It's less than a week since the election for the 19th Knesset, but the final results are already known, and the various estimates of the possible permutations for forming a coalition, with or without the haredi (ultra-orthodox Jewish) parties, have been widely covered. Each possible government will place different emphases on security, social policy, and the economy, but there is one thing that no government will be able to escape: the numbers with which the previous government has left it.
The outgoing government posted a huge deficit of NIS 39 billion in 2012, 4.2% of GDP. This came as no surprise to most economists, but that didn't stop the scary number from reaching the headlines, or our politicians from crying rape and inveighing against "fiscal irresponsibility."
Now, with a new government about to be formed, it's time to deal with the fiscal deficit for 2013-2014. The high deficit in 2012 arises from two causes. The first is high budget performance by government ministries' leading to higher than expected expenditure. This high performance (i.e. proportion of budget actually spent) arises from decisions made by the government in the past year, partly in connection with implementation of the Trajtenberg committee recommendations, and partly in connection with wage agreements signed with various groups of public sector workers. The second cause of the deficit is the only moderate rise in tax revenues.
The high deficit brings into focus a number of points. The first is that the difficulty in forecasting state revenues is clear. It is especially difficult for Ministry of Finance officials when they are required to do this is conditions of extreme uncertainty. Projections become even more difficult when the demand is to forecast tax collection not just for one year ahead, but for the year following as well, in the framework of the two-year budget.
The figures for 2012 highlight the weakness of the two-year budget, which incidentally, is not in fact a budget for two years, but a budget for one year and for the year after, and the difference is material. Given the 2012 figures, the need arises for research and an in-depth examination of the advantages and disadvantages of the two-year budget, and to make an informed decision whether a two-year budget is appropriate for the Israeli economy. It will be no surprise if it turns out that it is not, although the government will probably pass a two-year budget for 2013-2014, since there is no point in passing a budget covering just a few months in 2013.
A further point relates to the fiscal decisions the new government will have to make as soon as it is formed. We have begun 2013 without an approved budget, and the economy is currently being run on the basis of the 2012 budget, whereby the spending ceiling each month is one-twelfth of the 2012 budget (including loan repayments).
The first matter that the new government's ministers will have to deal with is passing the 2013 budget, which, as mentioned, will probably be for 2013-2014.
A message of return to fiscal responsibility
What options will the new government have for the 2013 budget?
A first option is a NIS 20 billion budget adjustment, of which NIS 15 billion will come on the expenditure side and NIS 5 billion on the revenue side (tax hikes). Such a budget adjustment would enable the government not to exceed the 2013 deficit target by very much (Psagot estimate: 3.5%, compared with a 3.0% target), and would convey a message of a return to fiscal responsibility, but it would be hard to implement.
Why? Because unless the defense establishment lends a hand and participates in the required budget cut, a NIS 15 billion cut in civilian spending would hit the services that we receive hard, particularly for the weaker sections of society, which have no alternative of buying services such as education, health, welfare, and so on, privately.
A second option: the government decides that it cannot carry out a NIS 15 billion budget cut, and it changes the law, so that the spending ceiling will be higher. In that situation, there are two possibilities.
One is that the government cuts less than NIS 15 billion (it can chose any number between 0 and 15 billion) and makes no change on the revenue side. The fiscal deficit will then be higher than 3.5% of GDP.
While I am not concerned about the government's ability to finance a high deficit, for, despite the high deficit in 2012, the government bond market has seen a fall in yields, I am concerned about the effect of a second successive high deficit on the economy's credit rating. A cut in Israel's credit rating will bring in train a rise in the economy's risk premium, and that will mean capital losses for investors in government and corporate bonds (and for every one of us in our long-term savings portfolios), and a rise in the government's interest payments on domestic debt, and even more so on external debt. It follows that this possibility is to be avoided.
The second possibility is to cut the budget by less than NIS 15 billion, but, against any spending increase that is allowed, to raise taxes accordingly. In other words, in this scenario, the rise in taxation will be higher than NIS 5 billion. That way, the deficit will not rise, and the risk of a cut in Israel's credit rating will substantially diminish.
Austerity measures
It is important to point out that each of the options involves austerity measures, whether by way of reduced public services, or by way of a higher tax burden. In recent years, we have seen a fall in direct taxation (in retrospect, perhaps too sharp a fall), while the indirect tax burden has risen (chiefly VAT). It would therefore be right (despite the prime minister's declaration that he does not intend to raise taxes) for the government to make a correction, and raise direct taxes rather than indirect taxes.
The fear is that, despite the attempt to form a more socially aware government, in the end the tax rise mix will be "both and".
What then should the new government do? If a spending cut can be imposed on the military, then the first option (a NIS 20 billion budget adjustment) is the better alternative. The likelihood of a cut in military spending rose after the election, since the Yesh Atid and Habayit Hayehudi parties, which are expected to be in the government, support such a cut.
If, however, the defense establishment will not participate in the required budget cut, then the second option, of a cut smaller than NIS 15 billion and a corresponding rise in taxation without exceeding the deficit target set, will represent the lesser evil.
The writer is chief economist and strategist at investment house Psagot.
Published by Globes [online], Israel business news - www.globes-online.com - on January 28, 2013
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