Abstract
This Selected Issues paper analyzes the empirical relationship between corporate leverage—and other indicators of financial health—and investment in Israel, using dynamic panel data techniques. The results suggest that weak balance sheets may well have contributed to the investment decline of recent years. The impact of financial variables on investment is more pronounced for firms under financial pressure. However, there is little evidence that weak balance sheets’ impact on corporate investment increases during real downturns or following an equity market bust.
II. Fiscal Policy in Israel: Trends and Prospects1
Abstract
In recent years, Israel has taken important steps to strengthen fiscal discipline. However, despite a gradual decline in the size of the public sector since the mid-1980s, the authorities have failed to achieve long-lasting fiscal consolidation. Looking forward, deficits of 3 percent of GDP imply but a modest decline in the high public debt relative to GDP. Therefore, early and more ambitious fiscal retrenchment is desirable. This paper attempts to inform the public debate on the need for early fiscal adjustment by assessing the sustainability of public debt. The application of the Fund’s Global Fiscal Model is also used to illustrate the trade-off between early and delayed fiscal consolidation.
A. Introduction
1. Despite a gradual decline in the size of the public sector since the mid-1980s, Israel has failed to achieve long-lasting fiscal consolidation. Following the stabilization program of 1985, public deficits declined sharply, and government debt was reduced by 40 percent over the next 10 years (Figure 1). Since the turn of the century, progress has slowed, and government debt has remained at around 100 percent of GDP (Figure 1).
Israel: General Government Finances 1/2/
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Source: Bank of Israel.1/ In percent of GDP.2/ The 1 percent expenditure ceiling was enacted at the end of 2003, but it applies only to the periodIsrael: General Government Finances 1/2/
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Source: Bank of Israel.1/ In percent of GDP.2/ The 1 percent expenditure ceiling was enacted at the end of 2003, but it applies only to the periodIsrael: General Government Finances 1/2/
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Source: Bank of Israel.1/ In percent of GDP.2/ The 1 percent expenditure ceiling was enacted at the end of 2003, but it applies only to the period2. In recent years, however, the government has taken important steps to strengthen fiscal discipline. Legislation in 2004 limiting the central government’s fiscal deficit to no more than 3 percent of GDP and real expenditure growth to no more than 1 percent a year was key to the fiscal adjustment. While the implementation of this legislation is applied to the 2005–10 period only, the deficit of the central government reached 3.8 percent of GDP in 2004, which was considerably lower than the 4.6 percent of GDP average deficit in 2001–03. In 2005, the fiscal deficit target was raised from 3.0 to 3.4 percent of GDP to accommodate onetime costs associated with Gaza disengagement, but lower-than projected expenditure and stronger-than expected revenue helped bring down the deficit to an estimated 1.9 percent of GDP.
Deficit/Surplus Progression, 2003–05
(In millions of NIS)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Source: Ministry of FinanceDeficit/Surplus Progression, 2003–05
(In millions of NIS)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Source: Ministry of FinanceDeficit/Surplus Progression, 2003–05
(In millions of NIS)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Source: Ministry of Finance3. More can be done to achieve early fiscal consolidation. Going forward, deficits of 3 percent of GDP imply but a modest decline in public debt relative to GDP and are accordingly insufficiently ambitious. Early fiscal consolidation is desirable for several reasons. First, a more pronounced and consistent decline in the public debt ratio would help lower future interest costs and thereby give greater scope to priority spending. Second, it would increase the economy’s resilience to unfavorable shocks. Third, it would enhance credibility. Finally, it would help to cope with the associated long-run costs of aging.
4. This paper attempts to inform the public debate on the need for early fiscal adjustment. It is organized as follows. Section B describes Israel’s fiscal performance since the mid-1980s and compares Israel with other OECD countries. Section C assesses the sustainability of public debt going forward. Section D uses the Fund’s Global Fiscal Model (GFM) to illustrate the trade-off between early and delayed fiscal consolidation. Section E examines the long-term benefits of reducing government debt by delaying tax cuts. Section F concludes.
