​Summary:

The general-government deficit exceeded 5 percent of GDP in 2003 for the second year in a row and the gross general-government debt climbed to 107 percent of GDP. The central government-budget deficit ballooned to 5.6 percent of GDP, the highest level since the 1985 Economic Stabilization Program and 2.6 percent of GDP over the target. The deficit level dropped markedly during the year-from 7 percent of GDP in the first half of the year to less than 4 percent in the second half-due to the application of the Economic Recovery Plan. Since the deficit-cutting provisions of the plan were based largely on reducing expenditure, general-government expenditure declined in 2003 after years of rapid growth and a deceleration in 2002. Thus, the deficit increase in 2003, unlike those in 2001 and 2002, traced to a decline in government revenues-tax revenues in particular-and not to rising expenditure. The credibility of fiscal policy was enhanced in 2003 by the results of the war in Iraq, which eased Israel's expected long-term defense burden, and the receipt of US loan guarantees, which lowered the risk of a financial crisis in the short term.

The deficit resumed its upward march shortly after the mid-2002 ‘Economic Defensive Shield' program because the budget was again based on overoptimistic assumptions. Thus, in view of the impending war in Iraq, the depreciation of the NIS, and the upturn in interest rates on the government debt in the middle of 2002, another economic plan was needed. The 2003 Economic Recovery Plan restored confidence in fiscal policy because its immediate deficit-cutting measures were largely permanent and because it included additional steps to further reduce government outlays several years ahead. Furthermore, structural matters such as pension arrangements, the retirement age, and the structure of National Insurance benefits were addressed. The resulting credibility was further enhanced by the successful enshrinement of most of the main measures in agreements with the Histadrut (albeit after a lengthy struggle). However, the methods used to approve the plan-as well as some additional measures that were authorized along with the 2004 budget-touched off vehement public controversy due to the use (and the threat of use) of legislation to amend existing agreements and the hasty debate of several structural provisions of the plan.

In addition to the contribution of the economic plan to financial stability, the composition of the plan-especially the decisive share of expenditure-cuts in reducing the deficit and the attempt to leave infrastructure investment unscathed-is conducive to sustainable economic growth, as soon as global economic developments and domestic security make this possible. To apply the plan in full, however, the Government will have to make a long-term commitment to its implementation, a condition that was not fulfilled in the past. Moreover, at the time the plan was approved, the deficit was expected to surpass the Government's targets for several years ahead and the general-government debt was expected to continue rising even under the assumption that the plan would be fully applied. For these reasons, and since Israel still has very high levels of general-government expenditure and deficit by international standards, another large adjustment had to be made in the 2004 budget, alongside a significant raising of the deficit target. An additional sizable adjustment will probably be needed in the 2005 budget as well. The economy has been paying a heavy price for these recurrent adjustments in the coin of institutional instability, disruption in planning the activities of budgeted entities, and labor disputes. The harm was compounded in 2003 by overaggressive attempts to slash expenditure in several fields-e.g., in the general grants for municipal authorities-that had to be reversed and required additional adjustments immediately after the budget was approved. The budget measures applied in the past two years, taken as a whole, have also changed the composition of expenditure in a way that is less conducive to reducing inequality. Although the acceptable extent of inequality is a matter of sociopolitical preference, it is important for the Government to promptly invoke policy measures that will spare individuals who are incapable of working from too much harm, especially in regard to education and health. Such measures should aim to sustain the social mobility and earning potential of such people and their children and, thereby, to allow the economy to utilize its growth potential.

Israel's tax rates have undergone far-reaching changes in the past two years (including early 2004)-increases in 2002 and 2003 and cuts in 2004. These adjustments increased the indirect-tax burden, mainly due to the raising of the fuel and cigarettes excises. The direct-tax burden hardly changed but was significantly recomposed: general tax rates on wages were lowered and exemptions were revoked-especially in regard to regional benefits-and households' income from financial assets was taxed. The full application of the income-tax reform, planned for 2006, will eliminate most of the gap between Israel and the developed countries in tax rates on earned income in the three highest deciles. Concurrently, the imposition of taxation on households' capital income narrowed one of the most conspicuous gaps in tax-system structure between Israel and developed countries.

The State Budget and the General Government - PDF file