Israel’s Next Government Has a Long Economic To-do List and Little Time to Start on It

A yawning budget deficit and no budget at all for 2020 are topics A and B, but there are also issues in defense and health spending and creating economic growth engines

Israel hasn't done anything serious to address a growing budget deficit.
Bloomberg

Israeli politics and economic policy have been in a state of suspended animation since December.

Back-to-back elections and a caretaker government in charge of the country mean that nothing serious has been done to address a growing budget deficit. Ministers are too busy campaigning to devote much time to governing. Even directors general of ministries – the ones who weren’t fired in the last few months – know that their days in office are numbered and aren’t doing more than they need to.

The long interregnum means that the next government, no matter who forms it, will have to move quickly to make up for lost time, especially in the case of the 2020 budget.

By law the new Knesset has until March 31 to pass the budget, or the Knesset must be dissolved. The question is how long will it take for the new coalition to be formed; the longer it takes, the less time the new team will have to craft the budget.

The last time around, Prime Minister Benjamin Netanyahu took more than seven weeks before he finally gave up forming a government and agreed to another election. If the next government feels it doesn’t have the time, it could repeat what it did in 2015 and ask the Knesset to pass a deadline extension and/or a law authorizing a two-year budget. The 2019 budget, in the meantime, has been extended into 2020, with spending allocated based on 1/12th of the annual total each month.

In 2015, when the election was held in March, the budget deadline was pushed back to November, but when lawmakers voted they voted on a budget for both 2015 and 2016.

The 2020 budget will carry the added weight of the financial costs of a coalition agreement. No one can say how much the agreement following the April election would have cost if Netanyahu hadn’t opted for Tuesday’s do-over election, but the estimates run into the billions of shekels.

Will the next coalition agreement run up the same kind of tab? It depends on the composition of the government. A coalition that includes a large number of small parties – each with its own demands for extra budgets and mini-ministries that they can lead – could prove expensive. A national unity government would be much cheaper.

The Finance Ministry’s budget division is rarely called in to take part in the coalition talks – it’s left with the unenviable tasks of warning off politicians from the most economically unviable ideas and finding the funding for the deals.

It’s not a pleasant time for treasury officials to be scrounging for extra cash. This year the budget deficit has been running at around 3.8% or 3.9% of gross domestic product on a 12-month trailing basis, far higher than the 2.9% target.

Prime Minister Benjamin Netanyahu at a cabinet meeting, September 2019.
Marc Israel Sellem

Governments are expected to run wider budget deficits during slowdowns to compensate for a slack private sector. Because the Israeli economy is growing quickly and is at full employment at the moment, the deficit is unjustifiably high.

If the next government doesn’t quickly address the overspending, the deficit will probably come in at 4% for all of 2019. But the government probably won’t do much. One reason is that by the time it can act, the year will be almost over, so short of draconian tax hikes or spending cuts, there’s little it can do. In any case, the next finance minister can blame his or her predecessor and the long election interregnum for the problem, and move on.

Rising debt-to-GDP ratio

The more critical question is what the government will do about the 2020 budget, whose deficit by law is not supposed to exceed 2.5%. To avoid unpopular measures, the government will probably opt to raise the target; the only question is by how much – to 2.9% or even higher.

The problem with raising the deficit is that it will increase Israel’s debt relative to the size of the economy. The Bank of Israel says an annual deficit above 2.5% raises the government’s debt-to-GDP ratio; if it stays at 3.5%, which it will reach this year, the debt-to-GDP ratio will increase to 69% by 2025 from 61% today.

Like other countries, there have been calls in Israel for the government to loosen its purse strings in expectation that the global economy is entering a slowdown or worse. In addition, yields on Israeli government bonds are very low, meaning the cost of running a wider deficit is low. Thus the government may opt for an expansionary policy.

But at what cost? Credit rating agencies have raised Israel’s rating (thereby lowering its borrowing costs) due to its record of responsible fiscal policy. Even during the second election campaign, when the fiscal situation was clearly unraveling, the agencies expressed confidence that the next government would attend to the problem.

Most likely the next government will declare its fiscal rectitude while allowing deficit spending to rise and calling it a temporary measure.

