13 The Inflationary Process in Israel, Fiscal Policy, and the Economic Stabilization Plan of July 1985
- Mario Bléjer, and Ke-young Chu
- Published Date:
- June 1989
Eliahu S. Kreis
The Israeli economy had been plagued by inflation for over 12 years (1973-85), and accelerating prices became a permanent feature. Inflation, as measured by changes in the consumer price index (at year-end), rose from less than 6 percent a year in the 1960s to about 13 percent a year from 1970 to 1972. After the October 1973 war, it accelerated to almost 30 percent in 1973 and fluctuated between 30 percent and 60 percent annually during 1974-78. Following the second oil price shock, prices rose by 111 percent in 1979 and stabilized thereafter, increasing by between 100 percent and 135 percent annually, from 1980 to the fourth quarter of 1983. The largest jump in prices occurred in the last quarter of 1983, when inflation reached over 480 percent (on an annual basis), and continued at this rate during 1984, when prices rose by 445 percent (Chart 1).
Chart 1.Israel: Consumer Prices, 1981-87
Halfhearted attempts to reduce the rate of inflation were unsuccessful, and over time, deep-rooted expectations developed that inflationary prices would persist. Although successive governments and finance ministers talked about the importance of reducing inflation, they were much more preoccupied with finding short-term political expedients and keeping unemployment rates at very low levels. As a result, the course of economic policy changed frequently during 1973-85, with the budget deficit (before grants) increasing steadily, hovering around 20 percent of gross national product (GNP) since the mid-1970s and reaching 26 percent and 29 percent of GNP in fiscal years 1981/82 and 1984/85, respectively. However, because the amount of foreign grants has also increased over time, the financing requirements have averaged about 15 percent of GNP since the early 1980s.
The National Unity Government, which took office in September 1984, introduced a series of disinflationary programs, which included an agreement with the employers’ and workers’ federations on a wage-price freeze and some cuts in budgetary expenditure. Although these programs achieved some initial success in reducing inflation, prices began rising again, averaging about 12 percent a month during the first half of 1985. Along with the rise in prices, the tax system almost collapsed, subsidy payments for basic goods and services increased, capital outflows intensified, and the balance of payments weakened considerably.
In response to the deteriorating situation, at the beginning of July 1985 the Government introduced a comprehensive economic stabilization program incorporating a wide range of fiscal, monetary, and incomes policies with the objective of dealing simultaneously with inflation and the balance of payments. Some action was also taken to liberalize foreign trade transactions. The results of the plan have been dramatic: the average monthly rate of inflation dropped from over 15 percent during the first half of 1985 to 2 percent in the last quarter of 1985, and to about 1.5 percent in 1986 and 1987 (Chart 1).
II. Characteristics and Causes of Inflation in Israel, 1973-85
The inflationary process in Israel over 1973-85 was influenced by many and complex factors, including the structure of the economy, institutional arrangements, defense considerations, high budgetary deficits, external forces, and the changes in policy measures. It would be impossible to measure or quantify the effect of each factor separately, but several explanations can be given for the overall developments. For instance, the persistence of high inflation during periods of contraction in demand and slowdowns in economic activity can be explained by the deep-seated inflationary expectations and inflation-proofing devices that developed in many areas of the economy in response to the protracted inflation. Some of these devices became institutionalized, such as the cost of living adjustment (COLA) arrangements; adjustments of tax brackets, pensions, and tax credit points; and the linkage of bonds, foreign currency clauses, and long-term savings. Furthermore, as inflation worsened, these devices improved through more frequent adjustments at higher rates. In periods of expanding demand, inflation rose in steps to new levels, as the surges in demand were automatically accommodated by a steady monetary expansion, which was quickly translated into price increases. These jumps in prices were further intensified by frequent increases in basic commodity and fuel prices and by exchange rate adjustments.
Another factor in the Israeli context is the heavy defense burden, equal to over one fourth of GNP since the October 1973 war. (During the mid-1970s, it amounted to over one third of GNP.) In addition, about one third of Israel’s debt-repayment burden is defense related. Also, domestic defense spending is greatly underestimated, because it is difficult to quantify the real costs of reserve duty and the losses to the economy owing to the short-term diversion of manpower and resources to the defense effort.
Several characteristics of inflation in Israel over 1973-85 can be identified. First was its tendency to hold relatively steady for several years and then to jump to successively higher plateaus over comparatively short periods. Second was the large government deficit that affected most macroeconomic areas, particularly the monetary sector. Despite the high inflation rate, the deficit was financed mostly by the sale of linked bonds and foreign currency to the public and only fractionally by money creation. However, the Government also extended unlinked loans, the real value of which was eroded by inflation. Therefore, it is likely that the inflationary tax in Israel was negative during most of this period. A third characteristic is the lack of a direct relationship between the size of the government deficit and the rate of inflation, although it is generally recognized that the large deficit has caused the persistence of high inflation rates, either directly or indirectly. A fourth characteristic of inflation was its responsiveness to cost-demand pressures as the linkage between wage and price movements grew closer. Comprehensive indexation of financial assets resulted in inflationary shocks generally being accommodated automatically by the monetary aggregates. Fifth, given the large proportion of imported goods and products subject to price controls in the consumer price index (CPI), changes in subsidization and exchange rate policies caused sharp price changes, especially when these policy changes tended to aggravate inflation rather than reduce it. Sixth was the authorities’ preoccupation with maintaining low unemployment and raising living standards, which made them reluctant to adopt appropriate anti-inflationary policies.
The inflationary process in Israel can be analyzed in terms of two sets of factors: those that exert upward pressure on the inflation rate and those that produce large changes in the inflation levels. The most important factor in the first set is the pressure on demand. The persistent large budget deficits create imbalances in the economy; in periods of flexible exchange rate policy, these imbalances protect the balance of payments but result in pressure on prices and are usually accommodated by the expansion of monetary aggregates. An additional source of excess pressure on the economy is the level of real wages, which is too high to permit full employment and a competitive external sector without also generating upward pressure on prices.
The factors responsible for the step increases in inflation are the indexation system, changes in economic policies, and internal and external shocks. Most economists now agree that the jumps characteristic of accelerating inflation in Israel are generated largely by price shocks stemming in part from external factors—including higher energy prices—but more importantly from domestic policy actions, especially changes in tax rates, the exchange rate, and the degree of subsidization of basic goods and services. Because almost all (95 percent of) financial assets are linked either to the CPI or to the exchange rate, any increase in prices, of whatever origin, is automatically accommodated by increases in liquidity and financial wealth; spending behavior is thus not constrained by real wealth effects as it would be in a non-indexed environment. The impact of wage indexation is much less important, since it is only a partial indexation and is carried out with a considerable lag. However, overall wage policy has played a crucial role in the inflationary process because of the large discretionary wage awards that have been granted—in some cases, to compensate for future inflation.
a. Fiscal Imbalances
The impact of inflation on the central government budget is not easy to measure, and this has occasioned much controversy in Israel in recent years. It is widely accepted that the large deficit has been primarily responsible for the persistence of high inflation, but not necessarily for the jumps from one level to higher levels. Although it is also widely accepted that only a sharp reduction in the budget deficit will produce the desired stabilization of prices, some economists disagree about whether the budget deficit’s impact on inflation is direct or indirect. Essentially, the deficit is reflected in a deterioration in the current account of the balance of payments and through the accumulation of government debt, both of which lead to large devaluations and inflationary pressures. Some argue that a reduction (or elimination) of the budget deficit alone would not stabilize prices because of the inflationary inertia component that causes a downward rigidity in prices. Rather, synchronized actions in the areas of wages, credit, exchange rates, and prices are necessary to dissolve downward price rigidity and successfully combat inflationary pressure. Regardless of the methods used, it is generally agreed that a drastic reduction in the budget deficit is a precondition for a successful stabilization program.
The Central Government Budget Deficit and Its Financing. The budget deficits in Israel were very high in fiscal years 1979/80-1984/85. Although the amount of foreign grants almost doubled, and the sources of financing changed over this period, total government debt increased by one third to over 200 percent of GNP between 1979 and 1985. As a result, interest payments alone consumed about 35 percent of total revenue in 1984/85, compared with less than 20 percent in 1980/81. The large size of the deficits, reflecting the financial needs of the government, was the most important factor contributing to the development of the capital market in the country; it was the dominant influence on this market and also largely determined monetary policies. Since almost the entire domestic debt of the government was linked to the cost of living index or to a foreign currency, and since both the monetary base and unlinked financial assets made up a small portion of total financial assets, monetary aggregates accommodated themselves to the increasing rates of inflation.
