The Treasury's Dilemma: A Time to Tax or a Time to Scrimp?

After slashing taxes and government spending over the last decade, it's time for Israel to make a U-turn.

The treasury’s long-term plans called for reducing Israel’s budget deficit to 1.5% of gross domestic product by 2013. It didn’t happen – not as a result of financial crisis but due to poor economic policy management.

So in 2012 the government updated its deficit target for 2013 to 3%, but it isn’t achieving even this more modest goal either. At the end of October, the deficit stood at 3.3% and it is highly doubtful the 3% goal can be reached within the two remaining months. This means the State of Israel is about to miss the target it set for itself twice in a row in the very same year.

This double failure has been astoundingly labeled a huge success by Finance Minister Yair Lapid and other politicians. At the beginning of 2013 it seemed we had fallen into a deep budgetary crisis and there was concern that the deficit would skyrocket to as much as 5% of GDP, so today’s 3.3% is suddenly depicted as a triumph.

The method of portraying the situation as so desperate that it can only improve has been worked to death this year. First, there were warnings of a huge 5% deficit, so the excessive 3.3% deficit we did end up with turns out to be a cause for celebration. “I promised the situation would improve within two years and it’s happened even sooner,” the Finance Minister gloated as he sent the treasury boys to check where taxes can be cut.

The rush forward to reduce taxes has cut short any serious and thorough discussion that should have taken place in the treasury, the government, the Knesset and among the public. Even if it turns out that the increase in tax revenues continues into next year and beyond, it would have been right to ask if this necessarily means that tax rates should be reduced.
Just last week the Organization for Economic Cooperation and Development released its report comparing the data for governments between 2001 and 2011. Israel was shown to be exceptional in two areas: It is the only country that reduced government spending in relation to GDP over the last the decade and the country that reduced its tax burden the most, by 7.3%. The next largest reduction was 4.9% by Sweden.

This should be qualified by mentioning that in 2001 Israeli government spending and the tax burden were both much higher than OECD average. After a decade of reducing government and taxes, Israel is more or less at average OECD levels. So it seems Israel did nothing but follow a policy of moving closer to the norm.

But the picture is more complex. On a per capita basis Israel is one of the countries spending the least on its citizens. Only Mexico, Turkey and eastern European countries spend less on their citizens than we do. Moreover, Israel is also exceptional among developed countries in the breakdown of spending, laying out four times as much on defense and a third less on welfare, despite being among the poorest countries in the OECD. In fact, after subtracting defense spending and interest payments, the civilian component of government spending – education, welfare, healthcare, and such – Israel is deep in the tail end of developed countries. Only South Korea spends less for non-military purposes than we do.

Fewer taxes, fewer services

All these figures point to how low government non-military expenditures in Israel have dropped. The tens of thousands of protesters who took to the streets in the summer of 2011 were protesting, among other things, against this.

Israel has a very heavy defense spending burden demanding enormous resources and the government could have funded it in one of two ways -- one by choosing to continue investing in its human capital by a heavier tax burden and other by maintaining a tax burden similar to what is common throughout the world and pay the price by providing inferior government services. According to the data, Israel chose the second option – fewer taxes and fewer government services. But was this the optimal choice?

This question, if it comes up at all, only gets discussed within the corridors of the Finance Ministry. Officials realized four years ago that a problem with the services the government provides its citizens and so they decided to increase the rate of spending growth. The 2012-2014 fiscal crisis, which officials feared would cause the deficit to widen to 5% of GDP, caused the treasury to re-think this rule. If they were to continued to allow spending to grow, taxes would have to rise sharply, too.

It turned out that to continue holding this course Israel would need to keep raising taxes at a quick pace. Now, the treasury pendulum is moving back in the direction of less government spending and lower taxes.

They no longer believe at the Finance Ministry that the OECD averages need to be the benchmark for everything they do. They may be collecting more taxes and providing more government services at the OECD but economic growth for the organization’s member countries is much lower than Israel’s, which is creating double-digit levels of youth unemployment.

Earmarked for the old

“A large part of government spending in Europe is earmarked for services to older people – pensions, healthcare, nursing,” they say at the treasury. “The result is enormous transfers from the young to the old at a time when those needing help are actually the young. This isn’t wise policy, but due to political reasons the countries of Europe can’t manage to change it.”

Treasury officials point out that the countries Israelis choose as their destinations for emigration –- mainly the U.S. and Britain –- have a policy of lower government spending and taxes that creates greater inequality but also higher rates of economic growth. Perhaps this is the better model for Israel?

On the other hand,it can be said that no developed country suffers from such high levels of poverty and inequality as Israel, and that government intervention is needed to narrow the gaps, which means more government services supported by collecting more taxes. The choice was to finance defense spending by cutting spending on welfare and not via higher taxes.

In hindsight, this apparently contributed to the country’s economic growth over the past decade but also to widening the income gaps.

Is this the equilibrium that Israelis aspire to? Before mortgaging any budget surpluses (if they, in fact, exist) to tax reductions, discussion should be held on the bigger question of social and economic policy. But there is no public debate. The treasury is making the decisions on a matter of deep concern to each and every Israeli behind closed doors.  

Emil Salman