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The Bank of Israel recommended Monday that the government temporarily raise the value added tax back to 16.5 percent to fund the cost of the war in Lebanon while minimizing the growth of the deficit.
The Treasury is trying to find a way to finance the conflict within the framework of the 2007 budget.
Finance Minister Avraham Hirchson is expected to unveil his plans for next year's budget at a press conference scheduled for Tuesday afternoon, following two days of leaks and speculation hinting at various cutbacks, raised costs and stretched fiscal limits.
The central bank made its recommendation in a statement aimed at countering reports that Bank of Israel Governor Stanley Fischer and Hirchson were facing off on economic policy related to the 2007 budget.
"The Bank of Israel research division supports the stance of the Finance Ministry, by which the government would increase the cap on 2007 budget spending to fund the one-time expenses related to the war in Lebanon and the disengagement [from the Gaza Strip and an enclave in Samaria], but would avoid further increases," the central bank said.
Maintaining the spending cap and temporarily raising the VAT, through an emergency order valid through 2007, would "emphasize the government's commitment to long-term fiscal goals and strengthen the economy's financial stability," the central bank said, adding that the temporary VAT hike would help continue reduction of the public debt, "which is still deviating from the accepted [level] in developed countries."
Hirchson lowered VAT by 1% to 15.5% effective July 1, shortly after taking office, as part of the economic reforms initiated by former finance minister Binyamin Netanyahu.
Reports in the Hebrew press portrayed Fischer as being in favor of raising the money through tax hikes, as opposed to increasing the deficit.
Nonetheless, the central bank did stress the importance of "ensuring that the 1.7% cap on growth of spending, which was raised only four months ago, will be maintained, aside from specific costs of the war."
Leaks to the Hebrew press describing Hirchson's plans for the 2007 budget - to pay for the costs of the war - set off a political storm Monday and unleashed immediate debate.
Although the Finance Ministry declined to provide official information on the program, rumors of an imminent unveiling were rampant throughout the day.
Hirchson reportedly is planning to increase tuition at universities and colleges, cancel grants for soldiers who finished their mandatory service, halt the planned raise in minimum wage and dismiss 30,000 civil servants.
The ministry is also reportedly considering to freeze the increase of the minimum wage, which was expected to be raised by June 2007, and the age of those eligible for unemployment benefits would be raised from 20 to 28, while the age of retirement would rise to 67 for men and 64 for women.
It was also suggested that the official announcement of Hirchson's program was put off as a result of the controversy caused by the leaks.
Ayelet Nir, chief economist of IBI, reacted to unconfirmed reports that the government had decided to expand the budgetary spending and deficit targets for 2007 to 3.3% and 2.8% respectively, from earlier aims to limit expansion to 1.7% and 2% respectively.
"One may assume that the final numbers will not be very far off [from the reported figures]," she said.
Noting that a 2.8% deficit would amount to some NIS 16.8 billion, and that, by conservative estimates, net credit would reduce the sum by about NIS 1.8b., Nir suggested that the deficit to be funded next year would be approximately NIS 15b.
The Finance Ministry would then seek to finance the deficit from three main sources, she said.
Privatizations could help fund about half of the amount, as the state may sell off another 10% chunk of Bank Leumi stock for NIS 2.1b. or cash in its holdings on the Tel Aviv Stock Exchange, and is likely to realize the sale of the Haifa oil refinery as well.
Raising capital abroad could bring in another NIS 4b., through sales of Israel Bonds and issuing debt in Europe and elsewhere.
Nir said domestic fundraising could provide the remaining sum through an issuing on the Israeli government bonds market.
"After examining the numbers, we see that, in fact, the Treasury has to raise a net amount of just over NIS 3b. on the domestic government bonds market," she said, adding that the gross amount would be offset somewhat by interest payments that will bring revenues on the bonds market to a surplus of some NIS 20b.
"So the level of liquidity is expected to stay high," Nir said. "Raising the deficit target is not expected to cause pressure on the government bonds market," but political uncertainty and decisions by foreign investors could, she added.
Furthermore, increased budgetary spending could lead to inflationary pressures that would force Fischer to accelerate monetary tightening and interest rate hikes, Nir said.
"One must not ignore the risks added to the market," she warned.
Meanwhile, the Industry, Trade and Labor Ministry on Monday presented its wish list for a total of NIS 1.136b. in additional funding for 2007-2010.
In the presentation, Industry, Trade and Labor Minister Eli Yishai detailed the needs for more money for investments, research and development, and promotion of exports and small businesses, alongside other ministry activities that would accelerate economic growth and reduce poverty.