Bank of Israel: Rising expenditure, reduced taxes endangers economy

"The risks inherent in such a situation will increase if the growth rate slows," said Bank of Israel Governor Prof. Amir Yaron in a letter to the government.

Amir Yaron (L) delivers a report to Benjamin Netanyahu (R) (photo credit: AMOS BEN-GERSHOM/GPO)
Amir Yaron (L) delivers a report to Benjamin Netanyahu (R)
(photo credit: AMOS BEN-GERSHOM/GPO)
The combination of increasing government expenditure and the simultaneous reduction of taxes is increasing the nation’s structural deficit to an “undesirable” and potentially dangerous level, Bank of Israel Governor Prof. Amir Yaron warned on Sunday, as he unveiled the bank’s annual report on the state of the economy.
“The risks inherent in such a situation will increase if the growth rate slows,” said Yaron in a letter to the government.
The outgoing government, the central bank said, adopted an expansionary fiscal policy during its term, reflected by a significant increase of public expenditure – notably civilian expenditure – as a share of GDP, alongside a lowering of tax rates.
As a result, the deficit in the government budget increased by 2.9% of GDP in 2018, in accordance with its revised deficit ceiling, and the general government deficit increased to 3.8%, the highest level since the government’s deficit adjustment program in 2013.
“This highlights the need for fiscal adjustments, which are advisable to be made when the economic situation is expedient. Postponing them could necessitate more significant adjustments, precisely when fiscal expansion is needed in order to support activity,” said Yaron.
“As the government’s plans for the coming years involve large expenditures, fiscal adjustments will apparently require that the government increase the efficiency of its activities, change its priorities [and] align the growth rate of expenditure with the budget-aggregate growth rates it determined for the coming years, as well as increase tax revenues.”
The Israeli economy grew by 3.3% in 2018, the bank said, slightly lower than the pace of growth in the previous two years but still representing a “good year for the Israeli economy.” Per capita GDP also increased by 1.3% but still remains low by international comparison.
The inflation rate accelerated in 2018, eventually stabilizing around the lower bound of the annual target range, standing at 0.8% at the end of December. Inflation remains one of the lowest in the OECD, with elements previously contributing to low inflation weakening – including the shekel depreciating against the dollar, little impact of government intervention, increased inflation abroad and, finally, proximity to full employment.
Demographic and other processes, Yaron said, are expected to slow potential GDP growth in the coming decades, highlighting “the need for an overall policy to increase productivity in the economy,” focusing on human capital, infrastructure and business.
Required steps, he said, include improved education for all age groups, including for under-threes, significant investment in transportation infrastructure, simplified regulation, continued efforts to enhance competition, and to increase employment rates among sectors currently with low participation in the national labor force.
In welcome news for those seeking to step onto the property ladder, home prices declined in 2018 for the first time after a decade of rapid growth. Yaron cited steps taken by the government to “markedly expand supply” as well as to “reign in demand” as a contributing factor to the decrease.
The number of building starts, however, declined in the past two years and, Yaron said, “the government should create the conditions that will allow an appropriate number of building starts over time, particularly in areas with high demand. This is especially in view of the forecasts regarding the additional homes that will be needed in the coming years.”
Looking forward, the report highlights several new and ongoing processes that are expected to have a positive effect on the economy in the coming years. These include enhancing competition in the household and small business credit markets and the establishment in mid-April of a new credit data system open to the public.
“The economy is presented with opportunities. If we succeed in improving education, infrastructure and smart regulation so that we reach the 75th percentile of the OECD in each of these fields – an aspiration that is not excessive – our model predicts that the GDP will be 13% greater in 2065 than our baseline forecast, which is a very significant figure.”
Responding to the report, Prime Minister Benjamin Netanyahu told Yaron that “the economy is in good shape because our policy is good.”
“We have reached a unique achievement where unemployment is at an all-time low and wages are rising rapidly,” Netanyahu said. “It’s a combination that is, as you know, unusual, but it’s one of [our] great achievements.”