, income taxes and value added taxes (commonly referred to in the United States as "sales tax"), and transfers that revenue to the PA on a monthly basis. It was the transfer of this revenue that the cabinet decided to halt Sunday.

But the Paris Protocols go much further in creating a customs union which envelopes Israel and the PA into a single trading body that allows goods to move between the two, tax free. The accord also harmonized nearly the entire tax structure of Israel and the PA and provided for goods originating in the PA (mostly produce) to be exported under the same conditions and in the same ships and airplanes used by Israeli goods.

However, according to David Brodet, who led the Israeli negotiating team in Paris, the accord is out of date.

The Paris Protocols, Brodet said, were brokered based on four assumptions: that relations between Israel and the PA would be peaceful; that there would be no physical barrier; that an Israeli presence would remain in all parts of the customs envelope; and that the accord would give way to a final economic status agreement by 1999.

Those assumptions have been replaced by terrorism and violence; a fence around Gaza and one being completed around the West Bank; a disengagement from Gaza, leaving no Israeli presence in the territory; and the unlikely prospect of reaching a final status agreement with Hamas.

The final factor, Hamas assuming power in the PA, has finally "brought Israel to consider unilaterally changing part of the Paris Protocol and that's part of the price [exacted on the Palestinians] for Hamas's stance," Brodet said. "We should be very moderate in giving all kinds of possibilities to the Palestinian people to continue to benefit from any trade regime with Israel. But of course, the level of economic relations will be fixed according to the political situation."

While withholding the tax revenue has put pressure on the Hamas- led PA, if the decision was made to unilaterally abdicate the Paris Protocols and break the customs union, the effect would likely be far-reaching across the Palestinian economy.

In the immediate term, it would mean a huge shortfall of funds generated by the PA through the tax revenue Israel collects for it. Though that money is currently being withheld, the assumption that it will be transferred at a later date allows the PA to borrow against it to finance its budget.

"But if we stop collecting indirect taxes for the PA, that's a big change. There's no way for the PA to collect them," said Avi Ben-Bassat, a professor of economics at the Hebrew University and the director general of the Finance Ministry under Ehud Barak. "They would have to build a new system [of tax collection] and that takes time, so meanwhile they are losing the money."

The second consequence for the Palestinians of breaking the customs union, and the one which would remain in the long-run, would be the taxation of every commodity that travels to and from them through Israel. In effect, aside from some agriculture products and a few low-end garments, everything Palestinians buy and sell would be significantly more expensive.

While taxing goods between Israel and the PA would also mean higher prices for Israelis on some items, the macroeconomic affect on Israel would be negligible. Israel's economy was worth an estimated $140 billion in 2005, half of which was in the hi-tech sector. The best estimates of economists (because of circumstances it is hard to measure) value the PA economy at only $3 to $4 billion. And whereas the vast majority of Israeli trade is conducted directly with the United States, Europe and other large economies, nearly everything which flows into and out of the PA comes from or is destined for Israel, or at the very least must pass through Israel.

"The connection between Israel and the PA economy as Israel sees it is marginal. The dependence of the Palestinians on the Israeli economy is absolute," said Ezra Sadan, a partner in Sadan & Leventhal consulting, a member of the government task force which prepared the Paris Protocols.

YET, FOR all its potential as an economic sanction against Hamas, breaking the customs envelope is not a step Israel can take immediately - at least not in totality.

Partitioning any economic union requires the ability to inspect everyone and everything passing between two entities, and subsequently physical separation. As long as the border between Israel and the West Bank remains porous (under the best-case scenario, the security fence will not be complete before the end of 2007), the customs envelope including the two must remain.

"You can't have a different customs scheme in Hebron or any other Palestinian city than you do in Jerusalem, because anyone will just take goods from the lower tax area to the higher one," Ben-Bassat said.

The same is not the case in Gaza, however, which not only has a fence surrounding it allowing for customs control, but also possesses a gateway to the outside world in the Rafah border- crossing with Egypt. Since the Palestinians would be able to import goods without using Israel as an intermediary, and Israel could easily inspect anything coming in from Gaza, Israel should be able to dissolve the customs envelope where Gaza is concerned.

Whether this is the right time to do so is another story. "Israel doesn't have much leverage, politically speaking, over Hamas. Maybe the only thing we have is the customs envelope," said Eran Shayshon, an analyst with the Re'ut think tank in Tel Aviv. "Israel could be playing its cards too soon."

Were Israel to dissolve the customs envelope around Gaza, Shayshon said, Hamas may decide to abdicate the Rafah agreement signed in November which limits Rafah to a pedestrian-only crossing. While the reality of known terrorists entering Gaza through Rafah has already created problems, the extent to which it erodes Israel's security pales in comparison to what Hamas could do with an Egyptian-linked goods-crossing.

Under those circumstances, acting as the PA, Hamas may seek to import weapons far more potent than the rifles and crude rockets currently finding their way through the border. The arrival of "strategic weapons" - such as shoulder-fired anti-aircraft missiles - into Gaza, Shayshon said, could force Israel "to reconsider its national security conception, which is currently based on the premise that the PA is demilitarized."

Moreover, despite the temptation to enact punitive measures on Hamas, Israel should remember that it is the stronger player and should not rush into any hasty decisions, said Jonathan Lipow, the chief economist of Forum FIE, who also served as a consultant in the Office of the Economic Adviser to the Defense Ministry.

"What's missing from the public forum is: What are we trying to achieve? Once we decide that, it's very easy to do," Lipow said. "Jettisoning the whole agreement is a decision we might want to take, but it's not clear why we should do it now instead of four years ago. What Hamas says doesn't matter as much as what Hamas does. Under the circumstances, I would say let them push the issue first."

©2006 The Jerusalem Post