Bank of Israel Urges Tax Hikes to Cover Growing Budget Deficit

Annual report scores government fiscal policy, warns overspending cannot continue at current levels

Bank of Israel Governor Amir Yaron presents annual report on Israel's economy, Jerusalem, March 31, 2019.
Emil Salman

The good years of falling taxes and growing government spending are approaching an end: Israel’s budget deficit has grown so quickly and dangerously that the next government will have no choice but to raise taxes or impose budget cuts.

That is the gloomy message the Bank of Israel relayed on Sunday in its annual report, the first under its new governor, Amir Yaron.

Prime Minister Benjamin Netanyahu, who is facing the voters in just over a week, chose to emphasize the positive aspects of the report, saying, “The economy is in good condition because our policies are good. We have achieved something unique – record low unemployment and rising wages. That shouldn’t be taken for granted.”

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Israel’s economy enjoyed “balanced growth” in 2018 of 3.3%, but that was lower than the previous two years and growth was trending lower by the end of last year to a 2.8% rate in the final quarter.

In any case, the thrust of the report was on Israel’s growing budget deficit, which has emerged as a major issue in the last few months as the overspending has grown increasingly greater.

The headline figure for last year was 2.9% of gross domestic product, which was inside the government’s official target. But the target had been raised from the 2% the government had targeted three years earlier for 2018, and in 2019 the deficit has been rising sharply to 3.5% of GDP in the 12 months ended in February.

Moreover, said the Bank of Israel, the headline deficit severely understates the extent of Israel’s overspending. Using a wider measure that includes items such as deficits run up by local authorities, Israel’s deficit reached 3.8% of GDP.

The wider measure, which is more accepted internationally than the treasury’s number, is the highest since 2013, the central bank said.

Worse still, the government has allowed the deficit to widen as the economy was growing – the opposite of conventional economic policy that generally seeks to reduce government spending when the economy is growing and increase when it slows or fall into a recession to give a lift to the private sector.

Yaron and Bank of Israel economists made clear that the next government would have to undertake painful measures to reverse the situation and that it had little time to lose – or risk leaving Israel unprepared for a possible economic slowdown.

“The government’s increasing expenditure in recent years, at the same time it was reducing statutory tax rates, has worked to increase the structural deficit to a level that is undesirable for it to remain at for an extended period,” Yaron said in a letter accompanying the report. “The risks inherent in such a situation will increase if the growth rate slows.”

The report called for “fiscal adjustments,” meaning either tax increases or reduced spending, while the economy is still enjoying strong growth. “Postponing them could necessitate more significant adjustments precisely when fiscal expansion is needed in order to support activity,” Yaron warned.

Bank of Israel economists laid blamed on government policies in place since 2014, mostly during the term of the current finance minister, Moshe Kahlon.

Government spending rose 4.7% annual after inflation in the years 2016-2018, far faster than GDP grew. At the same time, said Bank of Israel economists, the government lowered taxes, including the corporate income tax and import duties on many items.

The government never found what the report called “permanent sources of financing” for the added spending, meaning tax revenues. Instead, it counted on one-time tax-collection windfalls, such as from the 2017 sale of the Israeli auto-tech company Mobileye to Intel. By the end of 2018, however, the revenue shortfall began to emerge and is Israel is now saddled with big structural deficits.

The Bank of Israel report last year elicited an angry reaction from Kahlon after it mildly criticized his Machir L’Mishtaken (Buyer's Price) program for lowering the cost of housing. However, this year’s report, which leveled far more fundamental criticism of Kahlon is unlikely to draw the same response because Kahlon is to distracted by campaigning.

In all events, the polls show his Kulanu party faring poorly in the election, making it very unlikely he will be able to retain the treasury portfolio.

As to the choices the government faces on the budget, the central bank said that even with the big increase in civilian spending in recent years, Israel’s still spends relatively little compared with other countries in the Organization for Economic Cooperation and Development (OECD).

Therefore, the bank urged the next government to give preference to tax increases over spending cuts. “It is important to maintain expenditures that support growth and enhance productivity,” Yaron said in his letter.