Bank of Israel slams defense budget increase

Karnit Flug  photo: Eyal Izhar

The Bank of Israel accuses the government of using sleight of hand to evade spending restrictions it enacted itself.

The Bank of Israel has criticized the initiative by Prime Minister Benjamin Netanyahu to increase the defense budget in the coming years by making it at least 6% of GDP. In a biannual fiscal review, the Bank of Israel states, "The proposal to increase the defense budget commensurate with the GDP growth rate over the next decade is inconsistent with the declining deficit path established in law; government resolutions about the expansion of social services; social programs and infrastructure investments; and the government’s aversion to raising tax rates. If such an outline for defense spending is adopted, it should specify stable and transparent sources of funding for the plan and should depict the adjustments that the other aggregates will have to undergo."

In order to illustrate its position, the Bank of Israel examined the government's ability to meet its future commitments to increase the defense budget and the social budget on the one hand and its promises to maintain budget responsibility to refrain from raising taxes and the debt ratio on the other. The conclusion reached states, "…given its existing decisions on multiyear spending programs, its aversion to raising tax rates, and its interest in increasing the defense budget at a rate similar to that of GDP growth, the government will be rather strongly challenged to stay within the deficit-decline trajectory enshrined in law and to stabilize, or to continue to reduce, the debt to GDP ratio." Furthermore, the high current deficit at the current time, which features a comfortable macroeconomic environment that contributes to high tax revenues, is liable to require budget restraint in a slowdown, when increasing spending and cutting tax rates are important for encouraging economic activity.

The fiscal review analyzes the budgets in 2018 and 2019 and examines the correlation between the government's plans for 2020-2022. The review discusses the government's expanded use of budgetary bypasses and non-budget activities in view of the gap between the cost of the programs it is adopting and the fiscal targets.

The Bank of Israel states that on the basis of the good budget performance, the S&P rating agency raised Israel's credit rating in early August from A+ to AA-, Israel's highest rating to date. In S&P's announcement of the upgrade, it credits Israel with the commitment demonstrated by its various governments to revise the budget framework in periods in which the budget deficit grew rapidly and the ratio of debt to GDP rose.

The Bank of Israel, however, takes issue with the alleged achievement of a low deficit in 2017, stating that were it not for one-time revenue, the deficit would have exactly met the 2.9% of GDP target set in the budget: "The low deficit in 2017 was achieved by unexpectedly strong tax revenues, tracing mainly to one-off receipts from dividends distributed by firms that exploited a temporary tax benefit and from taxation of proceeds from the sale of autonomous vehicle technology company Mobileye. These windfalls offset a major increase in spending - by more than 1% in the share of public expenditure in GDP. As a result, the structural deficit widened appreciably and the deficit net of the unexpected one-off revenues came to 2.9% percent of GDP."

What the Bank of Israel really found disturbing, however, was the methods developed to bypass its own fiscal responsibility rules - the first rules set by Netanyahu himself when he was Minister of Finance in the Sharon government in 2003-2004. The rule for spending restricted the permitted year-on-year increase., Another rule requires the government to set a lower deficit target each year. "The expenditure ceiling and the deficit path have been raised repeatedly in recent years, impairing their effectiveness as anchors for multiyear government planning," the Bank of Israel writes. The rapid increase in spending is requires the government to find additional budget resources, but "Since the government also lowered tax rates at times of rising revenues, it had to raise the deficit target-and this year, most likely, also the actual deficit-precisely at a time of vigorous economic growth. This conduct clashes with the essence of the expenditure rule, under which spending increases should be restrained during economic upturns in order to obviate the need for cutbacks at times of recession, when public expenditure helps to stimulate economic activity."

The second major rule cited approvingly by the Bank of Israel, which was enacted into law at Netanyahu's initiative, is the “numerator” (the multiyear monitoring mechanism of the budget aggregates). It turns out, however, that the government has found ways of sidestepping the restriction it set for itself. The first way is spending not included in the budget: "Recent years have seen growing use of sales of state-owned land by the Israel Land Authority… In this manner, these expenditures are excluded from the expenditure and deficit ceilings," the Bank of Israel writes. "…the sale of state-owned land is reported as revenue instead of the realization of an asset, as had been the practice until recent years and as is customary under generally accepted accounting principles. Given the magnitude of the sums already at stake - several billions of shekels per year - and the steadily widening purview of the activities, this comportment may have a material effect on the presentation of budget expenditure and the deficit.

The second method utilized by the government to bypass the budgetary responsibility restrictions is the use of temporary provision, which are not counted as legislation and are therefore not subject to the numerator rule. "Such provisions are meant to deal with transitory developments that do not justify legislation or that require urgent attention until regular legislation can be completed. The government, however, used temporary provisions to activate several important programs in the 2018 and 2019 budgets, entailing expenditure of billions of shekels per year and which are not meant to address some temporary crisis or one-off necessity. Although most of these programs will probably be extended or made permanent in the next budget, their presentation in the form of temporary provisions at this stage excuses the government from having to find sources to pay for them in post-2019 budgets, as the multiyear budgeting rules require. In the meantime, the government can take on other budget liabilities for those years - the very mechanism that the numerator is supposed to prevent." The third method employed by the government to bend the rules it set for itself is through future across-the-board budget cuts: "Alongside the 2019 budget, the government approved a 2.5 percent across-the-board reduction in the 2020 budget and an additional 7.0 percent cutback in the 2021 budget. Cumulatively, these measures commit the government to an NIS 7 billion spending cut in 2021 relative to the 2019 budget.

"Although these reductions bring the numerator into balance at the present writing, they merely express an undertaking to cancel unspecified existing programs. Unless it specifies which programs it intends to eliminate, the government cannot prepare for the spending cuts and the discussion is postponed to the time when future budgets will be approved-the very outcome that the numerator is supposed to prevent. In addition, the across-the-board cutbacks apply only to some forms of expenditure and tend to take a greater toll on infrastructure investment than on other kinds of spending. While such a bias is reasonable in terms of applicability when cutbacks are needed at once, it is harder to justify in the case of budget adjustments that will be made three or four years ahead, by which time there will be ample opportunity for preparatory and planning work." The fourth and final method (as of now) used by the government to bypass the rules is issuing bonds on the basis of future government payments. Government companies issue bonds, while the state undertakes directly or indirectly to pay in full for repayment of the principal and interest (for example, Israel Railways issued bonds in March 2015 and the Amidar government housing company issued bonds in March 2018). "When this happens, the flow of government liabilities reflects the deficit not in real time but rather over a period of several years, with the burden of payback shown in the budgets for years beyond the term of the numerator," the Bank of Israel writes.

Published by Globes [online], Israel business news - www.globes-online.com - on August 22, 2018

© Copyright of Globes Publisher Itonut (1983) Ltd. 2018

Karnit Flug  photo: Eyal Izhar
Karnit Flug photo: Eyal Izhar
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