B. Fiscal Performance Since 1985
5. Israel has a history of attempting—with little success—to set up a mechanism to control fiscal outcomes on a multiyear basis. Fiscal discipline increased substantially after the stabilization program of 1985, following a long period in which both budget deficits and public debt were very high. Since the mid-1980s, public expenditure has been reduced by more than 16 percent of GDP. This has enabled the general government deficit to be reduced from about 14 percent of GDP in 1984 to a still high 5 percent in 2004. The improvement in the deficit has also made possible a reduction in the tax burden of about 5 percent of GDP. However, the reduction of public deficits has proved insufficient to achieve durable fiscal consolidation, and public debt has remained high as result.
6. The initial improvement in public finances was due to the Law of No-Printing of 1985 and the Budget Deficit Reduction Law (DRL) of 1991. The first law passed in September 1985 as part of the stabilization program. It prohibited the Bank of Israel from lending money to the government to finance its deficit and put lower bounds on the government’s accounts in the Bank. The 1991 enactment of the DRL called for the incorporation of medium-term fiscal targets, which were intended to compensate for the lack of a fiscal policy anchor. The targets were intended to bind future governments, thereby making fiscal policy more transparent and credible.
7. Successive governments found it difficult to meet the deficit targets set by the DRL, particularly during periods of weak economic activity. The DRL targets were not adjusted for the cycle, and, therefore, the law had to be amended continuously (Table 1). Notably, the budget overshot its deficit targets in the mid-1990s, over-performed in 2000, overshot the target again in 2001, 2003, and 2004, and over-performed in 2005. In addition, because the DRL prescribed the ex ante deficit path, it appears to have created a bias for overly optimistic revenue and growth projections at times of slow economic growth. In fact, an analysis of Israel’s fiscal forecast errors shows that the under-performance on fiscal balance since the mid-1990s has been mainly driven by lower-than-expected revenue.2 A significant part of the forecast error on the revenue side came from deviations in the projections of VAT and non-tax revenue. Optimistic revenue projections permitted the annual budget law’s expenditure allocation to be higher than it realistically could be, given the deficit target. As a result the budget’s effectiveness as an expenditure planning tool may have been lessened.
Israel: Central Government: DRL Ceiling Versus Actual Deficits
No specific deficit targets were given for the years 1995–97. The only requirement was that the deficit, as a percent of GDP, would decrease from its level in the previous year. Numbers underlined represent the deficit targets that the government decided on when it presented the budget for this year.
No specific deficit targets were given for the years 2001–02. The only requirement was that the deficit, as percent of GDP, would decrease by 0.25 percentage points from the previous year, and that the deficit in 2003 would rise to 1.5 percent of GDP. Numbers underlined represent the deficit targets that the government decided on when it presented the budget for this year.
The DRL was amended to include ceilings on expenditures growth between 2005 and 2010. Accordingly, budget expenditure, indexed to the CPI, would not increase by more than 1 percent each year and the budget deficit would not exceed 3 percent of GDP.
The original target was 3 percent for 2005 but was later modified to account for the estimated cost of Gaza disengament of 0.4 percent of GDP.
Israel: Central Government: DRL Ceiling Versus Actual Deficits
| 92 | 93 | 94 | 95 | 96 | 97 | 98 | 99 | 00 | 01 | 02 | 03 | 04 | 05 | 06 | 07 | 08 | |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Deficit Targets by year announced | |||||||||||||||||
| 1991 | 6.2 | 3.2 | 2.2 | 0 | |||||||||||||
| 1994 1/ | 3 | 2.8 | 2.5 | ||||||||||||||
| 1997 | 2.8 | 2.4 | 2 | 1.75 | 1.5 | ||||||||||||
| 2000 2/ | 2.5 | 1.75 | 1.5 | ||||||||||||||
| February, 2002 | 3 | 2 | 1.5 | 1 | |||||||||||||
| June, 2002 | 3–3.5 | 2.5–3 | 2–2.5 | 1.5–2 | 1–1.5 | ||||||||||||
| 2004 3/4/ | 2.5–4 | 3.4 | up to 3up to 3up to 3 | ||||||||||||||
| Actual Deficits | 3.8 | 2.4 | 2.3 | 4.1 | 3.7 | 2.6 | 2.3 | 2.4 | 0.7 | 4.4 | 3.8 | 5.6 | 3.8 | 1.9 | |||
No specific deficit targets were given for the years 1995–97. The only requirement was that the deficit, as a percent of GDP, would decrease from its level in the previous year. Numbers underlined represent the deficit targets that the government decided on when it presented the budget for this year.