Although no direct correlation between the size of the government deficit and the changes in the rates of inflation can be established, it is clear that the excess demand generated in the economy between 1973 and 1985 was manifested by inflationary pressures and balance of payments crises. Although initially the budget deficit may have been reflected in the balance of payments, the external imbalances eventually resulted in large devaluations and price shocks as a necessary means of adjustment; these, in turn, generated additional inflationary pressures—through the indexation mechanism and accommodating financial policies.
Of course, the way Israel’s deficit was financed and the public’s desire to save determined the degree of direct inflationary pressures. To the extent that the deficit was financed by borrowing from the private sector, it would not generate excess demand, although it would increase the domestic debt and future interest payments. Borrowing abroad would create more domestic demand but also result in a larger government external debt. The rest of the deficit would be financed by the Bank of Israel, but only partly through money creation and mostly through the sale of foreign currency to the public. During 1973-85, the Bank of Israel initially extended credit in local currency to finance the Government’s domestic purchases of goods and services, but the public immediately purchased foreign exchange from the Bank, which led to lower international reserves and higher net external debt. During the years of high inflation rates, 1982/83-1984/85, a portion of the government deficit equal to slightly more than 2 percent of GNP was financed by money creation, while the equivalent of 6 percent of GDP was financed by purchases of foreign currency.
Impact of High Inflation on the Budgetary Process, Expenditure, and Expenditure Controls. The existence in Israel of very high and volatile rates of inflation for long periods has created major problems in the preparation, presentation, monitoring, and execution of the budget. During 1978/79-1982/83, attempts were made to restrict, or at least delay, the spending authority of individual ministries. One procedure limited, on a monthly or quarterly basis, the proportion of the total budgetary appropriation that could be used by the ministries. Another procedure left approximately 10 percent of the total budget as unallocated funds or reserves to be used, in part, to accommodate higher-than-planned price increases. Generally, these measures met with little success, partly because most budgets were based on price and exchange rate assumptions which invariably led to gross underestimation of actual rates of increase. Consequently, the practice of formulating a supplementary budget developed and, in the process, further weakened expenditure control procedures.
Over the fiscal years 1983/84-1985/86, the budget was prepared on the basis of prices in the first quarter of each fiscal year. However, even these constant prices were estimated a few months in advance. The expenditure figures were then adjusted quarterly according to various indices; these subsequent adjustments fully compensated for any underestimations in the previous quarter and allocated funds for the remainder of the fiscal year at a new, constant price level. These quarterly adjustments resulted not only in the validation of inflation but also made it difficult to determine the level of expenditure commitments. Indeed, entering into multiyear commitments in periods of high inflation created serious budget-management problems, since the accounting system had not been designed to handle this situation, and ad hoc steps had to be taken to monitor these commitments. Essentially, the only real control on expenditure was on cash operations through a monthly quota set by the Accountant General’s Office.
Even after monthly cash quotas were established for each ministry, the high and variable rate of inflation directly contributed to expenditure overruns and a larger budget deficit. The process of raising and reducing the level of subsidies, transfers, grants, and loans helped create both open and repressed inflation. The desire to avoid a higher rate of inflation prevented or delayed the needed rise in prices of subsidized goods and services, resulting in larger expenditure and higher deficits. The higher deficit compelled the Government to cut subsidies and increase prices of public services, which, in addition to the direct impact on prices, was also reflected in higher wages and further price increases through the indexation system.
Revenue Collection. The experience gained over the period 1980/81-1984/85 demonstrates that despite the measures taken to counterbalance the impact of inflation, the net effect was lower revenue (although various categories of taxes were affected differently). Only additional discretionary measures, including new taxes and rate increases, kept revenue from falling even lower. Almost all taxes were collected with lags, which ranged from a few days to one year. The real tax “losses” from such lags increased with higher rates of inflation. As a result, it became very profitable for taxpayers to delay payments as long as possible, even at the risk of having to pay high penalties. Also, the tax administration was likely to deteriorate in periods of high and variable rates of inflation, since, under these conditions, the accounting procedures used to prepare enterprises’ profit and loss statements make it hard to distinguish between real gains and nominal adjustments.
The Israeli authorities introduced measures and administrative procedures to reduce the losses as much as possible and to cope with the problems of high and variable rates of inflation and tax evasion. Measures to reduce the lag between the due date and the date payment is made included the pay-as-you-go system; deduction at the source of payment (for example, deduction of a fixed percentage of the interest on bank deposits as income tax); and monthly payment obligations. Corporations and individuals are assessed annual amounts based on previous years’ earnings and must pay monthly advances. However, in most cases, these advances are adjusted according to the monthly rate of inflation. In other cases, businesses must also pay a percentage of their estimated gross sales (with estimates based on previous experience) every month. Substantial increases in tax penalties have been successful in speeding up tax payments, particularly since both the penalties and the interest payments are adjusted to the cost of living index and the penalties are not tax deductible.
The acceleration of inflation during the mid-1970s posed a serious problem for taxpayers. As nominal wages rose, pushing up nominal taxable income, taxpayers moved into higher tax brackets and their take-home pay continued to erode. To nullify the inflationary effect, a 1975 tax reform commission recommended making upward adjustments in tax brackets twice a year of up to 70 percent of the rise in the consumer price index. From 1980 onward, tax brackets were adjusted upward four times a year—by 100 percent of the rise in the CPI each time.
The increase in inflation rates also drastically eroded business profits. As mentioned earlier, profit and loss statements of enterprises did not reflect real developments, and attempts to exclude the inflationary component of profits were unsuccessful because of the complexity of the issues involved. Most companies kept their accounts on a historic-cost basis—at nominal values. Tax was usually charged on the difference between recorded income and expenses. This difference included, in addition to actual profits, “inflation profits,” which were mostly related to the timing of purchases and sales. To compensate for the taxes on these inflationary profits, producers increased prices faster than was necessary. Also, firms withdrew their own equity capital and replaced it with borrowed funds, which enabled them to treat the cost of credit as a tax-deductible expense. Meanwhile, they invested their own capital in government bonds, which were tax exempt.
Some tax-relief measures for business were introduced in 1980, according companies tax exemptions on nominal growth in the value of inventories up to a specified percentage of the CPI increase. Although this tax relief reduced the tax burden, it actually discriminated against firms with small or no inventories, which remained exposed to the inflationary tax. Eventually, to neutralize the adverse effects of inflation on firms’ income tax, a special tax reform committee recommended, and the Knesset (Israel’s legislature) approved, the Taxation Under Inflationary Conditions Law in early 1982. The adoption of this law resulted in a precipitous fall in income tax revenue from corporations and other businesses. It was estimated that these tax losses (beyond what was necessary to compensate for inflation) amounted to almost $400 million in fiscal year 1984/85, or about 2 percent of GNP. A special commission was set up in 1984 to revise this law and reduce the revenue losses to the Treasury.
Recent tax studies by the Bank of Israel indicate that the Tanzi effect on changes in tax collection amounted to 5 percent of GNP during 1983/84-1985/86. The average lag in tax collection in 1983 and 1984 was more than three weeks. With monthly inflation rates averaging 15 percent, the resulting revenue losses were about 10 percent on an annual basis. Almost the entire increase in tax collections for 1985/86 (equivalent to 6 percent of GNP) is explained by the rapid deceleration of inflation and the amendments made to the Taxation Under Inflationary Conditions Law which canceled some of the tax breaks previously extended to firms.
During the 1950s and 1960s, indexation—which had been a feature of the economy before the State of Israel was established in 1948—was expanded to cover wages, contracts, financial assets, and prices. Initially, when the inflation rate was low, adjustments were made on an annual basis. But, during 1973-85, as inflation accelerated and indexation became widespread—covering mortgages, tax payments, tax brackets, social security benefits, credits, and the exchange rate—the periods of adjustment were also shortened; in 1984, adjustments were being made on a monthly basis. During most of the period from 1950 onward, the indexation arrangements were far from uniform, and there were large differences in the rates and standard of indexation, as well as in the frequency of adjustments.
