Austerity comes knocking

With the state budget veering far into the red, the government imposes painful austerity measures.

PM Netanyahu, Finance Minister Steinitz 370 (photo credit: Sebastian Scheiner/Reuters)
PM Netanyahu, Finance Minister Steinitz 370
(photo credit: Sebastian Scheiner/Reuters)
Israelis have had good reason to feel smug about their economy over the past several years. Even as the global financial crisis savaged once strong economies, and countries such as Ireland, the United Kingdom and Estonia suffered under difficult austerity conditions, Israel consistently posted positive growth figures, placing it near the top of the list of developed countries in economic performance. Many took to describing the country as “an island of economic stability.”
But the smugness was wiped from the faces of Israelis in late July, when the government – noting that the state budget was veering dangerously into the red, with a deficit about to exceed a self-imposed 3 percent upper limit – announced that there was no way to avoid a series of painful austerity measures, comprising a mix of raised taxes and reduced government services.
Excess spending is now estimated to be between 13.5 billion ($3.4b) to 15 billion shekels ($3.76b) a year, and failure to adhere to budget discipline, warned senior government officials, could eventually cripple Israel’s credit ratings in international markets and put it in the same category as Greece and Spain.
The package of tax hikes and spending cuts was approved by the government in a 20-9 vote on July 30, with the ultra- Orthodox Shas party, Ehud Barak’s Independence party and the Likud’s Social Welfare Minister Moshe Kahlon voting against. The austerity measures aim to reduce the budget deficit by 1.5 percent, but they are certainly painful.
The Value Added Tax (VAT) is to be increased by one percent to 17 percent. Marginal tax rates for the fourth highest income bracket – those earning between NIS 8,881 and 14,430 per month – will increase from 21 percentto 22 percent. Marginal rates for the second and third highest income brackets will rise 1 percent to 31 percent and 34 percent respectively, while the two lowest and the highest income brackets will remain static at 10 percent, 14 percent and 48 percent, respectively.
Employer contributions to the National Insurance Institute for workers earning over 60 percent of the average salary are also slated to rise. Smokers and beer drinkers have taken a big hit, with the purchase tax on cigarettes and cigars rising from 260.6 percent to 278.6 percent and the purchase tax on beer increasing from 2.18 shekels per liter to 4.19 shekels per liter. As if that were not enough, in an independent decision the Energy Ministry raised the regulated price of a liter of gasoline by 0.43 shekels to 7.70 shekels. And the bad news did not stop with the heavier tax burdens. The government is also implementing an across-the-board 5 percent cut to ministry budgets for this year and plans a further 3 percent cut for next year. The Education Ministry, however, will lose only 1 percent of its budget this year and 3 percent next year and the across-the-board cut was reduced in the Housing and Defense Ministries.
How did things deteriorate so badly? “We do not resemble Spain or Greece,” says Avi Ben-Bassat, professor of economics at the Hebrew University and a Senior Fellow at the Israel Democracy Institute. “But there have been developments that require taking preventative action right now,” he tells The Jerusalem Report.
Among the causes that Ben-Bassat lists are successful demands for salary increases by large groups of workers whose wages ultimately come from the state budget.
These include physicians, social workers and nurses. The demands of last summer’s massive social justice protests, adopted by the government by way of the Trajtenberg Committee report, such as extending free education to all children from age three, came with a price tag. An influx of illegal immigrants coupled with a growing terrorist threat from the Sinai Peninsula prompted the government to start constructing a fence along Israel’s entire border with Egypt, at huge expense.
It is not difficult to find ample justification for each of those new budget items and many more. But they have to be paid for, either through an increased tax burden or a growing budget deficit. At the same time, the economy has not sustained the growth rates that characterized it through most of the last decade.
“The world economic crisis has definitely slowed economic growth here,” points out Ben-Bassat. “The pace of growth has been steadily declining for the last year and a half, through six consecutive quarters. That reduces tax revenues, further widening the deficit. The deficit has to be contained before it gets into the danger zone.”
Ben-Bassat agrees that imposing austerity measures, either through increased taxes or spending cuts, risks choking economic growth even more. However, he says, there is always a dilemma between growth and stability, and right now stability needs to be shored up.