No specific deficit targets were given for the years 2001–02. The only requirement was that the deficit, as percent of GDP, would decrease by 0.25 percentage points from the previous year, and that the deficit in 2003 would rise to 1.5 percent of GDP. Numbers underlined represent the deficit targets that the government decided on when it presented the budget for this year.
The DRL was amended to include ceilings on expenditures growth between 2005 and 2010. Accordingly, budget expenditure, indexed to the CPI, would not increase by more than 1 percent each year and the budget deficit would not exceed 3 percent of GDP.
The original target was 3 percent for 2005 but was later modified to account for the estimated cost of Gaza disengament of 0.4 percent of GDP.
Israel: Central Government: DRL Ceiling Versus Actual Deficits
| 92 | 93 | 94 | 95 | 96 | 97 | 98 | 99 | 00 | 01 | 02 | 03 | 04 | 05 | 06 | 07 | 08 | |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Deficit Targets by year announced | |||||||||||||||||
| 1991 | 6.2 | 3.2 | 2.2 | 0 | |||||||||||||
| 1994 1/ | 3 | 2.8 | 2.5 | ||||||||||||||
| 1997 | 2.8 | 2.4 | 2 | 1.75 | 1.5 | ||||||||||||
| 2000 2/ | 2.5 | 1.75 | 1.5 | ||||||||||||||
| February, 2002 | 3 | 2 | 1.5 | 1 | |||||||||||||
| June, 2002 | 3–3.5 | 2.5–3 | 2–2.5 | 1.5–2 | 1–1.5 | ||||||||||||
| 2004 3/4/ | 2.5–4 | 3.4 | up to 3up to 3up to 3 | ||||||||||||||
| Actual Deficits | 3.8 | 2.4 | 2.3 | 4.1 | 3.7 | 2.6 | 2.3 | 2.4 | 0.7 | 4.4 | 3.8 | 5.6 | 3.8 | 1.9 | |||
No specific deficit targets were given for the years 1995–97. The only requirement was that the deficit, as a percent of GDP, would decrease from its level in the previous year. Numbers underlined represent the deficit targets that the government decided on when it presented the budget for this year.
No specific deficit targets were given for the years 2001–02. The only requirement was that the deficit, as percent of GDP, would decrease by 0.25 percentage points from the previous year, and that the deficit in 2003 would rise to 1.5 percent of GDP. Numbers underlined represent the deficit targets that the government decided on when it presented the budget for this year.
The DRL was amended to include ceilings on expenditures growth between 2005 and 2010. Accordingly, budget expenditure, indexed to the CPI, would not increase by more than 1 percent each year and the budget deficit would not exceed 3 percent of GDP.
The original target was 3 percent for 2005 but was later modified to account for the estimated cost of Gaza disengament of 0.4 percent of GDP.
Growth and Fiscal Deficits
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Growth and Fiscal Deficits
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Growth and Fiscal Deficits
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Forecast Error
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
1/ In percent of GDP.2/ Revenue excluding foreignForecast Error
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
1/ In percent of GDP.2/ Revenue excluding foreignForecast Error
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
1/ In percent of GDP.2/ Revenue excluding foreign8. A key reason for the failure to consistently implement the DRL is the lack of more formal, less ad hoc medium-term fiscal framework—one that incorporates multiyear budgets and binding expenditure ceilings in a detailed and transparent manner. In 2004, the DRL was amended to include ceilings on expenditure growth between 2005 and 2010. Under this amendment, real expenditure would rise by no more than 1 percent each year, and the budget deficit would not exceed 3 percent of GDP.3 While this amendment was seen as a first step toward making the DRL a more effective fiscal policy rule, the 2005 and 2006 budgets lacked clarity with regard to how exactly the government intended to meet both the expenditure and deficit ceilings. The authorities’ ability to adhere consistently to the amended fiscal rule is thus questionable. A more detailed presentation of multiyear budgets, which clearly delineates the path of fiscal consolidation, including when the path is adjusted to cyclical fluctuations, is needed.
