Fiscal Policy in the Past Two Years and Fiscal Projection for 2019-2022

             The data file and graphs
           
             The full survey​​ 

  •  In 2017, the government budget deficit was 1.9 percent of GDP, markedly lower than the 2.9 percent target, and the ratio of gross public debt to GDP declined to 60 percent. This was the third straight year in which the deficit was at this level. These developments supported the lowering of the yield on the government debt and figured importantly in the upgrading of Israel’s sovereign credit rating by S&P.
  • The low deficit in 2017 was achieved due to NIS 12 billion in one-off (net) revenues, excluding which the deficit came to 2.9 percent of GDP.
  •  In 2018 and 2019, the budget deficit is expected to increase to 2.9 percent of GDP, matching the government’s target and similar to the 2017 deficit net of one-off revenues.
  • In the 2019 budget, as in previous budgets, the government raised the expenditure and deficit ceilings considerably. Although the increase in expenditure did slightly narrow the gap in the share of civilian spending between Israel and the OECD average, the pressures deriving from Israel’s low level of spending were reflected in decisions on further expenditure that have already exhausted the expenditure ceiling for the next few years. They have also led to the adoption of ways of circumventing the spending ceiling.
  • The expenditure ceiling and the deficit path have been raised repeatedly in recent years, impairing their effectiveness as anchors for multiyear government planning.
  •  Recent years have seen growing use of sales of state-owned land by the Israel Land Authority and the issuance of bonds by government companies, with state-funded payback, as ways of funding policy measures. In this manner, these expenditures are excluded from the expenditure and deficit ceilings, impairing the presentation of the budget data and the processes by which priorities are set.
  • The “numerator” (the multiyear monitoring mechanism of the budget aggregates) is an important tool that may enhance budget transparency and improve planning in the medium term. Ever since the government introduced it, however, it has been using various accounting and legal circumventions that degrade its utility considerably. Examples are (1) defining programs that are essentially long-term as temporary provisions; (2) establishing sizable across-the-board cutbacks several years forward without specifying which programs will be abolished; (3) making greater use of land sales to fund off-budget expenditure or recording such expenditure in the budget with a lag.
  • The proposal to increase the defense budget commensurate with the GDP growth rate over the next decade is inconsistent with the declining deficit path established in law; government resolutions about the expansion of social services; social programs and infrastructure investments; and the government’s aversion to raising tax rates. If such an outline for defense spending is adopted, it should specify stable and transparent sources of funding for the plan and should depict the adjustments that the other aggregates will have to undergo.

 

 

The Bank of Israel is releasing today a fiscal survey that analyzes the 2018 and 2019 budgets and examines the correspondence between the government’s plans for 2020 through 2022—including the intention of increasing the defense budget in the coming decade at a rate commensurate with GDP growth—and the downward trajectory of the deficit and the expenditure ceiling, both enshrined in statute. The survey also deals with the government’s growing use of budget circumventions and off-budget activities against the background of the discrepancy between the cost of the government’s programs and its fiscal targets.

The budget deficit in 2017 was 1.9 percent of Gross Domestic Product, well below the 2.9 percent deficit target, and the debt to GDP ratio declined to 60 percent. This was the third straight year that the deficit has been at this level. Based on this auspicious budget performance, the S&P rating agency announced at the beginning of August that it was upgrading Israel’s sovereign credit rating from A+ to AA-, the highest rating that Israel has ever attained. In its rating announcement, S&P referred approvingly to the commitment, demonstrated by various Israeli governments, to correcting the budget path at times of strong upward trends in the deficit and increases in the debt to GDP ratio.

The low deficit in 2017 was achieved by unexpectedly strong tax revenues, tracing mainly to one-off receipts from dividends distributed by firms that exploited a temporary tax benefit and from taxation of proceeds from the sale of autonomous vehicle technology company Mobileye. These windfalls offset a major increase in spending—by more than 1 percentage point in the share of public expenditure in GDP. As a result, the structural deficit widened appreciably and the deficit net of the unexpected one-off revenues came to 2.9 percent of GDP.

Decisions made in the course of 2017 boosted budget needs in 2018 to a level that far exceeded the reserve that was approved within the framework of the two-year budget, necessitating an NIS 2 billion across-the-board budget cut in order to stay within the budget limits. In view of these adjustments, along with economic and budget developments during the year, the 2018 budget deficit is projected to be 2.9 percent of GDP, similar to the target.

