Macroeconomic Policy 2001-2002

The 9th Caesarea Forum, June 2001

Policy Paper No. 30

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  • Cover Type: Softcover
  • Number Of Pages: 88 Pages
  • Center: Eli Hurvitz Conference on Economy and Society
  • Price: 60 NIS

This policy paper based on the discussions of a Caesarea Economic Forum research team focuses on desired macroeconomic policies for 2001-2002 and reflects the uncertainty concerning the developments in the market. Included in the economic goals for 2001-2002 are the deficit target, implementation of the tax-reform program, real per-capita public expenditure, and promotion of budget items that stimulate economic growth.

I. Fiscal Policy

A. The Budget and the Government Deficit

The team recommended that the government not exceed the real bounds of its original 2001 budget, including the internal revisions that the government decided on, which will most likely form the basis for the 2002 budget. The increase in wage expenditures should be considered like any other cost increase, and the government should find ways to cover it in the budget. The recommended fiscal policy for 2002 is based on an expected economic growth of four percent. The team was in favor of preserving the current deficit rate of 1.5%. Under these conditions, additional resources (coming from the increase in tax money) will be approximately 2.25-2.5-% per person. Changes in the defense budget and other areas influenced by political necessity must also be incorporated into this framework.

Regarding the defense budget, the team recommended maintaining the long-term achievement of the Israeli economy that began in 1985–reducing the proportion of the defense budget in the overall GNP. The team estimates that in the long run, this trend will serve both the security of the country and the economy.

A dispute about fiscal policy broke out among the speakers. Some called for fiscal restraint and adherence to the Deficit Reduction Law , in accordance with the recommendation of the preparation team, while others called on the government to increase the deficit in order to pull the country out of the recession. The first group stressed the importance of adhering to goals this year in particular, in light of the serious problems facing the economy as a result of the following three factors: a significant slowdown in the global economy; a drop in the Nasdaq, which has strong repercussions for the hi-tech sector; and the political-security situation. Although the deficit target is very important, even these speakers claimed that the current framework of expenditures should be preserved, and that temporary variations in the amount of taxes collected should not prompt the government to cut expenditures.

Other speakers believed that within the limitations of the economy it would be possible to achieve the three goals of employment, growth, and price stability. They called for a more flexible policy while adjusting the goals somewhat. In the team's position paper, the deficit target is based on an anticipated actual growth, and some of the speakers claimed that it should be based on a forecast of a potentially high growth rate of four percent (some claiming that after such a deep recession, the potential growth could reach six percent). These speakers contended that underestimating the rate of growth would lead to an underassessment of taxes and to an expenditure framework that would make it difficult to pull the economy out of the recession.

The current system, embodied in the Deficit Reduction Law, must be replaced by a system that sets a framework for spending based on a multi-year forecast and determines a ceiling for budget growth at a rate lower than the multi-year GDP growth rate. Such a system would preserve the long-range investment goal, at the same time maintaining the goal of reducing the weight of government expenditures in the GDP. The system also preserves the anti-cyclical flexibility of the budget: in strong years, the deficit will be small, but there will be no pressure to distribute excess income; in slower years, the need for budget cuts would be obviated.

Most speakers called for a change in priorities: to invest heavily in education, in the chief scientist's budget, and in the health system, at the same time reducing transfer payments in that system by replacing universal transfers with targeted transfers. One of the main problems with restraining budgetary growth is salary policy. The automatic creeping rise in public sector salaries must be arrested by doing away with the system of automatic advancement in rank.

B. Private Legislation

The team discussed this subject at length, and most speakers supported setting limits on private legislation. They agreed that in the current political situation, with a unity government, the government has the power to impose sanctions on private legislation.

C. Investment in Infrastructure

Most speakers joined the call of team members for expanded investment in infrastructure. Immediate expansion of these investments constitutes leverage for getting the economy out of the recession. According to estimates, an NIS 40 billion investment is needed for roads, water and sewage systems, and airports. An NIS 4 billion investment must be made each year in order to spread the outlay over a decade. Over the last few years we have been witness to the fact that because of populistic laws, reductions must be made in infrastructure investments funded by the budget . To overcome this problem, extra-budgetary investments by the private sector must be expanded, using the BOT and PFI methods. Recruitment of the private sector will lead to more efficient investments. The yearly budget for infrastructure investment can be expanded by an estimated NIS 1 billion, and additional resources can be attained through BOT and PFI. These methods must be applied in a balanced way in order to avoid imposing too heavy a burden on the budget in the future.

Further investments must also be made in a rail system, including a subway for Tel Aviv. A rapid rail system will reduce travel time from outlying areas to cities and will help solve the problem of unemployment in development regions. Conversion of the rail system to an independently managed government company, similar to Bezek or the Israel Electric Company, will enhance its efficiency (even if it necessitates a continued government subsidy).

D. Tax Reform

The issue of tax reform caused heated debate. All speakers agreed on the need for tax reform but had different opinions about the specific type of reform that can currently be achieved. Many saw tax reform as a tool for promoting growth, as in the past. Most speakers favored abandoning the principle of monolithic reform, preferring instead a staged plan. The initial focus should be on agreed-upon principles, such as capital gains taxes, and only later should more controversial issues be addressed. Others claimed that there are so many shortcomings to the proposed reform that the idea should be rejected in favor of decreasing the tax burden by lowering National Insurance rates and the health tax. These speakers said that reform as currently proposed makes no strides towards more progressive taxes. On the other hand, it is claimed that widening the tax base and including untaxed capital in the tax system would in and of itself contribute to greater equality and to a reduction in the customary indices of inequality. The goals of any reform plan must include the imposition of a 25% capital gains tax as early as the year 2002 and must advance the changes in income tax assessment within the framework of an NIS 2 billion reform.