Trends
9. The remarkable improvement in the public finances from the mid-1980s through the 1990s has given way to a noticeable deterioration in more recent years. To better understand the dynamics of fiscal policy in Israel, we identify three broad phases. During the first phase—1985–90—the general government balance improved by 11 percent of GDP on average, and the primary balance moved sharply into a surplus, reaching 4.5 percent of GDP by 1990 (Table 2). This improvement was achieved largely through cuts in public expenditure, principally defense and subsidies.4 The pace of fiscal consolidation slowed markedly during the second phase—1991–2000—as the overall general government balance weakened by 2.7 percent of GDP and the primary balance declined by about 6 percentage points. It is important to note that during the 1990’s Israel absorbed a very large number of immigrants (about 20 percent of its original population at the time), which resulted in higher government spending and contributed to the weakening of the fiscal balance. During this period, expenditure cuts in defense continued and Israel started enjoying the first fruits of its stabilization effort, as reflected in the substantial decline in interest payments. However, revenue fell as a result of tax cuts and a reduction of aid from the U.S.5 The year 2001 marked the beginning of a third phase, during which a deterioration in the public finances coincided with the economic recession. Over the period 2001–04, the overall budget deficit worsened from 2 percent of GDP in 2000 to 5.1 percent in 2004. The primary balance also declined by about 2 percentage points over the same period. In contrast to the previous phases, current expenditure increased (including transfers); combined with a further decline in revenue, this led to higher deficits and public debt.
Israel: Trends in Public Finances
(Average during subperiods, in percent of GDP)
Excluding defense imports.
Direct defense imports including advance payments, excluding taxes.
Israel: Trends in Public Finances
(Average during subperiods, in percent of GDP)
| 1980-84 | 1985-90 | 1991-2000 | 2001-04 | |||
|---|---|---|---|---|---|---|
| Revenues | 60.2 | 59.7 | 50.0 | 48.1 | ||
| Domestic receipts | 48.5 | 47.5 | 44.3 | 43.7 | ||
| Tax | 40.4 | 41.6 | 38.1 | 38.2 | ||
| External receipts | 11.7 | 12.2 | 5.7 | 4.4 | ||
| Intergovernmental transfer | 8.0 | 9.7 | 3.9 | 2.8 | ||
| Total expenditures | 72.6 | 60.9 | 54.0 | 53.0 | ||
| of which | ||||||
| Current expenditures | 66.6 | 56.3 | 48.1 | 48.9 | ||
| Public consumption 1/ | 30.9 | 26.3 | 26.3 | 27.8 | ||
| Defense 2/ | 6.7 | 4.8 | 2.1 | 1.9 | ||
| Interest | 11.4 | 10.8 | 6.7 | 5.8 | ||
| Transfers and subsidies | 17.6 | 14.5 | 13.0 | 13.3 | ||
| Capital outlays | 6.0 | 4.6 | 5.9 | 4.2 | ||
| Gross fixed investment | 2.4 | 2.4 | 3.1 | 2.6 | ||
| Primary spending | 61.2 | 50.2 | 47.3 | 47.2 | ||
| Primary current spending | 55.2 | 45.6 | 41.4 | 43.0 | ||
| Overall balance | -12.4 | -1.3 | -4.0 | -4.9 | ||
| Primary balance | -1.0 | 9.5 | 2.7 | 0.9 | ||
| Real GDP growth | 2.7 | 4.1 | 5.6 | 1.2 | ||
| Debt-GDP ratio (end-period) | 289.1 | 145.1 | 90.8 | 104.9 | ||
Excluding defense imports.
Direct defense imports including advance payments, excluding taxes.
Israel: Trends in Public Finances
(Average during subperiods, in percent of GDP)
| 1980-84 | 1985-90 | 1991-2000 | 2001-04 | |||
|---|---|---|---|---|---|---|
| Revenues | 60.2 | 59.7 | 50.0 | 48.1 | ||
| Domestic receipts | 48.5 | 47.5 | 44.3 | 43.7 | ||
| Tax | 40.4 | 41.6 | 38.1 | 38.2 | ||
| External receipts | 11.7 | 12.2 | 5.7 | 4.4 | ||
| Intergovernmental transfer | 8.0 | 9.7 | 3.9 | 2.8 | ||
| Total expenditures | 72.6 | 60.9 | 54.0 | 53.0 | ||
| of which | ||||||
| Current expenditures | 66.6 | 56.3 | 48.1 | 48.9 | ||
| Public consumption 1/ | 30.9 | 26.3 | 26.3 | 27.8 | ||
| Defense 2/ | 6.7 | 4.8 | 2.1 | 1.9 | ||
| Interest | 11.4 | 10.8 | 6.7 | 5.8 | ||
| Transfers and subsidies | 17.6 | 14.5 | 13.0 | 13.3 | ||
| Capital outlays | 6.0 | 4.6 | 5.9 | 4.2 | ||
| Gross fixed investment | 2.4 | 2.4 | 3.1 | 2.6 | ||
| Primary spending | 61.2 | 50.2 | 47.3 | 47.2 | ||
| Primary current spending | 55.2 | 45.6 | 41.4 | 43.0 | ||
| Overall balance | -12.4 | -1.3 | -4.0 | -4.9 | ||
| Primary balance | -1.0 | 9.5 | 2.7 | 0.9 | ||
| Real GDP growth | 2.7 | 4.1 | 5.6 | 1.2 | ||
| Debt-GDP ratio (end-period) | 289.1 | 145.1 | 90.8 | 104.9 | ||
Excluding defense imports.