In the 2019 budget, too, the government raised the expenditure ceiling markedly, by 3 percent (the equivalent of more than NIS 11 billion), in order to respond to liabilities accumulated in previous years. This was despite large permanent supplements already given in previous budgets. As a result of this breach of the limitation, the government had to raise the deficit target again, from 2.5 percent of GDP to 2.9 percent, despite a comfortable macroeconomic environment that is supportive of strong tax receipts. On the basis of the Bank of Israel’s current projections and tax model, the deficit in 2019 will indeed resemble the new target and the debt to GDP ratio will remain at approximately its current level.

The rupture of the expenditure ceiling and raising of the deficit target in the 2019 budget, together with a series of such changes in previous years, reflect the gap between the cost of attaining the government’s targets in respect of welfare, social services, and defense, and the level of expenditure set by the fiscal rule—which, although having been increased, is not high by international or historical standards. The increases were approved largely in response to a cyclical upturn in revenue. Since the government also lowered tax rates at times of rising revenues, it had to raise the deficit target—and this year, most likely, also the actual deficit—precisely at a time of vigorous economic growth. This conduct clashes with the essence of the expenditure rule, under which spending increases should be restrained during economic upturns in order to obviate the need for cutbacks at times of recession, when public expenditure helps to stimulate economic activity.

An important reason for the government’s difficulty in complying with the expenditure ceiling (which allows expenditure to grow by less than 1 percent per capita per year) is the small share of primary civilian expenditure in Israel’s GDP relative to almost all other advanced economies. This has been particularly conspicuous since 2012, when the government began trying to narrow the gaps between Israel and its peers in the quality of public services and infrastructures and the coverage that its social-services system provides. The advancement of new programs, however, has encountered a barrier because the rate of increase in expenditure allowed by the rule suffices mainly for natural spending growth occasioned by demographic and real-wage increases. To surmount this, the government has been budgeting various programs for years beyond the current budget. When the time to implement the programs comes, however, pressure to breach the spending ceiling builds up. This process is detrimental to the credibility of the budget rule, its contribution as an anchor for long-term budget planning, and the efficiency of the execution of government programs that are delayed repeatedly, deployed sub-optimally, and sometimes even canceled as part of a budget-finalization process. A stable expenditure rule that would yield a more transparent and candid reflection of the government’s priorities in terms of increasing or decreasing expenditure, while maintaining a credible and sustainable deficit level, would do much to improve budget conduct.

An important tool that the government has begun to use in order to improve its budgetary conduct is the “numerator,” a fiscal-management mechanism that forces the government to balance its liabilities against the expenditure ceiling and the deficit target in the three years after the latest fiscal year for which a budget is approved. Thus, the numerator, presented in June 2018 after the 2019 budget was passed, relates to 2020–2022. The "numerator" was invoked to halt the process of government decision-making on expenditure and tax cuts in years beyond the current budget, a practice that entailed the repeated upward resetting of fiscal targets. By requiring the government to specify budget sources for every move that deviates from the fiscal targets, the numerator forces policymakers to discuss priorities straightforwardly at the time the decision is made and not several years later, when it comes time to implement the decisions and the policy options are limited.

Despite the advantages of the numerator, sundry ways of diluting its influence were found as soon as full enforcement of this instrument began. They include:

1.      The use of temporary provisions: Such provisions are meant to deal with transitory developments that do not justify legislation or that require urgent attention until regular legislation can be completed. The government, however, used temporary provisions to activate several important programs in the 2018 and 2019 budgets, entailing expenditure of billions of shekels per year and which are not meant to address some temporary crisis or one-off necessity. Although most of these programs will probably be extended or made permanent in the next budget, their presentation in the form of temporary provisions at this stage excuses the government from having to find sources to pay for them in post-2019 budgets, as the multiyear budgeting rules require. In the meantime, the government can take on other budget liabilities for those years—the very mechanism that the numerator is supposed to prevent.

2.      Future across-the-board budget cuts: Alongside the 2019 budget, the government approved a 2.5 percent across-the-board reduction in the 2020 budget and an additional 7.0 percent cutback in the 2021 budget. Cumulatively, these measures commit the government to an NIS 7 billion spending cut in 2021 relative to the 2019 budget. Although these reductions bring the numerator into balance at the present writing, they merely express an undertaking to cancel unspecified existing programs. Unless it specifies which programs it intends to eliminate, the government cannot prepare for the spending cuts and the discussion is postponed to the time when future budgets will be approved—the very outcome that the numerator is supposed to prevent. In addition, the across-the-board cutbacks apply only to some forms of expenditure and tend to take a greater toll on infrastructure investment than on other kinds of spending. While such a bias is reasonable in terms of applicability when cutbacks are needed at once, it is harder to justify in the case of budget adjustments that will be made three or four years ahead, by which time there will be ample opportunity for preparatory and planning work.

