The cabinet on Sunday approved Finance Minister Yair Lapid's latest proposal to raise the budget deficit ceiling to 4.65% of gross domestic product this year, from 4.2% last year.
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The deficit will be reined back into 3% only next year, Lapid proposes.
Lapid and Bank of Israel Governor Stanley Fischer sparred last week over the size of the deficit. Faced with the prospect of painful spending cuts and tax hikes, Lapid sought to raise the figure to 4.9%, but Fischer warned against the move and Lapid agreed to 4.65% on Friday.
The new overspending targets are NIS 47 billion for 2013 and about NIS 31 billion for 2014.
The treasury must still cut government spending and increase taxes, but not as much as it would have under earlier deficit targets of 3% for 2013 and 2.75% for 2014.
Lapid took over as finance minister in March with more than enough work to do. Tax revenues have come in well under projections, while Prime Minister Benjamin Netanyahu's previous government undertook spending commitments such as pay increases for civil servants.
Fischer didn't attend Sunday's cabinet meeting because he was abroad, but his deputy Karnit Flug had both praise and criticism.
"A deficit of 4.65% of GDP for this year, after a 4.2% deficit last year – two years in which the economy is near full employment – is high and should be reduced," she said. "But the fact that an effort has been made to even slightly reduce the deficit this year [from the 4.9% target] reflects the government's commitment to addressing the fiscal problem."
The 2013 budget is not due to go into effect until late this summer because the cabinet and Knesset must first approve the full spending package. In light of this, Flug acknowledged that there was little the treasury could do to rein in the deficit. In any case, she was more buoyant about the 3% deficit goal for 2014.
"This is the right target and an important one, reflecting a commitment toward returning to fiscal discipline," she said.
Prices of government bonds dropped sharply on Sunday because of the cabinet vote and the raids on Syria that the foreign press has attributed to the Israel Air Force. Thursday's decision by Standard & Poor's, the global credit rating agency, to lower Israel's local currency rating to A-plus – the same as its foreign currency rating, which S&P kept unchanged – weighed on bonds, as did higher yields in the United States.
The 10-year shekel bond, which is not linked to the consumer price index, was down 0.8% in late trading on the Tel Aviv Stock Exchange, boosting its yield to 3.61%. The 13-year shekel bond dropped 1%. One-year inflation-indexed bonds lost 0.7% to yield 1.46%.
"Until the rating announcement, there were reasonably good odds for an interest rate cut by the Bank of Israel sometime soon," said David Reznik, fixed-income research head at Leumi Capital Markets. "The announcement means the Bank of Israel will sit on the fence for now."
A rate cut would help stimulate flagging economic growth and ease the pressure on the shekel, which has been strengthening against the dollar, making life harder for exporters. The Bank of Israel has intervened three times in the past month to stop the appreciation, with little success.
Flug said the government must strive to get this year's deficit below the new target and ensure that next year's target is met.
"The message sent to us by the rating agencies last Thursday is that we have lost control over the budget," she said. "We've known this for a while, at least since July 2012. We can no longer claim that Israel is consistently keeping to fiscal discipline."
Flug urged ministers to establish mechanisms to prevent a repeat of the previous government's practice of spending commitments without looking at the wider fiscal picture. "This need is more acute considering the challenge likely to face the government in the 2015 budget: The 2015 commitments already exceed the overall expenses," she said.
Eran Azran contributed to this report.