The Deficit / Netanyahu's Choice: Which Tax Hikes?

Dismal budget economics don't give the prime minister much wiggle room.

It's the right, even the obligation, of the prime minster to formulate the social and economic policies of the country. That is exactly what Prime Minister Benjamin Netanyahu did yesterday when he decided that the budget deficit for 2013 would be 3% of gross domestic product. That's 0.5% more than the treasury budget division was recommending - a difference of NIS 4.8 billion - but the same level that Finance Minster Yuval Steinitz proposed after he decided to demonstrate his independence and not adopt the views of his professional staff.

Netanyahu's decision to be less economically conservative and prefer a 3% deficit over one of 2.5% is not manifestly unreasonable. It does increase the economic risk to Israel, given the renewed world economic crisis. It would have been preferable for Israel to act especially responsibly with its budget, as have the Scandinavian countries and Australia. They went as far as creating budget surpluses in expectation of the worst. Nevertheless, Netanyahu's decision is in the realm of the reasonable.

What is not reasonable, however, is the prime minister's decision to increase the fiscal deficit to save the economy a tax increase in any way shape or form, particularly an increase in the value-added tax. It is not clear what Netanyahu's calculations were when he sent the message that generosity on the deficit will lead to generosity on taxes. But the calculation will not work.

Recall the figures: The government plans to preserve the size of the budget - the spending target - as already decided. That target is pretty generous, enabling the budget to grow by NIS 13 billion in real terms from 2012. But the state was being even more generous, with promises to increase spending in every direction. As a result, expenses will be closer to NIS 25 billion or more over those of 2012. To keep inside the spending increase target will require cuts of NIS 12 billion to NIS 14 billion from the planned budget.

Now, let's look at the deficit target. The slowing economy has brought a significant drop in tax collections, which is leading to a widening gap between expenses and income. That is the deficit. The prime minster has chosen to fix the deficit at 3%, but in practice, the fiscal hole is more likely to be in the range of 4% to 4.5%. What that means is that to meet Netanyahu's deficit target, income has to grow by NIS 12 billion to NIS 14 billion - or expenses of an equivalent amount have to be cut.

So here are the final numbers: a NIS 12 billion to NIS 14 billion spending cut to meet the spending target, and another NIS 12 billion to NIS 14 billion in cuts to meet the deficit target. Altogether, we're talking about as much as NIS 28 billion. Who can make a cut of that size?

The message coming from the Prime Minister's Office yesterday to the effect that widening the budget deficit will prevent any tax increase is nothing but an illusion. There is no way of avoiding a tax hike next year and almost as certainly no way of avoiding a rise in VAT either. A 1% increase in VAT would bring in nearly NIS 5 billion in revenue.

Netanyahu therefore is invited to consider possible alternatives to raising VAT.

The choices

The first is to cancel the VAT exemption on fresh fruits and vegetables, which would bring in about NIS 2 billion in revenue annually. Most of the exemption ends up in the hands of the produce dealers and wholesalers anyhow, so there is no reason not to cancel it. The problem is the exemption is backed by a populist lobby in the Knesset and the public. I doubt the prime minster intends to commit political suicide by ending the exemption.

The second is to end the exemption on taxes from educational training funds. Only a third of all wage earners have one, mainly those with the highest salaries. Something like 80% of the exemption ends up in the pockets of the richest tenth of the population. The only problem is that these exemptions are the baby of Ofer Eini. It is very doubtful Netanyahu wants to open up a front with the Histadrut.

The third alternative is to reduce the tax exemptions to exporters in the Law for the Encouragement of Capital Investment. In any event, most of the savings from the exemption flows to the five biggest exporters, who will make billions in profits with or without it. This exemption can and needs to be trimmed back. But the finance minster, who only a year ago expanded it, is resolutely opposed to touching it. Is Netanyahu ready to do battle with Steinitz? So there they are, all the options on the table. Netanyahu will have no choice but to raise taxes. Any message to the contrary is simply throwing sand in the public's eyes. Netanyahu will also have no other choice except confronting the most powerful interests in Israeli society over tax exemptions, or raising VAT. Want to take a guess what he will do?