3.      Off-budget expenditure: In recent years, several government programs in the field of construction and housing have been set in motion with direct funding from sales of state-owned land by the Israel Land Authority—and thus excluding them from the spending and deficit ceilings. Thus, the sale of state-owned land is reported as revenue instead of the realization of an asset, as had been the practice until recent years and as is customary under generally accepted accounting principles. Given the magnitude of the sums already at stake—several billions of shekels per year—and the steadily widening purview of the activities, this comportment may have a material effect on the presentation of budget expenditure and the deficit. It also impairs the efficiency of the budgeting process because the proceeds of the land sales are allocated only to specific programs that can put them to use and are not integrated into the overall prioritization and cost-benefit analyses of the budget. Furthermore, the process gives land-holding government bodies an advantage over others.

4.      Issuing bonds on the basis of future government payback: These are bond issues by government-owned corporations, in which the state undertakes directly or indirectly to finance the repayment (e.g., an Israel Railways issue in March 2015 and an issue by Amidar in March 2018). When this happens, the flow of government liabilities reflects the deficit not in real time but rather over a period of several years, with the burden of payback shown in the budgets for years beyond the term of the numerator.

The growing use of these accounting processes reflects the government’s difficulty in attaining its housing and infrastructure targets within the framework of the expenditure and deficit ceilings that it established, particularly in view of its low level of primary civilian expenditure by international standards and its declared and revealed aversion to increases in tax rates. Even if some of the programs that are funded in this manner are valuable, it is important to maintain transparent budget behavior so that decisions may be made in accordance with clear priorities. Other countries’ experience, and Israel’s experience in the past, show that circumventing the budget limits, even if done with good intentions at first, may eventually end in loss of control of the budget framework and the need to make budget corrections at times that are less convenient for policymakers.

The Survey presents four policy outlines that demonstrate the implications of different ways of coping with the discrepancies that emerged between the government’s decisions on expenditure in coming years and tax rates, and its budget targets (Figures 1–4). These outlines assume a macroeconomic environment similar to the one presented by the Ministry of Finance in the numerator document. Furthermore, they do not include potential expenditure on the expansion of the government’s infrastructure program, government aid for investments in Intel’s new plant, the High Court of Justice ruling on improving prisoners’ living conditions, the demand for a wage increase on account of the lack of occupational security among Police and Prison Service personnel, the High Court of Justice ruling on the Center for the Blind, and the High Court of Justice ruling on the delivery of nursing services. This means that even the most expansionary outline described below does not take account of the full set of existing budget risks, even though some of these risks are highly likely to materialize, at a cumulative cost of several billion shekels:

Outline 1: Compliance with the statutory expenditure ceiling and deficit path. This outline requires rather strong restraint of gross public expenditure and a 1 percentage point reduction in its share in GDP, by repealing some government resolutions on future expenditure and implementing all the across-the-board cutbacks that have been announced. A moderate increase in tax rates would also be necessary. According to this outline, further cutbacks in existing civilian spending programs would be needed to increase the defense budget at a pace commensurate with GDP growth.

Outline 2: Compliance with the expenditure ceiling: Unless moderate tax increases are made, the deficit will slightly deviate from the statutory trajectory.

Outline 3: Increasing the defense budget at a rate similar to that of GDP growth with no adjustment of tax rates, and expansion of civilian expenditure in accordance with existing government resolutions up to a deficit ceiling of 3 percent of GDP: This outline leads to a mild but protracted increase in the debt to GDP ratio and requires a 0.7-percentage-point decrease in the share of primary civilian expenditure in GDP, entailing the repeal of some government programs and full implementation of the across-the-board cutbacks.

Outline 4: Raising the expenditure ceiling in accordance with existing government resolutions and natural increase in civilian expenditure, and expanding the defense budget at a rate similar to that of GDP growth with no adjustment of tax rates: This outline results in an increase in the deficit—even excluding off-budget expenditure—to more than 3 percent of GDP and a protracted upturn in the debt to GDP ratio. The share of total public expenditure and of civilian expenditure in GDP remains at its current level.

These outlines indicate that, given its existing decisions on multiyear spending programs, its aversion to raising tax rates, and its interest in increasing the defense budget at a rate similar to that of GDP growth, the government will be rather strongly challenged to stay within the deficit-decline trajectory enshrined in law and to stabilize, or to continue to reduce, the debt to GDP ratio. Furthermore, the high level of the deficit in the current period, which is characterized by a comfortable macroeconomic environment that abets strong tax receipts, is liable to require budget cuts at times of slowdown, precisely when it is important to increase expenditure and lower tax rates in order to stimulate economic activity.