II. Capital Market Reform

The speakers cited the need for comprehensive supply-side reform of the capital market that allows for the issue of privately held debenture bonds and a variety of complex financial tools that can be traded in a number of international markets. The Tel Aviv Stock Exchange does not currently have a liquid market. There are simple solutions for this, however, such as permitting market makers, which would contribute to the creation of a liquid, merchandisable [tradeable?] market. Efforts are now being made to generate ideas for solving the TASE's problem of low tradeability? trading?
Other issues to be addressed are changes in the Securities Law, limitations on bank supervision, removal of foreign currency control and other limitations related to the tax system. For example, preferred shares are not issued by the capital market in Israel because its tax law differs from that of other countries. Likewise, Israel does not have a short-term money market other than that of the banking system, mainly because of restrictions on issuing (makam-short term deposit). Decisions regarding privatization must also take into account the requirements of the capital market, as well as a greater role for the stock exchange in government ownership sales.

III. The Labor Force

A. Unemployment

The team suggested a reform of the support system, including comprehensive reform of support for low income families, in order to increase rates of participation in the labor force and reduce dependence on the government budget. Similar reforms have taken place in Western countries through increased support and incentives for entering the job market and stiffer eligibility requirements for unemployment compensation. At the core of these reforms are professional training and an effort to eliminate negative incentives that prevent people from entering the job market (and put them on the National Insurance rolls). Some countries even provide a direct subsidy to citizens who reenter the job market.

In Israel, a committee headed by Yossi Tamir was established to draft a proposal for creating centers to encourage citizens to enter the job market. This type of reform has yet to be implemented. The only measure that has been taken thus far is to stiffen eligibility requirements for unemployment compensation. There must be more efficient means used to identify and monitor fictitious cases of unemployment, thus reducing their number.

The issue of foreign workers demands immediate attention. The speakers supported the team's recommendation that foreign workers not be hired by government offices.

IV. Wages

The speakers expressed their support for the recommendations of the team regarding wages in the public sector and enforcement of the Minimum Wage Law.

V. Monetary Policy

Many of speakers called on the Governor of the Bank of Israel for a speedier reduction in the interest rate, bringing it within a short time to the European level. Many speakers recognized, however, that a reduction in interest rate alone would not lead the economy out of the recession. A high interest rate is known today to be secondary among the causes of recession. The primary causes are a global economic slowdown (most importantly in the U.S.) and the security situation. But an excessively high interest rate results in exaggerated leverage on many companies, commercial instability, the closing of factories, and increased unemployment. It may also indirectly threaten the stability of the banking system. The sectors harmed most by high interest rates are households and small businesses; the sector that has the most to gain is that of high wage earners who hold savings accounts. Gradual lowering of interest rates is highly important in setting the stage for a period of growth in the economy, since it reverses the conditions that lead to recession.

Some speakers believe that stability in prices and financial markets stems directly from the Bank of Israel's policy of promoting a gradual reduction in interest rates, rather than a quick reduction that could harm the country's economic stability.

VI. The Exchange Rate

A lively debate was prompted by a speech by the Governor of the Bank of Israel that called for cancellation of exchange rate bands. Three recommendations were made in the course of the debate: preserving the status quo, cancellation of fluctuation bands in favor of a totally mobile [fluid?] exchange rate , and joining one of the world's currency blocs.

A. Support for Fluctuation Bands

Fluctuation bands contribute to saving the economy in general and the foreign currency market in particular from the "Dutch disease" (revaluation caused by a flow of capital into the economy).

The bottom limit of the band is almost the only effective restriction today on the Bank's monetary policy , and it prevents excessively high interest rates from being set. In order to prevent the exchange rate from dropping to the bottom of the band, which would require the Bank of Israel to intervene in the foreign currency market (intervention that would come at a high price), the interest rate must be lowered. An imbalance in the foreign currency market reflects an imbalance in the capital market when the interest rate is too high, as evidenced in comparison with the U.S.

Cancellation of the band would result in a revaluation of the shekel; it would also harm exporters and aggravate the recession.

B. Cancellation of the Fluctuation Band

The main argument against adhering to the exchange rate band policy is the high cost of maintaining it. The Bank of Israel buys foreign currency when the exchange rate reaches the bottom limit of the band, an expensive transaction that neutralizes the stabilization policy of the Bank. It is doubtful whether the Bank can continue this policy over the long term.

C. Attaching the Shekel to a Currency Bloc

A third recommendation, the most radical, supports the total cancellation of a fluctuating exchange rate and proposes attaching the shekel to one of the big currency blocs (such as the dollar or the Euro.) Proponents of this recommendation claim that globalization has recently led to the creation of large currency blocs as part of a trend toward improving the efficiency of international trade by having small nations give up their own national currencies. Joining one of these large currency blocs would greatly contribute to the financial stability of the economy. While it is claimed that this action negatively affects independent policymaking when local and international business cycles conflict with each other, the current exchange rate policy does no better job of preventing foreign fluctuations from affecting the country's economy. There are limits to the degree of freedom countries have in setting anti-cyclical policies that counteract the cycles imported from abroad. When the central bank restricts itself to a single goal–lowering inflation – there is no such freedom at all.