A big element of the budget is defense. The back-to-back elections have delayed plans by military chief Aviv Kochavi to begin work on a multiyear defense budget. The current one, which was the product of negotiations in 2015 between Finance Minister Moshe Kahlon and then-Defense Minister Moshe Ya’alon, is due to expire next year.

The Finance Ministry wants the next multiyear budget to be smaller because it’s coping with the growing budget deficit. For example, it wants to save money by shortening mandatory service and ending the practice of giving career officers bridge pensions – pensions for the years between retirement and the legal retirement age of 67.

Kochavi wants to increase the defense budget; he cities the growing threats from Hezbollah and Hamas and the need to beef up air defenses. As deputy chief of staff, he fought off previous attempts by the treasury to limit bridge pensions.

Whatever the election results, Kochavi is likely to have strong allies. Netanyahu has already said he wants to increase the defense budget by tying it to the size of GDP. If Benny Gantz’s Kahol Lavan forms the next government, his will team will include two other former chiefs of staff, who will no doubt look favorably at Kochavi’s views.

The health budget presents another inescapable challenge. The state-funded health maintenance organizations are running deficits, waiting times for consultations with specialists are getting longer, the hospitals are facing serious budget problems, and the gap between the quality of medicine in the center of the country compared to the outskirts is widening.

Meanwhile, the government has committed to building new hospitals in Be’er Sheva and the Haifa suburbs, as well as to increasing the number of rooms at existing hospitals to end the practice of patients being left in corridors. There are also the long-term problems of Israel’s aging population and its growing medical needs, and the need to increase the so-called health basket of government funded drugs and services to reflect higher costs. A new collective labor agreement with doctors is also on the horizon.

Without a significant increase in the health care budget, all these problems will worsen in short order. The minimum increase to the basic budget sought by the Health Ministry just to keep the system intact is 3 billion shekels ($850 million).

Deputy Health Minister Yaakov Litzman sought 5 billion shekels in last spring’s coalition talks. They collapsed and will have to be started from scratch. In the meantime, the health basket committee has no defined budget.

Still, Health Ministry officials are preparing for budget cuts after the election because of the growing budget deficit. They understand that their plans can’t happen without an increase of at least half a percentage point in the health tax, and that’s politically difficult to win approval for. A lot will depend on who the finance and health ministers are in the next government.

Pricey Tel Aviv light rail

Israel’s traffic-clogged roads and its still underdeveloped rail network will also require a lot of spending. But as a short-term measure the treasury wants to introduce a congestion tax to discourage people from driving, and in the longer-term to invest in public transportation.

There’s a long list of transportation-infrastructure projects; the biggest is the Tel Aviv light rail system, which is expected to cost 150 billion shekels.

How will the government fund it at a time of rising budget deficits? The treasury and others are considering public-private partnerships, increasing the deficit target or imposing taxes on landowners closest to the planned projects – who would benefit the most from them.

But with officials focusing on the 2020 budget, these decisions will likely take a back seat for the time being.

Meanwhile, Israeli economic growth has slackened in the last two years and is forecast to slow further in 2020. Thus policy measures aimed at spurring faster growth are expected to take center stage for the next government. Looser fiscal policy, aided by low interest rates, will play a role.

All other things being equal, demographics will spell slower growth for Israel in the coming decades; that is, unless steps are taken to improve the workforce capabilities of the Israeli-Arab and ultra-Orthodox, or Haredi, communities.

One important measure is increasing the labor force participation rate of Haredi men, which hasn’t grown since 2015. If the next government doesn’t take steps to increase this number, it will be tough to boost economic growth.

Beyond that, policy reforms are the economy’s other growth engine. Last month the Bank of Israel published recommendations on how to achieve that growth – mainly by stepping up investment in human capital and increasing labor productivity.

The central bank says its plan, if undertaken, would increase GDP by a fifth and raise living standards. But the fact is, the plans aren’t ready to be implemented.

They would require an increase in taxes, which the political establishment will be loath to undertake. Politicians also don’t like adopting other people’s programs because they can’t take as much credit, especially when the fruits are borne years ahead.

The Bank of Israel wants to do away with government policy giving priority to industry through the Law for the Encouragement of Capital Investments. But the Economy and Industry Ministry can be expected to oppose that change. The Finance Ministry wants to boost productivity via more business-friendly regulations and investment in transportation, energy and communications infrastructure.