It has been argued that indexation is essential if a democratic society is to function in periods of high inflation and maintain social stability. The Israeli indexation system was seen as a means of ensuring that no economic group would be impoverished. In fact, indexation enabled the public to avoid the hardships associated with inflation in other countries. However, others have argued that in the absence of indexation, no government would tolerate high inflation, and the existence of such arrangements permits the maintenance of policies that generate economic imbalances and inflation.
It should be remembered that wages and financial assets were originally indexed as a hedge against the erosion of their real values. In the absence of these adjustments in times of accelerating inflation, savings would not have been maintained and capital flight would have created conditions for even higher inflation rates. Nevertheless, it is recognized that the extensive indexation system hampered efforts to reduce inflation (even in periods of declining economic activity) and was the main cause for the transfer of price shocks to higher inflation levels.
The inflationary process in Israel appears to have operated with a ratchet effect during 1973-85. With each successive shock, inflation rose to a new level, and indexation then tended to perpetuate it at the newly established rate. This mechanism ensured that price increases were immediately passed into wages, the exchange rate, and back into prices, thus augmenting the effects of the initial shock. The indexation of financial assets meant that the growth of monetary aggregates was largely beyond the control of the monetary authorities and produced automatic liquidity expansion in line with increases in prices and adjustments of the exchange rate.
Wage Determination. The wage-determination process in Israel consisted of three components: wage indexation (cost of living adjustment (COLA)); centralized, negotiated wage adjustments; and negotiated wage adjustments at the sectoral, or enterprise, level. Wage indexation accounted for most of the wage adjustments, and changes in the frequency and degree of the adjustments, as well as an increase in the degree of indexation, reflected the acceleration of inflation since 1973. Whereas before 1973 cost of living adjustments were made annually, subsequently they were made semiannually and, from 1980 to 1983, quarterly. By 1983, the practice of granting monthly wage increases in advance of formal quarterly adjustments had become widespread, with the increase in compensation fluctuating between 70 and 90 percent, depending on the quarterly rate of inflation. (The higher the inflation, the greater was the increase in compensation.) In May 1984, the period between adjustments was reduced from three months to one month, and the increase in compensation to be paid was 80 percent when the accumulated rate of inflation reached 12 percent, and 90 percent when inflation exceeded 25 percent.
A temporary modification to this procedure was agreed to in the first package deal (November 1984), which stipulated that for three months, compensation for inflation would be limited to two thirds of the amount computed from the standard formula. In the second package deal (February 1985), the full standard formula was reinstated, but the effect on prices of the cutback in subsidies on goods and services under the 1985 stabilization plan was excluded from the cost of living index for February and March 1985. As part of the economic program announced in July 1985, the cost of living mechanism was suspended for three months, but special compensation awards were granted to offset the erosion in wages.
Cost of living allowances are supplemented by annual wage adjustments following negotiations undertaken by the Employers’ Federation and the Histadrut Trade Union Federation. Until 1982, it was generally understood that these adjustments should, at a minimum, provide protection against erosion of real wages. During the 1982 round of negotiations, however, the principle of real wage maintenance was qualified, and greater emphasis was attached to the industry or economy’s ability to pay. The third component of wage determination, sectoral wage negotiations, consists of specific wage agreements within sectors or enterprises and provides for some degree of differentiation in wage outcomes.
Because wage indexation does not fully compensate for the effects of inflation and is usually paid with some time lag, trends in real wages have been determined principally by discretionary wage awards. In fact, between 1977 and 1985, the COLA mechanism resulted in an erosion in real wages of as much as 14 percent annually; the real increase in wages during most of this period was generated solely by the large wage awards. Therefore, it can be contended that wage indexation has not been an important inflationary factor in recent years. It has even been argued that wage indexation in Israel may have contributed to, rather than hindered, real wage flexibility. On several occasions, the Histadrut agreed to forgo indexation temporarily. This happened most recently in July 1985, when the Histadrut, threatened by a Government emergency decree, agreed to a three-month suspension of the COLA mechanism. Such coordinated real wage reductions, it is argued, might have been harder to achieve in the absence of indexation.
Indexation of Financial Assets. Almost all financial assets in Israel are linked to the exchange rate or the consumer price index. Although indexation of liquid assets started in the mid-1950s, the proportion of indexed assets in the public’s portfolio began rising in 1973, in response to the prolonged and accelerating rate of inflation, climbing to 85 percent by the end of 1984.
Medium- and long-term financial assets are almost 100 percent indexed. Because of the substantial deficits incurred by the central government since 1973, its domestic and external debts have risen to very high levels. In fact, the Government’s dominance in the Israeli capital market reflects this. Indeed, a major share of financial assets held by the Israeli public is either directly or indirectly backed by the Government. Most of the funds of insurance institutions, pension plans, retirement savings plans, and other savings schemes are invested in government bonds. Foreign currency deposits and linked deposits have very high liquidity requirements (sometimes close to 100 percent) and, as such, enable the Bank of Israel to extend credit to the Government. At the end of 1985, 70 percent of the Government’s internal debt was indexed to the CPI, 6 percent to the U.S. dollar, 11 percent to a combination of the domestic price and U.S. dollar indices (according to the saver’s choice), and 13 percent to a basket of foreign currencies.
The Government’s liabilities to the private sector are totally indexed, but there is also a large stock of unlinked private sector debt to the Government in the form of outstanding mortgage loans to households and industrial and development loans to businesses. Until 1979, these loans were not indexed and were subject to nominal interest rates well below the inflation rate; since 1979 only new loans have been indexed. However, although this practice yielded large capital gains and increased inflationary pressures in the past, its effect is diminishing because the real values of old debts are eroding rapidly, along with their impact on demand and prices.
Although some economists in Israel have claimed that the indexation mechanism guaranteed the continuation of high saving ratios, despite the high inflation, it is generally accepted that financial indexation facilitates and fuels the inflationary process. The scope of exchange rate policy has been limited by the direct and indirect linkage of large shares of total deposits to a foreign currency which, as a result of a devaluation of this currency, led to a faster rise in monetary aggregates and higher inflation. The authorities were then obliged to choose between loss of external competitiveness and increased inflation. If the exchange rate were appreciated, the attempts to return to the equilibrium level would bring about creation of excess liquidity and an increase in prices. Because of this linkage, the rate of inflation in Israel was—and remains—very sensitive to any internal or external price shocks.
III. Fiscal Developments, 1979/80-1984/851
Central government activities play a predominant role in economic and financial developments in Israel. The influence of the Government on economic activity is much greater than is indicated by the level of expenditure, which in recent years has accounted for over two thirds of GNP. The Government controls and directs economic activity through laws, regulations, ordinances, selective taxation, tax incentives and exonerations, and direct grants. Most of the operations of financial institutions are subject to regulations regarding source of funds and credit allocation. The capital market and new bond issues are controlled by the Government, since it must approve all domestic issues, most of which are in direct competition with its own large domestic borrowing. Also, the Government subsidizes various economic activities through direct financial transfers and low-interest credit. Finally, the central government greatly influences policies and activities in public sector enterprises.
During 1979/80-1984/85, central government expenditure and revenue averaged 68 percent and 45 percent of GNP, respectively. As a result, budget deficits (before grants) were consistently high, averaging almost one fourth of GNP during the period. However, because a substantial part (over one third) of the budget deficit was covered by foreign grants, the overall deficit (after grants) was somewhat less, averaging about 15 percent of GNP during the period (Chart 2). Foreign net loans—mostly on concessional terms—were an important source of financing over this period, although they declined from about 6 percent of GNP (over one third of total financing) in the first three years to almost nil in 1984/85 because of the switch from loans to grants in U.S. foreign aid. Concurrently, domestic borrowing rose sharply, averaging about 12 percent of GNP. However, although until 1981/82 a sizable part of this amount was mobilized through domestic bond sales, net credit by the Bank of Israel to the central government subsequently increased sharply. Excluding government indebtedness to the Bank of Israel, the overall government debt increased from about 160 percent of GNP in 1979/80 to an estimated 215 percent of GNP in 1984/85,2 with internal debt accounting for about two thirds of the total. In the same period, interest payments rose from less than 5 percent of GNP to 15 percent of GNP.
Chart 2.Israel: Central Government Operations, 1979/80-1986/87
(As percentage of GNP)1
Source: Data provided by the Israeli Ministry of Finance.
