The Ministry of Finance is busy preparing the state budget for 2025, but the work is becoming more complex every day. While senior ministry officials are trying to promote a balanced fiscal plan to deal with higher defense spending, the politicians, led by Prime Minister Benjamin Netanyahu and his economic advisor Prof. Avi Simhon, are pushing for tax breaks and are in no rush to move ahead with the new budget.
One of the main disputes is over the VAT hike from 17% to 18%, due to come into effect in January 2025. This measure, which was already approved by the Knesset as part of the 2024 state budget last March, is seen by the Ministry of Finance as one of the main anchors in the fiscal plan for the coming years. However, Simhon is pressing for cancelation of the hike, and proposes instead to use the expected revenues from a plan to release trapped corporate profits that he is promoting.
The situation is causing major concern in economic circles, especially due to Israel's recent rating downgrades. Last February, Moody's cut Israel's credit rating for the first time in history, and in April S&P followed suit. Both rating agencies commended the VAT hike as a positive step that would strengthen Israel's fiscal stability. In fact, the VAT increase was the main measure that the Ministry of Finance and the Bank of Israel marketed to the rating agencies in their efforts to prevent the cut.
Moody’s said in its announcement earlier this year, "The government's willingness to raise taxes is a positive sign regarding the strength of the state's institutions, as previous governments have avoided raising taxes in the past." Moody’s added, "As long as they are approved in full, these measures can roughly offset the increase in defense spending and higher interest rates."
In its most recent update on Israel two months ago, Moody’s said about the VAT hike that it "considers it an important step in responding to the deterioration in the fiscal data, which will help limit their weakening from 2025 onwards." S&P echoed this sentiment saying, "The State of Israel has taken several measures to contain the fiscal impact for the longer term by hiking the VAT rate from 2025."
Moody’s warning
Attempts to cancel the VAT hike raise serious concerns that Israel may cross the red line set by the rating agencies. Both agencies have already given Israel’s rating a negative outlook as well as downgrading it, which hints at further future downgrades.
The situation gets even more complicated due to concerns about further delays in preparing the budget. The budget is usually approved by August. Due to delays in recent weeks by the prime minister's advisors, which have prevented the setting of frameworks for the budget and progress in its preparation with the various ministries, it is doubtful whether they will be able to meet the August deadline.
Ministry of Finance officials believe the prime minister and his advisors may even be aiming not to pass a budget and get by as they did during the Covid pandemic with a budget linked to this year’s budget with "additional payments." All this could further exacerbate economic uncertainty.
While Prof. Simhon claims, "The economic situation is good and there is no need to raise taxes", senior officials in the Ministry of Finance warn that without significant measures, the fiscal deficit could exceed previous forecasts. They are proposing a package of cuts and tax hikes amounting to at least NIS 30 billion, with the aim of a deficit of about 4% next year.
So is Israel’s credit rating in danger of being cut further? In fact there is no need to predict because last May, Moody's listed, "Factors that could lead to a downgrade." These included, "Indications that Israel's institutional capacity is reduced even more than the agency currently estimates due to the need to focus on the country's security will also be negative. Moreover, an increase in the likelihood of a substantially larger negative impact on the economic and fiscal strength of the country in the medium term, than the agency’s current forecasts, will exert downward pressure on the rating."
Put simply Moody’s is saying Israel's institutional capacity is, among other things, the state's ability to make difficult decisions and stand behind them. The VAT hike, as noted by analysts at the rating agencies, is the most prominent of them.
If the government does a U-turn on the issue, Moody's may see it as "indications that Israel's institutional capacity is even more limited than the company estimates." All the more so if the government refrains from passing an orderly state budget, in efforts to avoid cuts and painful measures for political reasons. In such a case, the other scenario that Moody's warns of will also materialize: "An increase in the likelihood of a substantially larger negative impact on the economic and fiscal stability of the country in the medium term."
November or before
According to the formal timetable, the next round of Israel's rating announcements from Moody's and S&P will be in November. However, in recent times there have been ‘spontaneous’ early publications by the rating agencies due to the upheavals in Israel - the war and before that the judicial reform. The rating agencies closely follow what is happening in Israel and they could advance announcements if they see that Israel is crossing the red line that they have drawn.
The credit rating reflects the risk that a country (or business company) will not repay debt. One of the most important indicators for analysts when calculating a country's risk is the debt-to-GDP ratio. In Israel, this ratio is relatively low compared to Western countries. However, it has been on a dangerous upward trend since last year. According to the S&P forecast, which calculates the figure slightly differently from the Ministry of Finance, Israel's debt is expected to jump from 60.5% of GDP in 2022 to 69.3% of GDP in 2025, and remain unchanged in 2026.
Israel's S&P rating is A+, down AA-. Moody's rates Israel one grade lower at A2, equivalent to A on the S&P scale. The third rating agency, Fitch, gives Israel a A+ rating. All three agencies have a negative outlook for Israel.
Published by Globes, Israel business news - en.globes.co.il - on July 25, 2024.
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