Treasury Now Starts Wrestling With the Bill for Protective Edge

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Finance Minister Yair Lapid.Credit: Olivier Fitoussi

Even as the fighting in the Gaza Strip was still simmering, the Defense Ministry last week handed the treasury the bill for Operation Protective Edge and other spending requests. All in all, it amounts to a whopping 18 billion shekels ($5.2 billion) over this year and next.

If the Finance Ministry were to agree to the army’s requests in full, it would increase defense spending in 2014 by 7 billion shekels, to 68.5 billion shekels, and by 11 billion shekels in 2015, to a stunning 70 billion shekels. By way of comparison, the defense budget was 61 billion shekels in 2012 and cut to just 58.4 billion shekels last year.

Defense officials admit that would constitute an exceptional increase — they agree that normally spending should be somewhere in the area of 62 billion shekels — but Operation Protective Edge has been unusually long and expensive in comparison to Israel’s two previous rounds of fighting in Gaza.

As the next battle gets under way – this time the two sides being the defense and the finance ministries – the Israel Defense Forces can count on broad public support. The IDF suffered relatively heavy causalities but did an enviable job of protecting civilians.

The treasury’s ammunition is purely fiscal, namely the impossibility of meeting the army’s money demands without raising taxes or cutting spending, which the public will not so easily swallow.

The treasury maintains that the army is exaggerating the cost of Protective Edge. They contend that the total bill is no more than 4 billion shekels, not 7 billion shekels as Defense Ministry Director General Dan Harel estimated last Thursday.

A major factor in how much Israel can afford to increase its defense budget is the state of the economy. In June, on the eve of the fighting, the treasury reported that tax collections had fallen.

In fact, economic growth has slowed, but it is still not clear whether June was a one-time decline or the start of a trend that will make the treasury’s job of keeping the 2015 budget in line even harder. What economists can say with more confidence is that tax receipts for July and perhaps August will be low because Hamas rocket attacks caused so many businesses to shut down wholly or partly.

Assuming that Protective Edge’s costs are closer to the lower estimate, the treasury is in a good position to absorb the costs. The budget deficit in the first seven months of the year is just 2.6% of GDP, 0.4 percentage point below the target. That gives the budget division some 5 billion shekels without raising taxes or cutting other spending.

If it turns out that Protective Edge is closer to Harel’s estimate, the treasury could order across-the-board spending cuts. A 1%-cut would yield 4 billion shekels.

The 2015 budget presents more formidable challenges. Even before the army presented its bill for the war and other expenses, the treasury estimated it will face a fiscal hole of as much as 12 billion shekels next year. More pessimistically, the Bank of Israel believes the hole will actually be 18 billion shekels deep.

The lower figure, together with the army’s spending requests, adds up to a shortfall of up to 23 billion shekels.

Treasury officials, backed up conditionally by their peers at the central bank, contend that Israel could safely increase its budget deficit for 2015 to 3% from the current target of 2.5%. It could even risk 3.5% so long as it could convince the financial markets that this isn’t a structural deficit, but only a one-time exception.

Finance Minister Yair Lapid, who is still feeling the bruises from the responses to the tax hikes he imposed when he first came to office, has already promised no tax increases in 2015.

But officials said Lapid may have to consider dropping his showcase legislation exempting many home buyers from the value-added tax, a move that would restore as much as 3 billion shekels in tax revenues. Raising VAT overall by one percentage point would generate 4.2 billion shekelss and every one point rise in the income tax 2.5 billion shekels.

Another option is to end tax breaks, which in 2014 cost the government some 44.6 billion shekels.