1 GNP data adjusted to fiscal-year (April-March) basis.
Following the second oil price shock and rapidly accelerating prices in 1979, the Government, in fiscal year 1980/81, introduced a stabilization program which included sharp cuts in budget subsidies and other transfer payments, cuts in real wages, and an increase in taxes. But despite these efforts, the outturn continued to be expansionary; notwithstanding a reduction in total expenditure equivalent to 2 percentage points of GNP and the slowing of the rapid increase in public employment, revenue collection declined by a corresponding amount and the budget deficit (before grants) stayed, in 1980/81, somewhat above 20 percent of GNP, the same level as in the previous two years. The fiscal situation deteriorated sharply in 1981/82, when the budget deficit rose to over 26 percent of GNP, as total revenue fell further, by an amount equivalent to 3 percentage points of GNP and total expenditure increased by the same amount. The deterioration stemmed from an attempt by the Government to combat inflation through slower devaluation, a reduction in tax rates, and an increase in subsidies on basic products. Subsidies alone increased from the equivalent of $550 million in 1980/81 to $1.5 billion in 1981/82, or by 3.5 percentage points of GNP (Table 1).
(In percent of GNP)2
|Tax on incomes, profits, and capital gains||18.2||20.0||18.6||19.4||18.4||17.9||15.9||17.9||19.2||20.4|
|Capital and net tending||7.1||8.9||8.4||8.2||7.9||9.5||5.9||5.7||5.4||5.8|
|Of which: Interest||(2.6)||(8.1)||(2.9)||(2.8)||(5.0)||(5.3)||(7.1)||(6.9)||(5.8)||(5.8)|
|Foreign borrowing, net||9.0||8.0||4.9||5.0||5.1||4.5||0.1||−1.1||−1.6||−1.5|
|Domestic bonds, net||5.1||6.7||8.3||10.3||3.9||3.9||6.2||5.1||4.1||3.2|
|Bank of Israel, net||—||−3.2||−1.6||3.7||5.3||7.0||9.0||−2.7||0.5||−1.1|
The large budget deficit and the outbreak of hostilities in Lebanon prompted the Government to take strong fiscal measures, which resulted in a strong improvement of the fiscal performance in 1982/83, when the budget deficit declined by 7 percentage points, to 19 percent of GNP. The entire improvement came from revenue, and it was almost equally shared between tax and non-tax revenue. The increase in taxes was due chiefly to new tax measures introduced in midyear. Also, to counteract the expansionary influence of the larger domestic defense spending, expenditure for subsidies and transfer payments was reduced considerably. The fiscal position deteriorated again over the next two years, with the budget deficit rising sharply in 1984/85, reaching 29 percent of GNP because of a 7 percentage point fall in revenue, while expenditure declined only marginally. However, although the total expenditure ratio declined slightly, the composition shifted substantially as capital outlay fell by 3.5 percentage points of GNP and interest payments rose by a similar magnitude. Foreign grants almost doubled to 14 percent of GNP in 1984/85, compared with the annual average of the previous five years.
Notwithstanding this substantial increase in grants, the ratio of the deficit (after grants) to GNP still remained high at over 15 percent in 1984/85, similar to the ratios registered in 1982/83-1983/84. As the share of net foreign borrowing in total financing declined during the period beginning with 1980/81, domestic borrowing needs rose even more steeply than total financing, reaching over 15 percent of GNP in 1984/85.
While a sizable part of domestic financing was mobilized through the issuance of long-term bonds—principally the nonmarketables, which the National Insurance Institute (NII), pension funds, insurance companies, and commercial banks were required to purchase—net credit from the Bank of Israel to the central government rose dramatically. Starting in 1982/83, net bond issues, especially those sold to the general public, fell rapidly as a percentage of GNP, reflecting difficulties encountered in raising funds on the domestic capital market. The weakening in the public’s demand for domestic bonds also reflected its preference for financial assets denominated in foreign currencies and, until September 1984, some uncertainty about the real rate of return on government-backed savings schemes. Accordingly, greater reliance was placed on borrowing from the Bank of Israel to finance the budget deficit, and net use of the Bank of Israel’s resources rose dramatically, from almost 2 percent of GNP in 1980/81 to 9 percent of GNP in 1984/85. (See Table 1.) However, despite this sharp increase, money creation was almost constant, averaging less than 2.5 percent of GNP annually between 1979/80 and 1984/85. The entire increase was funded by sales of foreign exchange to the public and a drawdown of net international reserves.
IV. Disinflationary Programs in 1984 and 1985, and the Economic Stabilization Plan of July 1985
1. Acceleration of Inflation
After remaining more or less stable at 120-130 percent annually between the fourth quarter of 1979 and the third quarter of 1983, inflation accelerated sharply, to 16 percent a month (490 percent annually), during the last quarter of 1983. This acceleration was accompanied by a substantial decline in real income, a weakening of domestic demand, a slowdown in economic activity, and only a moderate improvement in the balance of payments. Moreover, because of the lack of confidence in government economic policies and increasing expectations of large devaluations, the public purchased large amounts of foreign currency (equivalent to over 7 percent of gross domestic product (GDP) in the last quarter of 1983) from the Bank of Israel, and there was a massive shift into exchange rate-linked deposits. Under these circumstances, the most important task faced by the authorities was to shore up the Government’s credibility and regain public confidence. Nevertheless, despite all measures taken from October 1983 to March 1984, the authorities were only able to check the acceleration of inflation and stabilize it at a monthly rate of 13 percent during the first quarter of 1984, or over 300 percent at an annual rate.
The decision to hold early elections in July 1984 and the corresponding changes in government policy again caused a loss of confidence, and public purchases of foreign exchange grew rapidly. The Government responded with a large devaluation and administrative restrictions on imports. Inflation shot up to over 500 percent at an annual rate during the second and third quarters of the year (Table 2). Similar measures were introduced again after the elections by the new National Unity Government in September, and inflation reached a record level of 24 percent in October (over 1,200 percent at an annual rate). Fears of hyperinflation prompted representatives of the Government, the labor unions, and employers’ organizations to sign an agreement calling for the stabilization of prices, wages, profits, and taxes, and reduction of inflationary expectations and inflation. This agreement, known as the first “package deal,” was followed by two other package deals and, finally, by the economic stabilization plan.
|Prices (quarterly on annual basis)||109||141||158||120||118||135||137||487||311||496||536||565||222||361||247||29||7.5||29.6||12.6||30.0||19.3||16.5|
|GDP (seasonally adjusted data, at 1980 prices)||0.8||−2.2||0.7||4.4||0.6||−1.4||−0.1||0.8||−0.6||−0.8||6.0||−1.0||2.5||1.3||−2.1||−5.7||5.7||1.1||−2.2||1.21||0.61||…|
|(compared with previous quarter)||5.0||−3.0||—||1.0||15.0||−8.0||−5.6||−14.8||4.4||8.9||3.5||−8.5||4.2||−4.9||−14.6||−1.1||13.9||4.9||0.6||2.5||−3.5||6.0|
|Money and credit|
|(compared with end of previous quarter)|
|Balance of payments (billion U.S. dollars)|
|Balance on goods and services||−1.2||−1.3||−1.4||−0.9||−1.1||−1.3||−1.6||−1.0||−1.1||−1.1||−1.5||−1.1||−1.1||−1.1||−0.9||−0.9||−0.9||−1.0||−1.2||0.9||−1.4||…|
2. Package Deal I
Given previous experience, considerable skepticism was expressed about the potential success of a package deal that was not backed up by other necessary policy adjustments, such as cuts in government spending. However, the sense of urgency shared by all social sectors—including workers, industrialists, and political leaders—contributed to its initial success. The package deal was aimed at achieving a large and rapid drop in the inflation rate in order to calm markets while more fundamental measures were being put in place. Its principal provisions were a general price freeze and a three-month reduction in the COLA indexation to two thirds of the standard compensation for inflation. The Government agreed not to introduce new taxes or raise existing rates during the period of the freeze; and increases in rates or fees in the public sector that had already been approved were not to be implemented until the freeze ended. Prices of all imported goods and services were frozen at their levels of November 2, 1984, and payments of all import duties and taxes tied to foreign exchange were fixed at that rate. The Government also committed itself to lowering the budget deficit, partly through fiscal reforms related principally to the tax system, and to cut income tax payments by 5 percent over the three-month period commencing February 1985.
The formal agreement did not include any reference to prices of controlled goods and services, interest rates, or exchange rate adjustments, but it soon became clear after the deal went into effect that prices of subsidized goods would also be frozen, nominal interest rates lowered, and the nominal rate of depreciation of the shekel slowed; however, when the inflation rate began to abate, real interest rates rose significantly and the real effective exchange rate declined.
