The Bank of Israel’s position regarding the budgetary framework for 2015

27/08/2014
 
·         The Bank of Israel sees importance in the reduction of the public debt burden according to the framework decided upon by the government in 2013, which aimed to gradually reduce the debt to GDP ratio to 60 percent by the end of the decade.
·         Deviating from this framework means pulling back from the previous commitment to continue reducing the debt. Credibility of the budgetary policy is built on meeting commitments over time, and is an important pillar in the economy’s financial stability infrastructure.
·         There is room for some deviation from the deficit target set for 2015—2.5 percent of GDP—to about 3 percent of GDP, to the extent that it derives from one-time needs to cover the costs of fighting in Operation Protective Edge and its consequences, and from the effect on revenues of the slowdown that is apparent.
·         Increasing the deficit beyond this one-time deviation means an increase in the structural deficit, which will place Israel on a path of increasing debt to GDP ratio over the rest of the decade, and will lead to increased interest expenses for the government.
·         When determining the composition of increasing taxes, cancelling exemptions, or cutting civilian expenditure further, it should be taken into account that civilian expenditure in Israel is already very low, compared to other countries, to an extent that makes it difficult to provide a response to the social and economic challenges in education, health, welfare, and other areas.
·         The short term effect on growth of raising taxes is equal to that of reducing public expenditure.
 
The Bank of Israel’s assessment was formulated in accordance with the situation as it is known currently, and in line with the following assumptions, which serve as the base scenario:
 
1.      The Research Department’s macroeconomic forecast from June 2014 projected growth of 2.9 percent in 2014 and 3.0 percent in 2015. As of now, it appears that the 2014 estimate will be reduced, with the 2015 forecast remaining similar to what was published in June.
2.      Tax rates will not be raised.
3.      The plan for zero VAT on homes for eligible buyers will be implemented and will reduce the government’s revenues by about NIS 2-3 billion in 2015.
4.      The government will meet the expenditure ceiling in 2015, meaning that expenditure will increase, in real terms, by 2.6 percent.
 
Under these conditions, a deficit of 3.5 percent of GDP is expected, which is equal to a structural deficit of about 3 percent of GDP. This is a deficit level that does not allow reducing the debt to GDP ratio.
 
In order to meet the expenditure target in line with the ceiling that was set, a budget reduction of about NIS 4.5 billion, relative to the “automatic pilot”, is necessary. Such a cut is further to a reduction of about NIS 1 billion in education and NIS 1.6 billion in infrastructure, due to an assessment that certain programs decided upon—such as significant progress with the light rail in the Tel Aviv area—will not be carried out in 2015.
 
With that, additional expenses should be taken into account, for at least some of which there will be no other option but to carry out, whether in the defense budget or in civilian expenditures. Including these supplements in the 2015 budget, without cutting other expenditures, and without increasing revenues, will lead to a deficit that is liable to reach about 4 percent of GDP, already in the planning stage. Any shocks to activity, which would lead to a decline in tax revenues, or deterioration in the security situation which would require additional expenditures, are liable to lead to the deficit growing even larger.
 
It is important to note that the budget’s current targets were set after the 2012 budgetary framework was breached, when the government committed to a new deficit path, higher than what had been planned previously. According to this path, the deficit target for 2015 is 2.5 percent of GDP, and is set to continue to decline gradually, to 2 percent in 2016, and onward.
 
The Bank of Israel’s position
 
The Bank of Israel sees importance in the reduction of the debt burden to about 60 percent by the end of the decade, based on the framework decided upon by the government in 2013. Deviation from this framework means a retreat from a previous commitment, which will negatively impact the credibility of the government’s budgetary policy, which is a central pillar in the economy’s financial stability. Some deviation from the deficit target of 2.5 percent—to around 3 percent of GDP—can be justified, to the extent that it derives from one-time needs to cover the costs of the fighting in Operation Protective Edge (if those costs are not fully covered already in the 2014 budget) and its consequences, and from the effect on revenue of the slowdown in growth which is becoming apparent.
 
The increase in the structural deficit to around 3 percent of GDP, which is assumed in the base scenario, derives from decisions already reached on the revenues side before the start of the hostilities (cancellation of the increase in income tax for 2014, and the Zero VAT plan), as well as from the need for adjustment on the expenditures side. An additional deviation deriving from increasing the expenditure framework resulting from one of the factors above, will lead to a structural deficit of 3.5 percent of GDP (and an actual deficit of about 4 percent). A deficit at this level not only will not allow continued reduction of the debt to GDP ratio, but will even increase it—and lead in the future to an increase in the economy’s interest payments, and ultimately, as well, to the need to increase additional  taxes in the future.
 
The continuing display of trust in the Israeli economy by the financial markets, and the economy’s ability to contain the costs of Operation Protective Edge, are the result of courageous steps toward returning to the path of declining deficit and declining debt taken by the government in the past two years, which contributed to economic resilience. The experience of the past, in Israel and worldwide, teaches that the ability to deal with shocks is based on a government’s commitment to reduce the debt to GDP ratio and in responsible management over time.
 
Recognizing the importance of maintaining a deficit level of 3 percent presents the government with two alternatives: a further reduction in civilian expenditures in order to provide a response for the new needs, and raising tax revenues. Obviously, the two options can be combined to various degrees. It is important to note that from the perspective of short term growth, the effect on activity of raising taxes is equal to that of reducing public expenditure.
 
When determining the balance among cancelling exemptions, increasing taxes, or further cutting civilian expenditure, it should be taken into account that civilian expenditure in Israel today, by international comparison, is very low—to an extent which makes it difficult to provide an appropriate response to the social and economic challenges facing Israeli society.