Annual losses of NIS 50-100B: Treasury officials warn of overhaul’s ‘severe’ effects

Senior Finance Ministry officials on Monday warned Finance Minister Bezalel Smotrich that the government’s proposed judicial overhaul could stunt the country’s growth, resulting in a severe loss of tax revenue and do “very significant harm” to the economy.

During the internal discussion, budget division officials presented Smotrich with potential economic implications of the planned judicial changes, including a position paper prepared by the ministry’s chief economist, Shira Greenberg. The officials warned of the potential downside risk to Israel’s sovereign credit rating and related costs and lack of economic growth.

The shekel hit 3.7 per dollar in intraday trading this week, its weakest level in four years, as Prime Minister Benjamin Netanyahu’s coalition pushed ahead with legislation that would grant the government control over the appointment of judges, including High Court justices, and all but eliminate the High Court’s ability to review and strike down legislation.

A deterioration in the country’s credit risk profile will lead to higher financing costs of government debt and make borrowing costs for businesses more expensive, as well as negatively affect foreign direct investments, which in turn would slow down economic growth, according to the Finance Ministry documents cited in Hebrew media.

In such a scenario, the burden of financing public debt is estimated to increase by NIS 3.2 billion ($976 million) to NIS 8.6 billion a year and business financing costs by NIS 6.2 billion to NIS 8.7 billion, the officials said.

A credit rating downgrade was estimated to lead to a 2.8% to 5.6% loss in economic growth versus forecasted growth, which in a decade would translate into a loss of NIS 50-100 billion ($14-27 billion) annually to the GDP. The loss of product would within a decade reduce government revenue by about NIS 15-30 billion a year, based on the current tax burden.

Earlier this month, Fitch Ratings affirmed Israel’s A+ credit rating with a stable outlook, citing the country’s “diversified, resilient” economy, but warned that the planned judicial changes could have a “negative impact” on its credit profile. The rating agency also noted that some countries that have passed major reforms reducing institutional checks and balances have seen a significant weakening of World Bank governance indicators, which constitute an “influential” part of the agency’s sovereign credit model.

Workers from tech sector protest against the government’s planned judicial overhaul, in Tel Aviv, on March 9, 2023 (Tomer Neuberg/Flash90)

“Damage to Israel’s ranking in the democracy and governance indicators is expected to lead to a structural decline in the rate of GDP per capita growth rate of 0.8 percent per year, which means in the five years following the passage of the reform, this could lead to an aggregate loss of GDP of about NIS 270 billion and a decrease in aggregate state revenues of about NIS 70 billion,” according to Greenberg’s position paper. “A decade later the negative impact on state revenues is estimated at about NIS 385 billion over the following 5 years.”

The meeting with Smotrich was attended by Greenberg, Finance Ministry Director General Shlomi Heisler, budget director Yogev Gradus, accountant general Yali Rotenberg, and tax authority director Eran Yaacov.

The paper noted that due to the structure of the Israeli economy, the negative impact on long-term growth may manifest quickly, particularly in the tech sector, because of companies’ cross-border operations and their reliance on international funding and skilled workers who may leave the country.

The tech industry is the growth engine of Israel’s economy, contributing 17% of GDP, and is responsible for over 50% of exports and about 25% of payroll taxes. In 2022, foreign capital investments in Israeli high-tech amounted to about $12 billion (not including exits).

Greenberg cited initial indications of negative economic sentiment reflected in companies seeking to pull tech operations out of Israel, statements of intention to reduce foreign investments, and inquiries about corporate re-registrations by Israeli companies.

Finance Minister Bezalel Smotrich at a press conference in Tel Aviv, March 2, 2023. (Avshalom Sassoni/Flash90)

“This type of dynamic does not develop linearly but may snowball, and under certain scenarios may lead to a significant outflow of physical capital and/or human capital, meaning, brain drain in the high tech sector,” she warned. “Under these scenarios the negative impact on the Israeli economy is expected to be severe and lasting.”

Moody’s rating agency earlier this month already warned that the planned judicial overhaul could weaken the country’s institutional strength and if fully implemented could be “credit negative,” posing a threat to the economy and in particular to capital inflows into the tech sector.

In an official statement from the Finance Ministry, the discussion was described as a presentation of macro data, including the “possible risks and opportunities” of the judicial overhaul.

“It is our job… to prepare for any scenario, formulate budgetary and systemic solutions and turn challenges into opportunities,” Smotrich said. “I believe [the reform] holds great opportunities for the economy in terms of legal certainty and renewed synergy between authority and responsibility that will lead to a more flexible risk management model, which will lead to a reduction in bureaucracy and regulation and great growth.”

Bank of Israel Governor Amir Yaron speaks in an interview with CNN aired March 15, 2023. (Screenshot: CNN; used in accordance with Clause 27a of the Copyright Law)

On Monday, Bank of Israel Governor Amir Yaron met with Attorney General Gali Baharav-Miara to discuss the economic implications of the proposed legal overhaul, according to a report by Channel 13.

The economy expanded 6.5% in 2022, growing at a slower pace than the fast 8.6% expansion in 2021. GDP rose a seasonally adjusted, annualized 5.8% in the fourth quarter of 2022, surpassing analysts’ expectations. In 2022, average growth among OECD countries was 2.8%. The central bank forecasts 3% economic growth in 2023 and 3.5% in 2024.

Yaron cautioned in an interview with CNN last week that the government’s sweeping overhaul was “hasty,” and said one of the reasons an orderly and broadly agreed-upon process was important was to stop companies from directing investments away from the Israeli market, which several major firms have already announced they will do.