Because the price freeze did not become effective until November 5, 1984, and many prices were hiked in expectation, consumer prices rose strongly in early November (19.5 percent). However, from the beginning of November until the end of January 1985, prices rose at a relatively moderate 4.5 percent a month. This sharp cutback was important in calming speculation, but it was nevertheless widely recognized that the measures were temporary and that some of the program’s features were unsustainable. The fairly rapid depreciation of the shekel led to a widening gap between the prices of imported goods and the prices that had been frozen at the exchange rate level of November 1984. Also, the price freeze on subsidized items increased subsidy payments ($1.5 billion on an annual basis), imposing an unsustainable burden on the budget. These distortions and the Government’s failure to implement the other economic measures it had agreed to led the parties to negotiate a second package deal, which went into effect at the beginning of February 1985.
3. Package Deals II and III
The second package deal was considerably different in character and substance from the first. It was to apply for an eight-month period, with provision for a review in July if desired by any of the three signing parties. The deal provided for controlled increase in prices, rather than a freeze, and also permitted immediate increases in prices of nonsubsidized goods averaging 5 percent, with subsequent monthly increases of between 3 and 5 percent over the period of the agreement. Furthermore, the agreement provided for substantial, immediate increases in the prices of subsidized goods; some subsidies were eliminated entirely, notably on fuel products. Provision was also made for further price increases for certain subsidized products, particularly food items, in February and March. Although these increases were not to exceed 13 percent in real terms, they were, in fact, implemented in two steps of about 25 percent each. In the calculation of wages, workers were to forgo up to 6 percent of the increase in the cost of living index caused by the elimination or reduction of subsidies in the initial stage and an additional 1.5 percent for each of the price increases on subsidized goods in February and March.3 Workers were partly compensated for these concessions by a one-time cash payment of IS 6,575 (shekels) in February (equivalent to between 1 and 2 percent of monthly wages) and an additional IS 1,650 in both February and March. Commitments on exchange rate and interest rate policies were again omitted from the agreement, and it was understood that all tariffs, taxes, and other revenues collected by the Government would not be covered by the package deal.
The new attempt to stabilize inflationary expectations, while allowing some price flexibility, soon failed, and during February-May, inflation shot up to over 12 percent per month. Controlled price changes seemed harder for the public to grasp than a price freeze, and the former exerted a decidedly less favorable influence on inflationary expectations. The situation was further complicated by sharp increases in the prices of subsidized goods: in February, controlled prices—that is, prices fixed directly by the Government—were raised by 25 percent, compared with 13.5 percent for the general CPI.
The return to a high inflation rate in February made it clear that the second package deal was not working and led to pressure for a return to more rigid arrangements along the lines of the first package deal. Accordingly, in March, the three signatories adopted a third package deal which included a four-month price freeze beginning April 1, 1985, with a provision for a one-step increase at the end of May. The freeze did not apply to subsidized goods and services or to indirect taxes; and some of the general provisions of the second package deal continued to apply, particularly with respect to wage compensation arrangements. The price increases permitted in the period immediately preceding the April price freeze largely accounted for the further increase in consumer prices of 12.1 percent in March. The monthly inflation rates in February and March thus approached the average inflation rate seen during the first half of 1984.
Subsidies were reduced substantially in both the second and third package deals. The cost of the subsidization prevailing in November 1984 was about $1.1 billion on an annual basis; by February 1985, after the first package deal, the cost had risen to $1.5 billion, but it subsequently fell to $900 million in June. However, these planned price adjustments and other unplanned increases pushed consumer prices beyond all projections, to 19.4 percent in April 1985, followed by further increases of 6.8 percent in May and 14.9 percent in June. (See Chart 1.)
In assessing the results of the various package deals, one must recognize that although they did not succeed in arresting price increases, they did permit a sharp change in relative prices, an erosion of real wages, stabilization of the real exchange rate, and a significant reduction in the rate of subsidies and other expenditure—all of which are necessary conditions for the successful implementation of a stabilization program. Also, the trend toward reduction of the civilian deficit of the balance of payments that had started late in 1983 continued during the first half of 1985.
4. The Economic Stabilization Plan of July 1985
The economic stabilization plan was enacted against the background of the previous package deals, which had essentially failed to attain their objective of stopping inflation. The return to monthly inflation rates exceeding 15 percent, combined with expectations that economic policy was about to change drastically and a new devaluation was to be announced soon, resulted in renewed large purchases of foreign currency (about $700 million in the second quarter of 1985). This development not only nullified the improvement in the current account but also threatened the external liquidity position of the country. Also, the premium on the black market reached a very high level (about 30 percent).
In the fiscal area, even though the original central government budget for 1985/86 (April through March) called for a cut in the budget deficit (before grants) of 7.5 percentage points of GNP, the deficit remained high during the first half of 1985, although it was lower than it had been the previous year. Monetary policy remained accommodative, and total bank credit to the private sector expanded by over 300 percent annually (or 2 percent in real terms) during the first half of 1985. Domestic demand and GDP expanded, mainly due to the recovery of private consumption. The adverse developments in all economic and financial areas, and the loss of public confidence made it clear that drastic economic measures were urgently needed—and were actually being demanded by the general public. The decision of the manufacturers’ association to use its option to withdraw from the third package deal agreement prompted the Government to adopt, in early July 1985, a comprehensive emergency program for economic stabilization without first seeking the consent of the other parties.
a. Overall Purpose, Objectives, and Underlying Assumptions of the Stabilization Plan
The aim of the plan was to reduce inflation drastically and simultaneously, in order to improve the balance of payments position. As previously noted, past programs had concentrated on one of the two targets, usually to the detriment of the other. It was now assumed that the successful containment of both would lay the foundation for subsequent renewed growth and structural changes in the economy. The main objectives of the program were to reduce aggregate demand (and imports) through tight fiscal and monetary policies and to reduce inflation by establishing several synchronized nominal anchors in the areas of wages, prices, exchange rates, and credit. The plan had four main components: (1) the government budget deficit was to be cut substantially and the public work force trimmed; (2) monetary policy was to be restrained and the liquidity of linked financial assets reduced; (3) a sizable devaluation of the shekel was to be followed by a stable exchange rate against the U.S. dollar; and (4) prices were to be frozen and the COLA mechanism temporarily suspended, with immediate effect. The time span of the program was 12 months, the first 3 of which were declared an economic emergency period.
As mentioned above, because of the deep-rooted nature of inflationary expectations in Israel and the widespread institutionalization of indexation, the authorities felt that traditional measures alone were not sufficient to achieve rapid price stabilization. Restrictive monetary and fiscal policy measures were therefore supplemented by freezes of wage and price levels and of the exchange rate, in an effort to establish nominal anchors, of which the most important was the exchange rate.
Under equilibrium conditions, one monetary anchor would theoretically have sufficed to set all nominal levels. But since the Israeli economy was perceived to be in a state of disequilibrium, multiple anchors were needed. The quantity of money, the authorities felt, could not be relied on as an anchor, since it was bound to prove unstable during the disinflationary process. Bank credit could not serve as an alternative, because the Bank of Israel had only indirect control over its volume. As a result, and also because cost factors were presumed to have been an important cause of inflation in the past, the U.S. dollar exchange rate and the nominal wage were selected as the central nominal anchors. Stabilizing the U.S. dollar exchange rate was considered essential for stabilizing inflationary expectations, since this served as a widely quoted price index that was published daily, whereas the CPI was calculated only monthly and published with a two-week delay. To avoid a continued real appreciation, the exchange rate freeze against the U.S. dollar had to be conditional on a freeze of nominal wage costs (beyond an initial compensation), which justified the temporary suspension of the COLA mechanism. The price freeze, which completed the multiple anchor system, was not considered crucial to the program, but was needed to obtain the cooperation of the Histadrut, which traditionally demanded price control as a precondition for wage restraint.
b. Monetary Policy
The stabilization plan was based on restrictive fiscal policy and initial wage erosion, with the impact of the fiscal action expected to be felt only gradually. However, the success of the program rested on a sharp turnabout in inflationary expectations, and despite the price freeze, the authorities considered that only a highly restrictive monetary policy would immediately reduce domestic demand and support price stability. Therefore, the stance of monetary policy was very tight in the early phase of this plan, with some relaxation considered possible only after fiscal action had begun to take effect. It was also considered important to squeeze stocks—which were normally more responsive to credit tightening—quickly to ease the pressure on prices. Accordingly, the program called for outstanding bank credit to be cut by 10 percent in real terms in July and then kept at broadly the same level in nominal terms through October. Since almost one half of the outstanding credit was destined for exports—and there was no plan to cut this credit—the brunt of the cut fell on domestic free credit, with the corresponding implications for demand and production. Implementation of this policy was to be achieved through high real rates of interest; a lowering of nominal interest rates would be permitted only after a firm downward trend in the inflation rate had been observed and inflationary expectations reversed. This policy was reinforced by a lowering of the foreign currency lending ceiling (with ceilings applying to all foreign currency lending by the banks) aimed at discouraging capital inflows attracted by the large margin between domestic and foreign interest rates.
