Israel will find it challenging to meet its fiscal deficit target for this year amid expectations for a continued decline in tax revenue and growing signs over the negative effect of the planned judicial overhaul on local economic activity, economists warn.
As Prime Minister Benjamin Netanyahu’s coalition government is gearing up to pass the state’s 2023-2024 budget by the May 29 deadline, economists at both Bank Hapoalim and Meitav investment house are already forecasting that it is poised to fail to meet its fiscal deficit target of just below one percent of gross domestic product. Both Bank Hapoalim and Meitav now forecast that the budget deficit could reach 3% of GDP in 2023.
The trigger for the projections by economists is data that was released last week, showing for the first time in nine months that Israel swung to a budget deficit of 0.01% in March, as state revenue from taxes declined.
“Even before the budget approval, it is now quite clear that the 2023 deficit forecast of about 1% that has been set will not materialize as the downward trend in declining tax revenue is expected to continue,” said Alex Zabezhinsky, chief economist at Meitav. “As a result also the target for 2024 does not seem relevant anymore.”
For 2024, the Finance Ministry targets a budget deficit of 0.8% of GDP. That is after the government in 2022 posted the first budget surplus in 35 years of 0.6% of GDP as state revenues rose 4.8% to NIS 468.5 billion, benefiting from an exceptionally high increase in tax revenues. Israel posted deficits of 4.4% of GDP in 2021 and 11.3% in 2020 as the government introduced a NIS 196.3 billion multi-year economic aid spending plan to help the economy deal with the coronavirus pandemic.
In March, state revenues declined 4.7% to NIS 40.8 billion versus NIS 42.8 billion during the same month last year. State revenue from taxes dropped by about 10% in real terms, including corporate taxes. The most significant drop was in the collection of real estate taxes, which slumped 43% as Israel’s booming housing market is showing signs of a slowdown amid a higher interest-rate environment. Government expenditure stood at NIS 43.5 billion in March, compared with the NIS 41.9 billion in March 2022.
“Since the beginning of the pandemic, changes in tax revenues have been the best indicator for forecasting economic growth,” said Zabezhinsky. “If the link between tax revenues and growth continues this year, the decline in tax revenues we saw in the first quarter versus last year may point to zero or even negative economic growth in the first quarter.”
Although the March deficit is minimal in terms of the percentage of GDP, it comes during a period when Israel’s robust economic growth of more than 6% in 2022 is already expected to moderate to around 2.5% this year, as global economic growth slows. In addition, senior Finance Ministry officials have warned that the government’s proposed judicial overhaul could result in a severe loss of tax revenue and do “very significant harm” to the economy in general and the high tech sector in particular because of the latter’s dependence on cross-border operations and funding from abroad.
The high-tech industry in Israel generates about 17% of GDP and is responsible for over 50% of exports and about 25% of payroll taxes. In the first quarter of this year, Israeli tech companies raised $1.7 billion, down 70% from the $5.8 billion in the first three months of 2022, according to a report by IVC Research Center and LeumiTech. The quarter marked the lowest figure in four years.
A recent survey by Start-Up Nation Central, which tracks the local tech ecosystem, found that 80% of Israeli startups and 84% of investors fear that the planned changes to Israel’s judicial system will have a “negative impact on them and their portfolio companies.” About 84% believe the government’s plans will have a negative effect on their ability to raise capital from abroad.
State revenues and tax collection have in recent years of low interest rates benefited from strong growth and price increases in two sectors: real estate and high-tech. The Bank of Israel started hiking interest rates in April last year from a record low of 0.1% to 4.5% earlier this month.
“These industries experienced significant price increases, reflected in the rise in real estate prices and high valuations of start-up companies, and government tax revenue has been one of the main beneficiaries from that,” Bank Hapoalim wrote in a research report. “This year, real estate transactions have plummeted, and prices have begun to fall, which also hurts the revenue side. We see fewer exits of technology companies and at more modest prices.”
“As a result of all this state tax revenues are expected at least this year to be lower in nominal terms compared to last year, and decline by a considerable amount,” according to Bank Hapoalim.
Earlier this month, Moody’s Investors Service lowered Israel’s credit rating outlook to “stable” from “positive” citing the planned changes to the country’s legal system and the risks they pose to economic and social stability. Moody’s indicated that the country’s outlook could be further downgraded if the situation is not resolved, and social and economic tensions continue — in particular, if there is a significant negative impact on Israel’s high-tech sector.
Meanwhile, the rating agency reaffirmed Israel’s A1 credit rating, backed by “strong economic growth and improving fiscal strength,” while calling the current budget proposal 2023-2024 “prudent.”
In an interview with CNBC, Netanyahu last week dismissed mounting concerns about the negative impact of his government’s judicial overhaul plan on the Israeli economy, describing the steep drop in investment in high-tech and ratings agencies downgrading Israel’s credit outlook as “dust.”
“The momentary fluff, the momentary dust that is in the air, is just that, dust,” he said. “The fundamentals of the Israeli economy are very powerful.”