Bank of Israel Report Offers Little Succor for Kahlon

Researchers say higher defense spending must be paid for with tax hikes, see no short-term solution for housing prices.

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Moshe Kahlon.
Moshe Kahlon.Credit: Tomer Appelbaum

The Bank of Israel’s 2014 annual report released on Tuesday had very little good news to offer Finance Minister-designate Moshe Kahlon and the new government as far as policy prescriptions are concerned.

Bank of Israel researchers said that if the government goes ahead with further increases in defense spending, as Prime Minister Benjamin Netanyahu seems to want, it will have no choice but to raise taxes.

Kahlon and Netanyahu have both said they reject any idea of a tax hike, but the alternative of either reducing civilian spending or increasing the deficit are dangerous, the report warned.

Israel’s spending on civilian services, such as education, health and welfare, fell last year by 0.3% to just 30.8% of gross domestic product, a very low rate by international standards, the report said. Defense spending grew relative to the budget and GDP for the first time since 2006, and now accounts for 6.1% of GDP and 15.3% on the budget.

While Israel’s debt is low at just 67.6% of GDP, versus an average of 86.2% for countries belonging to the Organization for Economic Cooperation and Development, Israel still pays a steep 7.1% of its budget to repaying interest on its debt.

On the other hand, Israel’s tax burden – the percentage of GDP going to paying taxes – has grown in the last two years, but is still a relatively low 31%, the central bank said. But the burden is not shared fairly because the government relies so heavily on indirect taxes.

Exempting basic food products from the value-added tax, which ultra-Orthodox parties are demanding as a condition for joining the coalition, is the wrong way to go about helping the poor, the Bank of Israel said.

It estimated that for every 1 billion shekels ($250 million) of money saved by reducing or eliminating VAT, households in the bottom 10% of the population save 345 shekels a year while those in the top 10% save 590 shekels. Worse still, creating differential VAT rates for different products and services opens the way for tax evasion and cheating, and requires more supervision and bureaucracy to enforce, the report warned.

Regarding housing policy, another key issue facing Kahlon, the central bank was skeptical that any measures the government could take would have any short- or medium-term impact on prices.

They key to moderating the rising price of homes – which have climbed 65% since 2008 after discounting for inflation – is to increase the housing stock. But that is difficult because identifying land, getting planning and zoning approvals and building infrastructure take time.

However, Kahlon, who wants to take control over the government’s entire planning and building apparatus, can take some succor from the Bank of Israel’s conclusions that the multitude of government bodies rarely work in coordination with each other, adding to the delays.

On the other hand, the ability of the Israel Lands Authority, which Kahlon wants to control, to free up land for construction is limited. The ILA controls 93% of Israel’s land, but its holdings in the center of the country are much smaller and much of it is used by third parties, such as the army.

The report said Israel had been successful is raising the percentage of working-age adults in the labor force while lowering the unemployment rate. Only 9% of all households have no breadwinner, relatively low for an OECD country.

One reason is that income tax rates – as opposed to indirect taxes, like VAT – are low, as are child allowances and other welfare payments, which has made it harder for Israelis to stay out of the workforce.

However, the government has created few mechanisms, such as job training, for positively encouraging people to find work. Israel spends only 0.2% of GDP on incentives, a third the OECD average. The lack of state support has meant Israel’s workforce is less skilled and suffers lower productivity levels than other developed economies.

The central bank estimated that among full-time wage earners, a relatively high proportion earn a low salary, defined as two-thirds the median level nationwide. As a result, high levels of employment have done less than they should to alleviate Israel’s high rate of poverty.

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