On the financial saving side, the policy was to encourage the use of the capital market for financing private investments and to preserve the stability of long-term saving instruments. Therefore, although the indexation of long-term financial assets was maintained, its scope was narrowed for foreign exchange-linked deposits (PATAM) by a prohibition on deposits with maturities of less than one year. Also, it was announced that the Government would gradually increase the share of tradable bonds and use more open market operations.
c. Exchange Rate and External Sector
On July 1, 1985, the shekel was devalued by 16 percent in terms of foreign currencies. (In terms of the shekel, the devaluation amounted to 19 percent; the average exchange rate of the shekel was 31 percent higher in July than in June.) The rate was fixed at IS 1,500 per U.S. dollar.4 In conjunction with the devaluation, the authorities eliminated the requirement of a non-interest-bearing deposit of 15 percent for one year on a range of imports. The export subsidy on direct credits was eliminated by a requirement that such credits would henceforth be denominated entirely in U.S. dollars; these export credits would be charged at an interest rate equivalent to 2 percentage points above the London interbank offered rate (LIBOR). Together with the cut in the import deposit requirements, the measure was viewed as a step toward unification of the effective exchange rate. Finally, the exchange rate insurance scheme was changed from a guarantee of export profitability applicable to Europe into a commitment to pay all exporters up to 11 percent of their value added in exports.5 This new scheme was aimed at eliminating distortions and reducing the substantial costs to the budget.
The fixing of the exchange rate at IS 1,500 per U.S. dollar was made conditional on the freezing of nominal wages and the profitability of exports. Indeed, one of the key factors in the economic plan was to maintain an acceptable level of profitability in exports. This policy implied that in the absence of changes in export subsidies, terms of trade, and relationships between foreign currencies, the trend in nominal wages would be the major factor determining the exchange rate.
d. Wages and Prices
As mentioned earlier, the stabilization plan included a three-month freeze on prices, nominal wages, and the exchange rate; this was subsequently extended for six months. Prior to the price freeze, a one-time adjustment was carried out at the beginning of July: prices of subsidized goods and services, and of other goods whose prices were traditionally fixed directly by the Government, were raised between 30 percent and 100 percent (50 percent on average); other prices were allowed to increase by up to 17 percent with special permission. These and other adjustments produced a jump of 27.5 percent in the price level in July and some spillover into August. It was announced that starting in January 1986, the Government would gradually dismantle the price controls, starting with goods and services that only marginally influenced the CPI.
Taking into consideration the impact of the above-mentioned measures on prices and the resulting erosion of real wages owing to the temporary suspension of the COLA mechanism, the Government approved a one-time payment, equal to 14 percent of each worker’s wages, to wage earners. Although the Government had obtained emergency authorization from the Knesset to enforce the COLA suspension, this proved unnecessary because the new private sector wage agreement, signed by the Histadrut and the manufacturers’ association in mid-July, provided for a three-month suspension of the COLA and the 14 percent wage adjustment. This agreement, which expired on March 31, 1986, provided for a one-time, lump-sum payment equivalent to 12 percent of July’s wage bill, to be paid in early September 1985. (This payment was not considered part of wages and therefore did not change the base used to determine future increases.) The agreement called for a cumulative wage supplement of 12 percent, to be paid in three installments: 4 percent in December 1985, 4 percent in January 1986, and 3.5 percent in February 1986. These wage increases were to be absorbed by the employers, who had also agreed not to increase prices. The agreement stipulated that the COLA mechanism would be reinstituted in November 1985, and that the degree of indexation would be increased; henceforth, an adjustment of 80 percent would be paid when the cumulative CPI increase reached 4 percent, or after an interval of three months, whichever came earlier. Previously, the COLA had been paid only when the cumulative CPI increase exceeded 12 percent, or after six months.
V. The 1985/86 and 1986/87 Budgets and Fiscal Content of the Stabilization Plan
1. The 1985/86 Budget
The 1985/86 budget was prepared in the context of continuing economic and financial difficulties and an alarming increase in the rate of inflation. Although the budget was prepared during the period of the package deals, it attempted to incorporate the objectives of the economic stabilization plan that would be announced later in the year. The two main objectives were (1) an improvement in the balance of payments; and (2) a deceleration in inflation. Both were to be achieved largely by means of a reduction in the domestic demand of the public sector and a cash injection. Prior to presenting the 1985/86 budget to the Knesset, the authorities indicated that their long-term objective was to bring about a permanent reduction in public sector domestic consumption, both civilian and defense, and in capital spending. Emphasis was placed on reducing purchases of domestic goods and services, reducing and rationalizing welfare programs and other public services, reducing the number of employees in the public sector through attrition and voluntary retirements, and curtailing grants and loans for investment projects; eligibility qualifications for granting such financial aid were also to be tightened. Expenditures on subsidies for goods and services were also to be cut sharply. A major source of concern to the authorities was the size of overall public sector debt, which had risen to extremely high levels (over 215 percent of GNP). Servicing costs of this debt (interest and principal) had been rising rapidly and were becoming the main factor behind the higher deficits.
Although the authorities were aware that stabilizing the ratio of public debt to GNP implied cutting the budget deficit by 12 percent of GNP (equivalent to about US$2.5 billion), political pressures and defense needs forced them to scale down their suggested expenditure cuts. Thus, the budget that was presented to the Knesset called for a cut in the deficit (before grants) of 7.5 percentage points of GNP, to about 21 percent of GNP, to be effected through a combination of increases in revenue and reductions in expenditure. Although the overall deficit (after grants) was still projected to exceed 9 percent of GNP, this was 5 percentage points lower than in 1984/85. (The special emergency assistance from the United States of $1.5 billion—provided over a two-year period—was not included in the budget projections.) Notwithstanding the major projected improvement in fiscal performance, net credit from the Bank of Israel was budgeted at about 8.5 percent of GNP (equivalent to about $1.9 billion) because of planned net amortization in foreign borrowing and a drop in nonbank net domestic borrowing.
Total revenue was estimated to increase by 3.5 percentage points of GNP. Tax revenue was forecast to increase by about 3 percentage points of GNP, and non-tax revenue by slightly less than 1 percentage point. This outcome was to be realized through changes in the tax laws, the temporary imposition of new taxes, increases in rates of existing taxes, and administrative actions to improve tax collection and reduce tax evasion. The new measures to increase revenue included (1) imposing a one-time tax on commercial property, such as buildings, inventories and equipment, and private cars (which was estimated to yield $250 million); (2) increasing the corporate income tax paid by canceling tax breaks previously enjoyed under the 1982 Taxation Under Inflationary Conditions Law (which was estimated to yield about $350 million); (3) making child allowances subject to income tax for families with as many as three children in the marginal tax bracket of 45 percent; (4) imposing higher rates of deposit on certain imports; (5) imposing new surcharges on those persons traveling abroad; and (6) increasing various tax rates. The full-year impact of taxes introduced the previous year was also expected to contribute to the rise in revenue. Two revenue-reducing measures were also included: a 10 percent income tax levy on taxpayers in high income tax brackets was canceled; and a 5 percent reduction in employees’ income tax obligations for six months was granted. These measures were estimated to result in a 5 percent reduction in revenue from individual income taxes.
Non-tax revenue was estimated to rise, reflecting sharp increases in fees, user charges, and similar types of revenue collected directly by the ministries. Receipts from interest income and the transfer of royalties and profits of public enterprises to the central government were forecast to decline.
