Remarks by the Governor at the government meeting

Remarks by Bank of Israel Governor Prof. Amir Yaron at the government meeting regarding budgetary measures and the update of the three-year budget plan (the Numerator)

• The measures presented by the Ministry of Finance are important, even if they are modest relative to the size of the structural deficit.  It is important that the measures are approved and implemented, in order to signal to the markets that the policy makers are starting to deal with the growing deficit.
• The assumptions in the numerator document are particularly minimalist. Under realistic assumptions, the expected deficit without corrective measures is above 4.5 percent of GDP, even if we assume that the economy will continue growing in line with its potential and there will be no out of the ordinary events.
• The debt to GDP ratio, which has declined in recent years, and fiscal responsibility are important strategic assets for Israel. If the government does not correct the deficit path soon, the debt to GDP ratio is expected to rise to more than 65 percent as early as 2022.  There is a large difference between a decline from 70 percent to 65 percent of GDP and an increase from 60 percent to the same 65 percent, mainly when there is no apparent credible path to reduce the debt burden in the future.
• Should the government identify expenditures that are less important or inefficient from a social or economic standpoint, it will be important to reduce them, or at least to halt their increase.  It is also important to analyze the tax system and cancel unjustified exemptions.  However, the size of the fiscal gap is such that the government will apparently have no alternative but to show determination and increase the tax rates.
• The government recently initiated critical work processes to deal with the Israeli economy's painful lack of transport infrastructure.  It is important to prepare for those expenditures as well.  If the government wants to adopt further measures to increase productivity, it will need to find additional budgetary sources.
• Dealing with the current fiscal situation will be challenging, and it is important to start doing so when setting out the next government's targets and work plans.  Success in dealing with this issue will strengthen the economy's resilience and provide a stable basis for the government's long-term social and defense programs.

 

 

The Ministry of Finance presented the government with a picture of the budgetary situation for the coming years, and a number of initial measures that are intended to deal with it.  The picture presented is worrying.

 

The Bank of Israel separately examined the current and expected fiscal trends. In general, our assessment of the size of the fiscal problem—using the definitions set in the Numerator document within which the Ministry of Finance is presenting the expected deviation from the fiscal targets in the coming years—is similar to that of the Ministry. The measures presented by the Ministry of Finance, and particularly the across-the-board cut and the increase in tax rates on hybrid vehicles and solvents materials, are important, even if they are modest relative to the scope of the problem.  Although it is clear that the main part of the challenge will be faced by the next government, it is good that the transitional government is acting now, with the tools available to it, to moderate the deficit.  It is important that these measures are approved and implemented in order to signal to the markets that the policy makers are starting to deal with the growing deficit.  I would like to emphasize that if the measures are not approved, it will send a negative message to the markets.  As of now, the markets are giving credit to the government and holding to the belief that the problem of the deficit will be dealt with.  Rejecting the measures will increase concerns regarding the government's ability and determination to deal with the issue.

 

The budget for this year and the three coming years features a situation where the existing commitments on the expenditure side are higher than the government's on-going revenue—referred to as a "structural deficit"—which is reflected this year in an actual deficit of 3.5–4 percent of GDP, and according to the Numerator definitions, it is expected to remain at that level in the coming three years as well.  This is a very high deficit level relative to other OECD countries, even if we take into account the more rapid growth of the population in Israel.

 

It is important to emphasize that the definitions in the Numerator document are particularly minimalist.  They assume that (1) the important social programs approved by the government via temporary orders, the expenses related to coalition agreements in the previous government, and the Buyer's Price program, will all be stopped.  The cost of these programs is more than NIS 6 billion per year.  (2) The across-the-board cuts of NIS 5 billion set out for 2021 will be fully realized, without a need to provide alternative budget additions to the affected ministries. (3) The nominal defense budget will barely increase until 2022.  For that reason, under more realistic assumptions, the expected deficit without corrective measures is more than 4.5 percent of GDP, and even that is under the optimistic assumption that throughout the period, GDP will increase in line with its potential, the unemployment rate will remain at its historically low level, and that we will not have to deal with significant security incidents.  Otherwise, the increase in revenue will be lower than expected in this forecast, and the deficit will climb upwards.

 

The debt to GDP ratio, which has declined in recent years, and fiscal responsibility are important strategic assets for Israel. The expected deficit level greatly exceeds the deficit targets set out in the law: 2.5 percent of GDP in 2020, and a decline to 2 percent in 2022.  It is important to note that beyond the importance of the deficit targets set out in the law as an anchor for the credibility of fiscal policy, a deficit of about 2.5 percent of GDP is necessary to maintain the debt to GDP ratio at about 60 percent over time—which is a clear sign to entities examining the Israeli economy from within and without.  If the government does not correct the deficit path soon, the debt to GDP ratio, which increased in 2018, is expected to grow to more than 65 percent as early as 2022.  While Israel had such a debt to GDP ratio a few years ago, we need to understand that there is a large difference between a decline from, for instance, 70 percent to 65 percent of GDP, and an increase from 60 percent to the same 65 percent, mainly when there is no apparent credible path for reducing the burden of debt later on. The financial markets attribute significance to the trend of the changes in debt.  An increase in debt may have painful implications for the burden of the government's interest payments and for investors' confidence in the economy.  Again, the debt and deficit estimates that were presented were calculated under the assumption that the economy would continue to grow at its potential rate, but they will grow exponentially if there is even a moderate slowdown in growth.  Moreover, since the current deficit is structural, an increase in the debt to GDP ratio will not stop at 65 percent, but will continue until the policy is corrected.

 

This picture presents a large challenge for the next government: reducing the structural deficit.  Should the government identify expenditures that are less important or inefficient from a social or economic standpoint, it will be important to reduce them, or at least to halt their increase.  It is also important to analyze the tax system and cancel exemptions that have no economic or social justification.  However, the size of the fiscal gap faced by the government is apparently larger than such measures can address, and the government will apparently have no alternative but to show determination and increase the tax rates.  Here, the government faces a mix of possibilities based on considerations of social targets and economic efficiency.

 

Beyond the worrying deficit path, it is important to remember that the budget in Israel has been characterized for years, including recent years, by low expenditures in growth-supporting items, particularly public investment.  The government has recently initiated critical work processes to deal with the Israeli economy's painful lack of transport infrastructure, but this process requires a large investment, a significant portion of which will be financed by the government's budget—even if the investment proves worthwhile in the future and leads to increased tax revenue.  For this reason, it is important to prepare for these expenditures as well, which, while they are not within the timeframe of the Numerator, are not far off from it.  The Bank of Israel will soon publish a collection of measures required to increase productivity.  These measures will pay off in the long run, but they are not inexpensive in the short term, and if the government wants to adopt even some of them, it will be necessary to find additional budgetary sources.

 

Dealing with the current fiscal situation will be challenging, and it is important to begin doing so already when setting the next government's targets and work plans.  Nevertheless, success in dealing with it will enable the economy to return to robust resilience against the storms that will come sooner or later from the global economy, prepare for the large investments required to close the persistent productivity gap between us and other advanced economies, and provide a stable basis for the government's long-term social and defense programs. 

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