Social Democracy Comes at a Price. Are Israelis Willing to Pay It?

Now with the 2013-14 budget approval process under way, it has become clear that a demand for subsidized government services is hardly sustainable.

The masses took to the streets calling for social democracy in the summer of 2011. They expected the state to improve services and alleviate the high cost of living.

Clearly the masses were right. The level of services is indeed poor by global standards and the cost of living is suffocating. But the demonstrators forgot one thing: Increased services come at a price that isn’t cheap.

Now with the 2013-14 budget approval process under way, Israelis are grasping the other side of the “big and generous government” equation, which is naturally “government imposing heavy taxes to pay for its generosity.” And there are concerns that this is just the beginning.

The reason is that Israel appears to be entering at least seven bad years. The Finance Ministry forecasts particularly hard times from 2015 to 2019 with annual economic growth of 2.7% to 2.9%, compared with the 3.5% to 5% we’ve gotten used to in the last decade. To put it bluntly, the Israeli economy is about to slow and we need to brace ourselves now.

The problem is that Israel is doing everything but getting ready. We’re entering the five slow years with an enormous deficit. Deficits in recent years reached 4% to 5% even though these were years of strong growth and a sense of economic security. In contrast to the Bible’s Joseph, we haven’t taken advantage of the good years to build up reserves for the bad ones.

Moreover, Israel is hobbled by economic management that doesn’t let it accumulate such reserves. This management is characterized by the fiscal rule, the formula determining the state budget’s growth each year. This rule just came into use in 2010 linking the annual budget increase to Israel’s distance from its financial-strength objective ‏(a debt-to-GDP target of 60%‏) based on a decade’s worth of growth rates.

Turning point

The fiscal rule, pegged to long-term historical and future calculations, is considered an exemplary model of economic planning. But it overlooks just one thing: What happens when the country reaches a turning point where growth in the past decade can no longer predict growth in the coming decade?

This is exactly where Israel finds itself today. The forecast potential for growth to the end of the decade is 0.8% lower than that of the past decade. Therefore budget growth as dictated by the fiscal rule could prove too high.

This is worrying the Finance Ministry. The question popping up lately is whether the fiscal rule is a mistake. There are concerns that today’s budget mess and lavish unkeepable promises might repeat if the state keeps increasing spending by the large amount dictated by the fiscal rule.

The treasury’s natural inclination is therefore to forgo the social-democratic dream and stem the tide of increasing spending. Forget about free after-school day care, more hospital beds and subsidized public housing. Forget about everything you dreamed about; the state simply doesn’t have the money.

This is one solution, but not necessarily the only one. The treasury’s natural inclination contradicts the public’s gut feeling as expressed by the protesters demanding more services. The public’s demands can be translated into an alternative solution: more services in exchange for more taxes.

But the public has to understand the implications. The 2013-14 budget crisis has already brought sharp increases in value-added tax, income tax, corporate tax and betterment tax ‏(on home sales‏), in addition to last year’s hike in the capital gains tax. The tax burden, 26.5% to 28% of GDP midway through the last decade, has fallen to around 23.5% but is now making its way back up.

In 2014 the tax burden will already reach 24.8%. In keeping with the fiscal rule dictating annual budget expansion of 3%, the tax burden will apparently need to continue climbing to 26%.

If we also want to maintain a declining deficit target to ward off a financial crisis and save our children heavy interest payments, the tax burden will probably need to rise to 27%. This would mean an additional NIS 20 billion or so a year in taxes, at least.

On this point, the Finance Ministry’s forecast contains two bits of bad news. One is that the treasury believes the practice of paying taxes has changed in recent years due to globalization and perhaps the tax authority’s weakness. In that case the previous decade’s tax rates will no longer be enough to bring in another NIS 20 billion, and rates would need to climb even higher.

The other bad news is that our current tax rates aren’t low. Income tax, corporate tax, capital gains tax and VAT are at similar or higher levels than a decade ago, and similar or higher than the global norm − and we’re still falling short by NIS 20 billion a year.

Even assuming the imposition of an inheritance tax and the cancellation of exemptions like those under the Encouragement of Capital Investment Law, the main remaining source for tax revenues is a hike in income tax at the low end and medium levels. It’s doubtful this is the price the people expected when they called for more social democracy.

Painful decisions

Therefore Israel faces painful decisions today: Forgoing continued spending growth or being prepared to pay a very heavy price in higher taxes amounting to tens of billions of shekels.

Of course, there’s a third alternative more attractive than the others but the hardest to achieve: streamlining public allocations so the same tax money can go further. This means the arduous task of cutting the defense budget, fixing the atrophied bureaucracy, reforming collective wage agreements to keep Ashdod Port labor boss Alon Hassan and his ilk from continuing to strangle the economy, and examining all obstructions impeding productivity.

It also means enormous efforts toward integrating Arabs and the ultra-Orthodox into the labor market and mainstream society. It means a dramatic change so that the very thin blanket provided in the state budget can cover everyone. Otherwise all the protests won’t get us much further. 

David Bachar