Total expenditure and net lending were budgeted to decline by almost 7 percent in real terms. Expenditure was to decline by slightly over 4 percentage points of GNP, to 69.5 percent, more than half of which was to come from cuts in defense-related imports. The remaining cuts were concentrated on transfer outlays and purchases of goods and services. The reduction in domestic expenditure (compared with the estimated outturn in 1984/85) was based on the decisions, announced by the Government in December 1984 and January 1985, to cut the equivalent of $1.1 billion from the 1985/86 budget.
An important target of the expenditure reductions was subsidies, which were cut by an estimated $650 million. Subsidies for oil products and electricity were completely eliminated in February 1985, and those for eggs, milk, poultry, and oil were to be reduced to a level no higher than 25 percent of the official price; for bread, water, and public transportation, subsidies would be reduced to a level no higher than 50 percent. Other cuts included about $200 million in domestic defense expenditure, but in contrast to previous years, the defense budget did not include the expected costs associated with operations in Lebanon. Curtailment of appropriations for education and health services amounted to $200 million.
Interest payments on government debt were budgeted to increase by 1 percentage point of GNP in 1985/86, mainly as a result of higher foreign payments, but transfers of funds to local authorities were to be reduced substantially. Investment incentives for industrial development were also forecast to decline by about $50 million. The real wage bill for government employees was budgeted to decline slightly, partly as a result of the elimination of some 4,000 positions in the central government during the fiscal year. The budget also proposed the elimination of more than 5,000 posts in the rest of the public sector, which was supported by the Treasury (employees of local authorities and educational and defense systems).
2. Fiscal Measures Included in the Stabilization Plan, July 1975
During the first quarter of fiscal year 1985/86 (April-June), it became clear that the budget deficit, on an annual basis, was running about $500-600 million higher than had been programmed. As a result of the reluctance of the Knesset’s Finance Committee to approve laws changing some tax procedures and adjusting various fees and charges, and the Government’s delays in increasing the prices of subsidized products, almost $900 million at an annual rate (compared with the budgeted $500 million) was spent on subsidies for basic products alone. Budget overruns were also registered for loans and grants for investment, transfers to the NII, and expenditure on education and health.
As was noted earlier (p. 369), one of the adverse developments that the July 1985 stabilization plan was meant to address was the rising budget deficit. The plan called for a return to the original 1985/86 budget estimates which was to be effected through the implementation of the revenue measures included in the budget and deep cuts in subsidies for basic commodities and services. Further, to compensate for shortfalls in projected revenue and overruns in expenditure, and with the objective of reducing the budget deficit even further than originally intended, the Government implemented new temporary tax measures and expenditure cuts amounting to $750 million on an annual basis (about 3 percent of GNP), or $560 million for the period July 1985-March 1986 (almost equally divided between revenue and expenditure).
The new tax measures were intended to raise revenue by $200 million, with one half of the increase intended to be temporary. Full implementation of the amended Taxation Under Inflationary Conditions Law was expected to yield about $150 million. The tax measures included a one-year, 8.3 percent surtax on income other than from wages, which was to be collected starting August 1985. The tax exemption on employee contributions to study funds (set up to finance attendance at work-related courses) was abolished, as was the exemption for subsidized meals in large enterprises. Also, the allowance for the first child in families with as many as three children was canceled, and a tax was imposed on the allowances for second and third children. Finally, the one-time tax on commercial property included in the original budget, but not yet approved, became effective on July 1, and was expected to yield about US$200 million. The valueadded tax rate was reduced from 17 percent to 15 percent, and the import deposit requirement was reduced by 15 percent.
Expenditure cuts consisted mostly of further reductions in subsidies, loans, selected categories of transfer payments, and purchases of goods and services. Subsidies for basic products were reduced by over 50 percent in real terms, and subsidized loans for investment purposes were converted to direct grants equal to the implicit subsidy in each loan. The additional cuts in subsidies and transfers for basic products, investment projects, and development of export markets amounted to an estimated $250 million. The large cut in real wages also contributed significantly to the reduction in expenditure.
3. Fiscal Outturn in 1985/86
As a result of the measures implemented in July, fiscal performance improved markedly in 1985/86, compared with previous years, the original budget estimates, and the plan targets. The budget deficit before grants was cut by 9 percentage points of GNP, to 20.5 percent, almost entirely as a result of an increase of 8.5 percent of GNP in revenue and only marginal cuts in expenditure. As in the past, the Government found it more difficult to reduce direct demand through cuts in purchases of goods and services, and the burden of reducing the deficit thus fell on the tax system and subsidies. The increase in revenue reflected the positive impact of decelerating inflation on tax collections, the elimination of various tax benefits previously enjoyed by businesses, and other one-time measures introduced in the budget in midyear. Although the level of expenditure remained almost unchanged in relation to GNP, there was a change in its composition. The sharp reduction in subsidy payments and the moderate decline in wages were mostly offset by increases in interest payments and domestic defense purchases. However, real expenditure, deflated by the average CPI for 1985/86, fell substantially.6
As a result of the reduction in the budget deficit and the increase in foreign grants (including special emergency assistance from the United States) from 14 percent in 1984/85 to 19.3 percent in 1985/86, for the first time in many years, the overall balance (after grants) was reduced almost to equilibrium (1.3 percent of GNP). (See Table 1.) The amount of grants was more than sufficient to cover all external expenditures, including foreign amortization payments, and helped to finance part of domestic expenditure. The shift in U.S. aid from loans to grants and the special emergency assistance accounted for a $1.2 billion increase in foreign aid. Since net domestic bond sales to the private sector exceeded the financing requirements, the central government was able to make a net repayment of its debt to the Bank of Israel while reducing its external debt.
As expected, developments in expenditure and revenue (mostly revenue) differed considerably between the first quarter of the fiscal year (April-June) and the last three quarters following the introduction of the new economic plan in July.7 The improvement in the fiscal performance, which had already started in the first quarter, intensified as the year progressed. Quarterly revenue collections were 5 percentage points of GNP higher during the period after June 1985 compared with the first quarter of the fiscal year, and over 8 percentage points of GNP higher than in the same period in the previous fiscal year. Owing to seasonal factors, average expenditure had typically been about 4 percentage points of GNP higher in the last three quarters than in the first quarter, but in 1985/86 it remained more or less constant. The overall deficit on government domestic operations was reduced from over 15 percent of GNP during the second half of 1984/85 to 3 percent of GNP in the second half of 1985/86.
4. The 1986/87 Budget and Fiscal Outturn
The 1986/87 budget was prepared within the general framework of the policies announced in the July 1985 economic stabilization plan. The budget attempted to consolidate the authorities’ objectives and the measures implemented in 1985.8 The aim was to reduce the budget deficit to a level at which all domestic expenditure could be financed with domestic tax and non-tax revenue and net placement of bonds. Although the proposed budget provided for some additional domestic borrowing, the authorities were concerned about the large size of government debt, the increasing share of interest payments in total expenditure and its impact on future budget deficits, and the crowding out of the private sector in the capital market. Therefore, they reaffirmed the goal of reducing the level of debt in relation to GNP.
The 1986/87 budget provided for a reduction in the deficit (before grants) by the equivalent of 3 percentage points of GNP (to 18 percent of GNP), compared with the estimated outturn for 1985/86.9 This was to be accomplished by a large cut in expenditure, while revenue was expected to fall moderately. The financing requirement (overall deficit after grants), however, was projected to decline by only 1 percentage point, to 3 percent of GNP, and foreign grants were estimated to decline by 2.5 percentage points of GNP.10 The projected fall in revenue was to come from non-tax revenue. Tax revenue was not projected to show much change from the previous year, because many of the tax measures introduced in July 1985 were temporary and their impact on revenue collections in 1986/87 was expected to be only partial; also, large adjustments in income tax brackets were to offset the gains from a lower rate of inflation. The level of expenditure was planned to be cut by the equivalent of almost 4 percentage points of GNP—about 2.5 percentage points from defense purchases abroad and the remainder from domestic spending—mostly in capital outlays. For the first time in many years, no provisions were made for budgeted expenditures to be adjusted to compensate for increases in prices.
Preliminary results for 1986/87 indicate a further improvement in budget performance, compared with both the approved budget and the actual outturn in 1985/86. The deficit before grants is now estimated at 15 percent of GNP, compared with the anticipated deficit of almost 19 percent, and the overall balance is now estimated to have been almost at equilibrium, compared with a projected deficit of 3 percent of GNP. Total revenue is estimated to have been 50 percent of GNP, or 2 percentage points higher than projected in the budget, and total expenditure and net lending are estimated to have been almost 66 percent of GNP, or 1 percentage point lower than projected. Although the financing requirement is estimated to have been about 0.5 percent of GNP, net placement of domestic bonds amounted to 3 percent of GNP because of the decision to make net amortization payments abroad and to reduce, for the second year in a row, outstanding credit from the Bank of Israel.
