The problem that won’t go away – Israel’s growing deficit

As we transition into a new year and new decade, there are many indications that Israel’s macroeconomic situation is relatively strong. Israel’s GDP growth rate is high, though GDP per capita growth lags behind other OECD countries because Israel’s population is also growing rapidly. Israel’s labor market is doing quite well with high employment and labor force participation rates – standing at 78% and 80%, respectively – and a historically low unemployment rate (3.3%).

There is also growing evidence that Israeli prices are slowly nearing those in other developed countries. While prices in Israel are still higher than expected of an economy with Israel’s per-capita income level, Israeli consumer prices have fallen by about 5% compared with the G7 nations since 2014.

Another positive development is the steady decline in income inequality in Israel (as measured by the Gini coefficient) over the past decade. Though inequality remains high relative to other developed countries, the extent of this decline has been quite exceptional in international comparison.

Remarkably, while in many other developed countries income growth was concentrated among households in the upper part of the income distribution, Israel has witnessed a steep rise in the income of households in the middle and lower portions of the income distribution. During the period 2012-2017, the net income of households in the middle and lowest quintiles rose at an average annual rate of 4%, versus just 2.6% for the highest quintile.

These improvements are the result of the rapid rise in labor income of the lower income quintiles due to both increased wages and employment rates. The latter stem from increased incentives for workers to join the labor market, on the one hand (due, in part, to an increase in the minimum wage), and to a high demand for labor, on the other.

Nonetheless, against these positive developments there is a problem that Israel cannot seem to shake off, and that is its growing budget deficit.

According to accepted economic theory, it makes sense for governments to take advantage of periods of growth, when there are higher revenues from taxes, to increase national savings. That is, the government can use these increased revenues to reduce the budget deficit or even produce a surplus. Just as individuals save during good times so that they have additional resources should they need them during periods of difficulty, reducing the deficit during a time of plenty frees up resources that will need to be used by the government during an economic downturn.

Despite the fact that Israel currently finds itself in one of the “times of plenty,” the deficit has not, as we might have expected, gone down. In fact, after declining for a number of years at the beginning of the past decade, in recent years Israel’s fiscal policy has consistently caused the country to surpass its legally-mandated deficit and spending limits.

The deficit target for both 2018 and 2019 was set at 2.9% of GDP. While the actual deficit in 2018 was right on target, the deficit reached 3.7% of GDP in 2019 according to reports by the Ministry of Finance and, under current policies, are expected to reach 4.5% by 2022.
The deficit also has an impact on the future level of civilian and social spending. To reduce the deficit, the government would need to increase revenues by raising taxes or decrease government spending. However, notwithstanding the rising deficit, in response to growing geopolitical threats, there are plans to increase defense spending to 6% of GDP.

As a result, there are concerns that civilian spending, which is already low by international standards, will have to be significantly reduced in the coming years. Thus, the country’s deficit is an extremely important issue, especially in light of the political stagnation of the past year, and should be placed high on the agenda of the next government.