All this, he continues, is all the more critical given global developments. The large number of countries experiencing difficulties obtaining credit in world markets is causing credit to tighten in general. Lenders are wary of taking on more risks. “They will take a harsh view of a growing Israeli budget deficit,” warns Ben-Bassat. “Every additional borrower increases risk in the entire system.”
In the international credit market, Israel consistently bears the handicap of its unique security risks, which lenders always take into account. Given that the Israel Defense Forces has conducted two major military operations over the past decade, each with its own unplanned expenditure, and that the instability in the region sparked by the Arab Spring and Iran’s nuclear ambitions is far from dying down, these are not idle concerns.
Prime Minister Binyamin Netanyahu defended the government’s tax increases by invoking the “no free lunch” principle, implying that his political rivals support irresponsible spending, while portraying himself as the guardian of financial prudence.
But Prof. Yossi Yonah, a lecturer in education at Ben-Gurion University of the Negev, and social activist tells The Jerusalem Report that in his opinion the major reason the Israeli economy is in its current state is due to the conservative policies that Netanyahu has been spearheading since he was Finance Minister in 2003.
“Netanyahu steadily reduced taxes out of ideology, believing that lower taxes would give a boost to the private sector. Now he is being forced to raise them,” says Yonah.
“He deliberately wanted to starve the government of revenue in order to reduce the role of the government. He was the one who crafted the policy that government spending must always be less than GD P growth, to make the private sector grow at the expense of the public sector.”
Yonah regards those policies as the cause of increased income inequality, which paved the way for the current need for drastic measures. “It was an irrational policy,” maintains Yonah. “The Israeli public sector is actually smaller than in most developed countries. Israel’s public sector is 42 percent of GDP, compared with an OECD average of 50 percent. That is an 8 percent gap representing 10 billion shekels, which is most of the deficit. Meanwhile public services are collapsing and citizens, including those in the middle class, have to pay out of their pockets to make up the difference, while the government deals with the holes in its budget by putting out fires instead of dealing with fundamental issues.”
Not surprisingly, Yonah is critical of the way the Netanyahu government has handled the recent tax increases.
Ben-Bassat concurs noting that although in his opinion there is no alternative to increasing taxes, he also does not agree with the specifics of the government’s new policies. In particular, he is concerned that the increases in marginal tax rates fall too heavily on the middle class, and he opposes an increase in the Value Added Tax on the grounds that it regressively hurts lowerincome groups, who of necessity spend a greater proportion of their incomes on immediate consumption.
The alternative he proposes is undertaking major reform of tax exemptions. “Tax exemptions now total 33 billion shekels a year,” points out Ben-Bassat. “Some are justified, but many are not.”
Yonah fully agrees with this analysis, seconding Ben-Bassat’s call for sharp reductions in tax exemptions while also advocating increased corporate taxes instead of new tax burdens on lower- and middleincome groups.
Ben-Bassat places continuing education funds (kranot hishtalmut) at the top of his list of unjustified tax exemptions. These employer-provided funds were originally granted tax exempt status because they were supposed to be reserved for the advanced education and training of employees, but they have long ceased to be used for that purpose.
They have instead become medium-term savings accounts that employees can withdraw as income supplements, while enjoying tax benefits. The problem with that, explains Ben-Bassat, is that in practice only 37 percent of employees have access to that benefit, an unfair discrimination.
He calculates that eliminating this tax exemption would provide an additional 2.5 billion shekels in tax revenue, equivalent to the amount of revenue gain from the latest marginal tax hikes, but the Histadrut labor union has warned that it would strongly oppose any move in that direction.
Additional tax breaks that could be targeted include tax exemptions granted to export industry corporations, which were originally intended to boost exports when the Israeli economy was much smaller and less developed, but today are essentially equivalent to public-provided subsidies enjoyed by companies making large profits in overseas markets. In Ben-Bassat’s opinion, the VAT exemption in the city of Eilat is similarly an anachronism, as is the exemption from VAT enjoyed by the fruit and vegetable industry.
Ben-Bassat ascribes the continued existence of discriminatory tax exemptions to strong special interest groups, which maintain their exemptions by effectively pressuring consecutive governments. “Every economist agrees that governments giving in to special-interest pressure groups is a source of economic inefficiency,” says Ben-Bassat. “The stronger the pressure group, the more it obtains for its special interests.
It is easier for a government to give in than to fight them, but elected officials are supposed to be tougher than that.
“My advice is to choose the right path, not the easier one.”