Direct defense imports including advance payments, excluding taxes.
How does Israel Compare with OECD Countries?
10. The fiscal consolidation from the mid-1980s through 1990s brought Israel more in line with OECD countries. In 1985, the relative size of the Israeli public sector, at around 70 percent of GDP, was one of the highest in the world. Although the subsequent fiscal adjustment placed Israel closer to OECD countries, public spending, at about 52 percent of GDP in 2004, is still 11 percentage points higher than the OECD average (Figure 2). The main difference in spending levels comes from defense, which is 5 percentage points of GDP higher than in the U.S., the country with the highest defense spending among OECD countries. On the revenue side, the Israel tax yield as a share of GDP is slightly higher than the OECD average (Figure 3). The composition of tax revenue has changed over time in favor of indirect taxation. Overall, the fiscal deficit in Israel is the third largest among OECD countries, surpassed only by Japan and Greece. As a result, Israel has one of the highest debt-to-GDP ratios in the industrial world.
International Comparison: General Government Finances, 1995–2004 1/
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Sources: Bank of Israel; and OECD, Economic Outlook.1/ Average over the period, in percent of GDP.2/ As of 2004.International Comparison: General Government Finances, 1995–2004 1/
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Sources: Bank of Israel; and OECD, Economic Outlook.1/ Average over the period, in percent of GDP.2/ As of 2004.International Comparison: General Government Finances, 1995–2004 1/
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Sources: Bank of Israel; and OECD, Economic Outlook.1/ Average over the period, in percent of GDP.2/ As of 2004.
Tax Revenues, 2003 1/
(In percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Sources: Bank of Israel; and OECD Revenue Statistics.1/ Data for Australia, Portugal and Greece are as of 2002. Israel goods and services taxes include taxes on economic activity and net taxes on imports.Tax Revenues, 2003 1/
(In percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Sources: Bank of Israel; and OECD Revenue Statistics.1/ Data for Australia, Portugal and Greece are as of 2002. Israel goods and services taxes include taxes on economic activity and net taxes on imports.Tax Revenues, 2003 1/
(In percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Sources: Bank of Israel; and OECD Revenue Statistics.1/ Data for Australia, Portugal and Greece are as of 2002. Israel goods and services taxes include taxes on economic activity and net taxes on imports.
Breakdown of Government Expenditure, 2003
(in percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Breakdown of Government Expenditure, 2003
(in percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Breakdown of Government Expenditure, 2003
(in percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Taxes (in percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Taxes (in percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Taxes (in percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
C. Assessing the Stance of Fiscal Policy
Medium Term
11. Israel’s high public debt, currently at just over 100 percent of GDP, presents important risks to the economy. One of these risks includes the possibility that investors lose confidence in the ability of the government to service its debt in the face of adverse shocks resulting in sustained loss of output and revenue. This would likely increase the interest cost of servicing the debt, which would further hinder the prospects of economic recovery. Although much of the public debt (75 percent) is domestically held and half of the external debt portion is guaranteed by the U.S. government, the overall ratio is very high, and the economy stands to benefit from bringing the ratio down. In order to assess the sustainability of public debt, we look at the public debt dynamics over the next five years. We concentrate on two key paths: a baseline scenario that encompasses the trajectory of public debt under the current fiscal policy framework of 1 percent real expenditure growth and 3 percent of GDP fiscal deficit (applied to the central government), and a more ambitious alternative scenario that reflects the 1 percent expenditure rule and a declining path in the fiscal deficit.
