War costs put Israel’s public services at risk of collapse, says former central bank head
Without policy shift, social welfare won’t meet needs of population; quality of life and economic growth will be harmed, says Karnit Flug, ahead of this week’s IDI conference
Sharon Wrobel is a tech reporter for The Times of Israel
Renewed fighting in Gaza and higher defense funding needs will put Israel’s already strained public services at risk of collapse, said Prof. Karnit Flug, a former governor of the Bank of Israel and current senior fellow at the Israel Democracy Institute (IDI).
These services include hospitals, schools, and public transportation, she said, speaking to The Times of Israel on Sunday, ahead of this week’s IDI Eli Hurvitz Conference on Economy and Society in Jerusalem.
Meanwhile, the looming menace of economic sanctions and international isolation by Israel’s Western allies over the country’s conduct in Gaza is feared to further impinge on the quality of life of Israelis.
All these factors threaten to bring down the standard of living, curtail the country’s growth engines, and trigger a massive outflow of taxpayers and human capital, unless the government changes its course of policy, cautioned Flug.
“What worries me is that, without changes in the government’s course of budget policy and without internalizing the potential snowball effect of sanctions and restrictions, Israel will find itself on a very risky path,” Flug said. “It’s not sustainable to increase the burden on the part of the population that serves in the country, pays taxes, and has high productivity, because they are also the ones who are the most mobile [to leave the country], and we don’t want to go down that road.”
“Israel is a small country with very few natural resources, an economy dependent on human capital as its main source of growth, and adequate infrastructure that is necessary to meet its potential for growth,” she said.
This year, Israelis are already grappling with higher taxes, eroding their disposable income, while receiving fewer public services as the government implements austerity measures to finance ballooning war costs. Meanwhile, Israel’s government, led by Prime Minister Benjamin Netanyahu, has been harshly criticized for failing to make necessary changes to the composition of budget expenditure, in light of higher future defense spending and the need to bring down the country’s debt to help the war-torn economy recover.
At this week’s conference, Flug will present the findings of a study on the repercussions of the government’s shift in budget priorities since the outbreak of war with the Hamas terror group on October 7, 2023, when thousands of Hamas-led terrorists invaded southern Israel, butchering some 1,200 people, abducting 251 to the Gaza Strip, and sparking the ongoing war in Gaza.
The study also examines the implications that the planned increase in defense spending might have for civilian spending and public services.
Flug said that, in the study conducted with IDI researcher Roe Kenneth Portal, the two found that during the war, funds earmarked for social welfare needs were mainly spent on war-related expenses, such as medical bills for those affected by the war, emergency infrastructure, and rebuilding costs for areas damaged or destroyed on and after October 7. As a result, she said, spending on basic public services was squeezed or compromised.
While the proportion of the budget allocated for social welfare remained unchanged relative to 2019, its composition has shifted during the war to answer the pressing needs of reserve soldiers and evacuees from the Gaza envelope and northern borders, to provide emergency infrastructure, and to support the budget of the Tkuma reconstruction directorate, according to the study.
“Civilian services such as education, health, and welfare, and the level of infrastructure that comes with these services, have a direct positive impact on both the quality of life and growth of the economy,” said Flug. “Even before the war, these services were at a relatively modest level in Israel.”
Assuming that the recommendations of the Nagel Committee — tasked with examining the future defense budget and IDF force design — will be adopted, and the government adheres to its fiscal budget deficit ceiling and spending limit to avert debt spiraling out of control, additional wartime expenditures will come at the expense of civilian spending.
“Resumption of fighting in Gaza with no end in sight will require additional spending and force the government to introduce further measures,” said Flug. “Since Israel is already paying high interest because of the country’s enlarged debt levels to finance the significant increase in the defense burden and needs to return to more reasonable deficit levels, we expect civilian spending will be cut even further.”
“Over the next decade, given the higher defense spending, and if the government adheres to the existing fiscal rules, then there will be a decrease in civilian spending, both as a percentage of GDP and in per capita spending,” said Flug. “There is a risk of collapse because if public services decline even further, we will be below all developed countries in terms of the quality of health, education, infrastructure, and research and development.”
“This will affect both our quality of life, and also growth in the economy,” she warned.
Civilian expenditure is projected to decrease by 4% to 5.5% of the GDP by 2034, “which places us at the lowest among advanced economies by far,” Flug said.
Flug, who served as the central bank’s chief from 2013 to 2018, criticized the government for continuing to distribute discretionary coalition funds and allocating vast sums to unnecessary ministries and ultra-Orthodox causes.
“Various budget components increasingly serve specific sectors of society, with funding for services that do not benefit the general public — for example, increases to the budget for ultra-Orthodox education [including planned wage increases, which are difficult to cancel], geographic subsidies for public transportation, and the skewed and harmful policy of land discounts allocated for housing lotteries targeted disproportionally at the ultra-Orthodox population,” the study elaborates.
In light of the risks, Flug and Kenneth Portal proposed an alternative policy plan, which includes a gradual increase in taxation to allow for a recovery in civilian spending, and a new order of budget priorities.
“Taxation would need to be broad-based and reduce some of the exemptions that don’t have either economic or social justification, but it shouldn’t increase the burden on those who already pay very high taxes,” Flug said. “It can be done by expanding the tax base since 55% of employees in Israel don’t meet the threshold of paying income tax.”
Flug noted that surveys show a mistrust among the general public that taxpayers’ money is not allocated to improve civilian and public services.
“The composition of spending needs to be such that the government will earn people’s trust,” said Flug. “People in Israel want better quality services and a government that invests in reducing social gaps, and with improved services, I believe the willingness to pay higher taxes will be there.”
Hence, she said, the government should eliminate coalition agreement funds, inefficient land discounts and tax exemptions, and make cuts to budgets that serve limited sectors of society and hinder growth.
“This approach would enable financing additional defense and interest expenditures, stabilize the deficit in the medium term, and moderately raise civilian expenditure,” Flug and Kenneth Portal concluded in the report. “It would allow for necessary investments in infrastructure, reduction of educational disparities, strengthening of higher education and Israeli research, and the attraction of higher-quality personnel to the public sector, assuming the right reforms would be implemented alongside the expenditure increase.”
“These changes would help preserve social security, economic growth, and the standard of living in Israel,” they said.
Looming trade restrictions
Flug also raised concerns about the potential implications of the UK and EU member states reviewing commercial ties with Israel, due to the country’s wartime policies in Gaza, and uncertainty surrounding the new US tariff regime.
“If there are restrictions, the shift to alternative sources will be harder, affecting prices and making imported goods more expensive,” said Flug. “If we need to invest our resources in producing things that we don’t have a comparative advantage in, we will all be much poorer.”
Facing higher taxes and higher prices, a lower standard of living, and the burden of reserve duty, this combination could “prompt an outflow of those who can live much better elsewhere — it’s a slippery slope,” she said.
“The government needs to internalize the high costs of isolation when it makes its decisions,” Flug said.
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