Total revenue is estimated to have increased by 8 percent in real terms, with tax revenue having risen by 12 percent and non-tax revenue having fallen by 7 percent. The strong increase in tax collection reflected the effects of decelerating inflation, the full annual impact of the elimination of various tax benefits for businesses, and the large increase in private income and consumption. Tax revenue was higher than expected in all categories, and particularly in the case of the income tax. In relation to GNP, tax revenue increased from 40 percent in 1985/86 to 44 percent in 1986/87.
Total expenditure and net lending are estimated to have been below the amount budgeted by about 2 percent, despite a supplementary budget presented to the Knesset in January 1987 authorizing the additional expenditure; the major part of this expenditure was a transfer to the NII to compensate for the 5 percent reduction in employers’ payments to the NII for their employees. In relation to GNP, total expenditure is estimated to have declined by 2 percentage points, to 66 percent. With the exception of transfer payments and domestic purchases, all expenditures are estimated to have been reduced. Defense purchases abroad and interest payments were each cut by 2.5 percentage points of GNP, and subsidies by 2 percentage points. Subsidies on food products were cut by almost 60 percent in 1986/87 and fell to their lowest levels since 1980. Net lending also declined markedly because of a large increase in loan repayments, especially for housing and industry. Despite the increase in real wage rates during 1986/87, the government wage bill declined marginally in relation to GNP. However, a large part of these reductions was offset by an increase in transfer payments of 4 percentage points of GNP.
VI. Summary and Conclusions
The Israeli economy experienced large chronic budget deficits over a long period, which resulted in a huge public debt equal to over 200 percent of GNP in mid-1985. In the period 1979/80-1984/85, the budget deficit excluding grants averaged almost 25 percent of GNP; the deficit including grants averaged 15 percent. Real interest rates on the public debt increased rapidly, reaching almost 15 percent of GNP in 1984/85. After remaining stable at about 120 percent annually over the period 1979-83, inflation accelerated sharply starting in the last quarter of 1983 and rising to levels exceeding 500 percent annually during most of 1984; it then decelerated to 300 percent annually in the first half of 1985, owing to the successive package deals signed between the Government and representatives of the private sector. However, although these attempts to contain inflation were initially successful, the acceleration of inflation in mid-1985 and the worsening of the balance of payments position led the authorities to introduce a comprehensive stabilization plan in July 1985.
The achievements of the economic stabilization program up to the end of 1987 were impressive. Inflation ran at less than 20 percent annually beginning in July 1985, compared with almost 400 percent just before the introduction of the plan (Table 3). Although items amounting to about 35 percent of the CPI remained under control, there were no signs of artificial distortion in relative prices. Speculative purchases of foreign exchange stopped, and the public repatriated and sold foreign exchange to the Bank of Israel. The current account deficit shifted to a surplus; the Bank of Israel accumulated international reserves; and the net external debt of the country was reduced. The overall budget deficit (including grants) was almost eliminated. These improvements were aided by a sharp reduction in the oil import bill, an improvement in terms of trade, an apparent stabilization of the exchange rate, and the return of public confidence.
|GDP at constant prices||12.0||3.6||4.7||3.5||3.8||0.5||2.5||1.7||2.8||2.2|
|Average exchange rates|
|(in relation to U.S. dollar)||3.8||29||47||102||123||112||132||421||302||26|
|Gross domestic investment at constant prices||24.0||−1.8||12.0||−14.1||−5.8||13.8||12.0||−7.5||−13.6||8.1|
|Money and credit|
|Total liquid assets of public||21||38||86||150||109||128||217||458||194||45|
|Bank credit to public||18||50||101||110||82||139||133||503||172||46|
|Balance of payments (billion U.S. dollars)|
|Goods and services||−0.9||−2.5||−3.7||−3.8||−4.4||−4.8||−5.2||−4.9||−3.9||−4.0|
|Current account balance||−0.3||−0.9||−0.9||−0.8||−1.5||−2.2||−2.3||−1.5||1.1||1.4|
|(percentage of GNP)||(−5.5)||(−7.2)||(−5.0)||(−4.0)||(−6.8)||(−9.9)||(−9.3)||(−6.9)||(5.2)||(5.3)|
The costs of the economic and financial improvements were relatively modest. Domestic production, after falling by about 5 percent during the second half of 1985, rebounded in the first half of 1986, and in 1987 it is estimated to have grown at the highest rate seen in over a decade. In 1987, the unemployment rate, after having risen by 1.5 percentage points in early 1986, fell below the level obtaining prior to the program. (See Table 2.)
Economists in Israel have differed over the relationship between the size of the budget deficit and the rate of inflation; some have seen a direct link through pressure on prices, whereas others have argued for an indirect link through the deteriorating position of the balance of payments and the corrective devaluations. However, it is widely accepted that the large government deficit was the main factor in the persistent high inflation rates and that a sharp reduction in the deficit had to be the cornerstone of a stabilization program.
Fiscal performance, compared with the budget estimtes, improved dramatically over the period 1985/86-1986/87, exceeding the most optimistic expectations. The budget deficit (excluding grants) was cut by 12 percentage points of GNP, although almost all of the improvement during these two years came as a result of increases in revenue, and only 2 percent of GNP came from cuts in expenditure. The overall deficit (including grants) was reduced from over 15 percent of GNP in 1984/85 to slightly over ½ of 1 percent of GNP in 1985/86 and 1986/87. Financing from the Bank of Israel, after exceeding 8 percent of GNP in 1984/85, turned into net amortization equal to almost 3 percent of GNP in 1985/86 and a little over 1 percent in 1986/87. Also, net amortization of foreign debt exceeded 1 percent of GNP for these two fiscal years. The net amortizations were financed by sales of domestic bonds.
The improvement in fiscal performance, although impressive, is still temporary. Most of the gains have come from higher taxes and reductions in subsidies and some categories of transfer payments. The tax burden in Israel is one of the highest in the world. Real claims of the public sector on resources (domestic purchases of goods and services) have been reduced only moderately. The amount of internal debt scheduled to mature in the coming years is very large. A sharp reduction in taxes, for both house-holds and corporations, will be necessary to improve the efficiency of the economy and to foster economic growth. Therefore, the more important fiscal task for the near future is to make cuts in expenditure large enough to not only reduce the budget deficit but also allow a reduction in taxes.
Chart 3.Israel: Selected Economic Data, 1970-87
The fiscal year in Israel runs from April 1 through March 31.
Average level of debt during fiscal year as proportion of GNP.
The restriction of compensation to only two thirds of the standard formula—applicable in Package Deal I—no longer applied in Package Deal II.
The new sheqel (NIS), which was equal to 1,000 (old) shekels (IS), was introduced on September 4, 1985; the (old) shekel notes were allowed to circulate along with the new sheqel notes until the former were withdrawn on September 3, 1986.
The original insurance scheme centered on a formula calculating the shekel appreciation vis-à-vis European currencies.
Owing to the high and variable rates of inflation in 1984/85 and the sharp deceleration of inflation in 1985/86, calculations in real terms and comparisons to GNP should be viewed with great caution.
Since no information is available on total government operations on a quarterly basis, the data used in this section are based on information provided by the Bank of Israel for central government domestic operations.
The 1986/87 budget was prepared on the basis of the original 1985/86 budget projections, taking into account the expenditure cuts announced during 1985, but adding all expenditure commitments approved in previous years, as well as the growth in expenditure owing to such factors as rising population and merit increases and other expenditure, such as interest payments, which are outside the control of the authorities. This level of expenditure was called the 1986/87 base budget, to which additional cuts amounting to about $550 million were applied.
Since the 1986/87 budget was approved in early January 1986, the fiscal outturn for 1985/86 was estimated under changing conditions, including a rapid deceleration of inflation. In the event, the actual results in 1985/86 were much better than had been expected, and objectives for 1986/87 that were initially perceived to constitute an improvement may, in fact, have constituted a deterioration.
Defense-related imports—which are based on long-term contracts and financed almost entirely by U.S. military grants—were projected to decline by the same amount.