Before the Next Shock Hits

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In this article, originally published in Haaretz on April 1, 2010, IDI Senior Researcher Prof. Avraham Ben-Bassat warns that Israel's policy of reducing taxes should be frozen since it may precipitate an economic crisis, and advocates giving preference to increasing public spending while preserving the economy's stability.

The main accomplishment of Israel's economy last year was its success in weathering the global financial crisis, and the fact that it sustained relatively little damage. In 2009, the rate of economic growth was lower than that of population growth in the country and, as a result, the standard of living dropped by 0.5 percent and the unemployment rate rose. Nevertheless, when comparisons are made globally, it is clear that the Israeli economy suffered substantially less damage than, for example, the European Union and the United States, both of which registered a negative economic growth rate of 4 percent and a sharp rise in unemployment.

The roots of the global financial crisis were events that took place in the United States, and thus their impact on other countries' economies, including that of Israel, was smaller. However, Israel's ability to emerge from the crisis as well as it did should be attributed first and foremost to the long-term policies of all its governments since 1985. These policies reinforced the fundamentals of the country's economy and reduced its vulnerability to external shocks. The main turning point was the restoration of fiscal discipline: The government decreased the budget deficit dramatically, and consequently the public debt fell from 160 percent of the gross domestic product, in 1985, to about half that today. In addition, structural reforms were introduced, reducing government intervention in the activities of the business sector, thereby enhancing the latter's performance.

As a result, Israel's biggest economic headache since 1948 was removed: The economy gradually shifted from a current account deficit, whereby imports chronically outweighed exports and the country was saddled with massive foreign debt, to a surplus, and the accompanying wealth of foreign currency. As research has demonstrated, the lower a country's debts, the smaller the impact of external shocks on its economy.

In addition, during the early stages of the world financial crisis, the government headed by prime minister Ehud Olmert adopted responsible management. It avoided the temptation of expanding the budget deficit by increasing expenses substantially and by spreading out an expensive financial "safety net" that would have primarily benefited higher income households. At the same time, the government wisely enabled the deficit to grow automatically due to the diminished revenue from taxes, which resulted from the recession; the motive for that policy was the desire to prevent the recession from becoming even more severe.

Benjamin Netanyahu and Finance Minister Yuval Steinitz's team has adopted a similar approach - thus, the budget deficit has grown to 5 percent of GDP, which is still considerably lower than the deficits of other industrialized nations, which averaged 8 percent of GDP.

The principle change in the new government's approach has been its tax policy. Although it was clear that revenue from taxes would drop because of the recession and the consequent economic slowdown, Netanyahu insisted on pursuing his plan for reducing income and corporate taxes. When he realized that the state of the economy would not permit such a strategy, he increased the value added tax and National Insurance premiums, instead of aborting his original plan. The result: a tax policy that is riddled with internal contradictions, which hurts those in the lower income brackets while benefiting those in the higher ones.

The policy of tax reductions can be expected to continue for the next few years. At the same time, however, public expenditures will rise at a faster rate than they did over the last decade. Undoubtedly, an acceleration in those expenditures is desirable, but only if the rate does not exceed GDP growth. In recent years, public spending as a percentage of GDP has decreased. But, while that percentage is similar to the OECD countries' average, it should be recalled that Israel's defense spending is proportionately much higher than theirs and that, in reality, civilian public expenditure in areas such as education and health is lower than that of the OECD average.

A long-range policy of lowering income tax rates runs contrary to the need for improving public services. Adopting a tax-cut policy along with accelerating the growth rate of public expenditures could end up increasing the budget deficit and the public debt, and undermining the economy's stability. Moreover, it should be noted that Israel's tax burden is lower than the OECD members' average, and any reduction would primarily benefit the higher income earners.

In light of the above, we should give preference to increasing public spending while preserving the economy's stability. For that reason, the plan to reduce taxes should be frozen. 

Prof. Avraham Ben-Bassat is a Senior Researcher at IDI and heads its project on Structural Reforms in the Israeli Economy. The former Director General of the Finance Ministry, he teaches economics at the Hebrew University of Jerusalem.