Israel’s economic response fails to address war needs, says former central bank head
Despite ‘basic resilience,’ the state has to take ‘tough’ steps, such as tax hikes, to start on a path of strong recovery, says Karnit Flug
Sharon Wrobel is a tech reporter for The Times of Israel.
Israel needs to prioritize spending on the ongoing war with the Hamas terror group in Gaza and take steps to shore up the economy in order to embark on a path of strong recovery and sustainable growth, urged Dr. Karnit Flug, a former governor of the Bank of Israel and currently a VP of research at the Israel Democracy Institute.
Flug talked to The Times of Israel on Wednesday, not long after ratings agency S&P Global warned that economic recovery would be slower than expected after over seven months of war that swelled spending by almost NIS 60 billion ($16 billion), leading to a fiscal shortfall of 7 percent of gross domestic product in April and breaching the target ceiling of 6.6% that the government set for 2024.
Flug, who served as the central bank’s chief from 2013 to 2018, criticized the government for failing to adjust its priorities to address wartime needs and support the economy’s recovery. She explained that a rise in taxation is inevitable and has now become an economic necessity to fund the expected increase in the defense budget, help reduce the structural deficit, and lower the country’s debt-to-GDP ratio.
“Israel’s economy has basic characteristics of resilience… it’s the beginning of the recovery, but not a very strong recovery,” said Flug. “The length of this war, the uncertainty about the possibility of a fully-fledged war in the north, alongside the government’s economic policy response put question marks or cast doubt about the strength of the recovery and about getting back on a sustainable growth path going forward.”
In a pessimistic outlook, S&P said on Monday that it expects Israel’s economy to recover at a slower pace compared with previous military campaigns or the COVID-19 pandemic. This prognosis came despite data last week that showed that the economy bounced back in the first three months of the year, growing by an annualized 14.1% following a 21.7% contraction in the previous quarter, as war with Hamas in Gaza took a heavy toll on consumer spending, trade and investment.
S&P, which earlier this year lowered Israel’s sovereign credit rating, sees war-hit sectors, such as tourism, construction, and agriculture, alongside elevated regional security tensions and domestic political uncertainty, as the factors hampering a fast recovery. S&P joined Moody’s Investors Service in cutting Israel’s credit profile by one notch, as the Gaza war is expected to last longer than previously estimated.
The ratings agency is projecting a budget deficit of 8% of GDP in 2024 and expects the economy to expand at a below-consensus rate of 0.5% this year compared with the 2% forecast by the Bank of Israel.
The Knesset in March passed an amended wartime budget that includes additional government expenditure of more than NIS 70 billion compared with the original 2024 budget approved in May 2023. About NIS 55 billion of this sum has been allocated to financing the military, while the rest will go toward civilian wartime needs.
To partially offset this increase in expenditure, the government presented a package of fiscal cuts and tax measures that add up to a total of about NIS 17 billion. However, half of this amount will only come into effect in 2025, according to an IDI research report co-led by Flug. One of the measures includes a hike of 1% in value-added tax (VAT) – from the current 17% to 18% — which is planned for 2025.
The government raised the 2024 budget deficit target to 6.6% of GDP, up from the ceiling of 2.25% before the outbreak of the war.
“The government’s response in the 2024 corrected budget was insufficient, in the sense that the spending cuts were insufficient, the tax measures will only be implemented in 2025, and not all of them have been passed through the Knesset,” said Flug. “This combination means that the deficit will be larger than set as the government target, which in my view was too high.
“When you look at the composition of the measures, they are not optimal, as there was only a very partial cut of what we call coalition agreement resources that don’t go through any professional scrutiny, and they are not consistent with long-term goals, while superfluous ministries were not shut,” she lamented.
The right-wing coalition has been harshly criticized for leaving in place billions of shekels in discretionary funds made available to political allies under deals reached in coalition talks over a year ago. Ultra-Orthodox parties in particular have been criticized for continuing to insist on money to fund educational institutions that do not meet core curriculum requirements.
“All of that is not optimal from a narrow economic standpoint, but it also doesn’t improve the confidence or the trust of the public in the government’s decisions,” said Flug. “Thus, it would be much harder to come to the public, which is bearing the war burden in all aspects, both economic and military, and say we have to increase taxes.”
In the IDI report, Flug and her co-authors called for a new order of priorities to address the urgent challenges the Israeli economy is facing: funding the costs of the fighting, upping defense spending in the longer term, rebuilding the Gaza border region, supporting war-affected businesses, as well as improving basic social services such as education, health and infrastructure.
2025 budget plan
As the Finance Ministry is now working on the 2025 budget, “it will have to introduce tough measures to increase revenues and make deeper cuts in those budget items that are not necessary to signal that we are starting to get on the path towards a sustainable fiscal position,” said Flug. The structural or basic deficit for 2025 should not exceed 4% of GDP, she recommended.
Flug pointed out that two credit rating agencies have put a negative outlook on the local economy, which means that there is a risk of further rating action.
“That is where the question of taking the right actions in terms of fiscal policy will be crucial,” she said. “I hope that this time around political considerations will not be the dominant considerations when the government decides what is the overall economic package, but that it will internalize the need to get on a path that will ensure that the risks [such as further rating downgrades] don’t materialize.”
To raise revenues, the government needs to increase tax receipts by bringing forward the VAT rise to 2024, expanding the tax base, and cutting certain tax benefits, Flug suggested.
“We need to expand those populations who pay taxes, as in Israel the threshold for paying income tax is relatively high because of all kinds of exemptions,” Flug explained. “What it leads to is that 80% of income tax is paid by only 20% of the population.”
However, Flug emphasized that the government needs to be cautious that tax changes do not damage the competitiveness of the economy and impinge on incentives for working and investing.
“Raising the marginal tax on labor and on capital [for corporations], which are already high, might erode our competitiveness and might lead people who are heavily taxed and also bear the burden of reserve duty to choose not to be here,” Flug said.
Looking at the growth outlook for the economy in 2025, all the projections point to a strong recovery, Flug noted. S&P expects economic growth to quicken to 5% in line with the Bank of Israel’s forecast, and the OECD foresees a rate of 4.6% for next year.
“All those who are looking at the economy realize it has this basic resilience and ability to recover and they base their forecasts on the expectation that the government will eventually go in the right direction,” Flug said.
