Bank of Israel May Back Rule to Link Increased Spending to Increased Taxes

Policy shift would require a change in the rule that governs government spending; the tax-revenue target would be linked to the budget-deficit target.

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The Bank of Israel is considering supporting a rule that would automatically raise taxes when government spending increases.

The policy shift would require a change in the rule that governs government spending; the tax-revenue target would be linked to the budget-deficit target. This would prevent the situation that occurred over the past two years in which spending ballooned without corresponding tax increases.

As a result, the government missed its deficit target, something analysts also expect to happen next year. Although the value added tax and other taxes were increased this year, the deficit problem has been worsened by a multiyear plan to lower taxes.

Under a revised rule, the government would still have flexibility to increase the deficit; for example, during recessions. But over the long term, the deficit would come under stricter controls, even though the new rule would not explicitly refer to the deficit as a percentage of gross domestic product.

Currently, the rule change does not have the support of the National Economic Council, which is part of the Prime Minister's Office. The council is concerned that the change would complicate the rule and run the risk that it would be misunderstood or abused by politicians. The Finance Ministry's position on the matter is not yet clear.

Bank of Israel Governor Stanley Fischer addressed the deficit issue in a speech last week in which he called the deficit a structural problem. He compared the country's situation this year, in which the economy fared relatively well, to 2003, a very tough year.

"In 2003," he noted, "the deficit was little more than 6% of [gross domestic product], but the cyclically-adjusted deficit was about 3.5%, whereas currently the deficit itself is lower than in 2003, but the cyclically-adjusted deficit is close to 4% - higher than in 2003."

The term cyclically-adjusted deficit corrects for cyclical events such as recessions, when the state would be expected to run a higher deficit, whereas during relatively prosperous times, such as the past year, one would expect a smaller deficit.

"The result is that we have a [cyclically-adjusted] deficit of almost 4% in a situation of almost full employment," Fischer said. "I feel very uncomfortable with such a deficit under current circumstances."

Fischer also explained why the deficit target had been exceeded, noting that government spending was running at 43.5% of gross domestic product while revenues were just 38% of GDP. The widening deficit compared to gross domestic product stems from a rule change in 2010, which instead of limiting annual budget growth to 1.7% allowed more flexible spending increases.

And as spending grew, no change was made in plans to lower taxes, which exacerbated the situation further. The budget deficit is not expected to decline in the coming years, Fischer said; it is only expected to reach as low as 2% in 2020, despite more-optimistic government targets.

The proposed change is one of four suggested revisions to the fiscal rules. Another revision would align the budgeting process to the current environment of low inflation.

At the suggestion of the National Economic Council, the budget would not be linked to inflation but would be stated in nominal terms. The expectation is that such a change would inject greater transparency into the budget process because it would end the practice of retroactively adjusting inflation figures when inflation rates differ from the rates on which the initial budget was based.

The Bank of Israel seems well-disposed to such a change but the Finance Ministry's position in not clear.

Another possible rule change involves revising the way the government's multiyear commitments for spending increases, the so-called automatic pilot, are handled. The automatic pilot comes into play, for example, when promises are made to increase the salaries of government employees in a particular sector over several years, thereby automatically requiring government spending in subsequent years.

A fourth rule change would inject more transparency in the use of budget reserves.

Bank of Israel Governor Stanley Fischer.Credit: Tomer Appelbaum

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