Public Debt, 2004 (Percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Public Debt, 2004 (Percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Public Debt, 2004 (Percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
12. Israel’s vulnerability to large shocks points to the need for a more aggressive fiscal consolidation than currently envisaged. Under the baseline scenario, average real GDP grows by 4.2 percent, the real interest rate is assumed at 4.5 percent, and the primary surplus is 2.4 percent of GDP. This is consistent with a general government deficit of 3.5 percent of GDP; that is, a central government deficit of 3.0 percent of GDP and local governments’ deficit of 0.5 percent of GDP6. As can be seen in Figure 4, maintaining a deficit of 3.5 percent of GDP in the years ahead implies only a modest decline in public debt as a share of GDP. Indeed, under such a scenario, the public debt-to-GDP ratio would fall only slightly, to 95 percent of GDP, by 2010. The debt ratio is vulnerable to interest rate and growth shocks.7 For example, if the real interest rate were to rise at a rate equivalent to one standard deviation above the baseline rate, the debt ratio would rise to 105 percent of GDP; whereas, if real GDP growth were to decelerate to an average of only 2.4 percent, the debt ratio would rise to 111 percent of GDP in five years.
Israel: Public Debt Sustainability: Bound Tests 1/
(Public debt in percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2006, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).Israel: Public Debt Sustainability: Bound Tests 1/
(Public debt in percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2006, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).Israel: Public Debt Sustainability: Bound Tests 1/
(Public debt in percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2006, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).13. Adhering to the 1 percent real expenditure growth target and allowing the automatic stabilizers to operate fully would go a long way toward achieving fiscal consolidation. The alternative scenario assumes that the authorities are able to gradually lower the fiscal deficit from 3.5 percent of GDP in 2005 to zero by 2008 and bring it to about a 2.5 percent surplus by 2010. If we apply the binding 1 percent expenditure rule, which translates to about a 1 percent of GDP annual decline in expenditure, and allow revenue as a share of GDP to remain constant (i.e. a revenue/GDP elasticity of one), the consolidation effort would amount to 6 percent of GDP over five years. Under this scenario, the public debt ratio would fall to 75 percent of GDP by 2010, or close to a 20 percentage point improvement over the baseline path.8
Public Debt (in percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Public Debt (in percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Public Debt (in percent of GDP)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Impact of Aging
14. Israel is relatively well placed to deal with aging with its current medium-term fiscal framework, provided the authorities adhere to the 1 percent expenditure rule. An international comparison of the old-age dependency ratio places Israel at the bottom of a group of industrialized (particularly European) countries. In addition, the pension system was recently reformed by raising the retirement age and lowering benefits.9 Moreover, Broida (2003) analyzes the long-run effects of demographic trends on public spending in Israel and finds that pressures on related expenditure are not likely to increase through 2010. However, the demographic changes in 20–30 years suggest the need for increased future public expenditure to compensate for the higher old-age dependency ratio. Public spending on the old-age population was 2.8 percent of GDP in 1995, rose slightly to 2.9 percent in 2000 and 2005, and is expected to remain at that level in 2010. Nonetheless, by 2020, such spending is expected to rise to 3.7 percent of GDP. Most likely, public spending will rise substantially after that, given that Israel is set to experience a significant aging of its population after 2030. This underscores the importance of achieving early fiscal consolidation in order to cope with the increase in age-related spending.
Old-age Dependency ratio, 1950–2050
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Source: United Nations Secretariat.Old-age Dependency ratio, 1950–2050
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Source: United Nations Secretariat.Old-age Dependency ratio, 1950–2050
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Source: United Nations Secretariat.Negative Income Tax
15. In their effort to reduce poverty incidence, the authorities are considering a broad range of measures, including the introduction of a negative income tax (NIT). In general, it is recognized that a NIT can be a useful mechanism in promoting employment and/or ensuring adequate income for low income earners. However, its effectiveness depends on a variety of factors (Appendix II).
D. Fiscal Consolidation: Now Versus Later
16. To evaluate the long-term benefits of early fiscal consolidation, we use the IMF’s Global Fiscal Model (GFM), calibrated to the Israeli economy and the rest of the world.10 The GFM is based on a micro-foundation model developed to examine fiscal issues. Several features of the model make it particularly suitable to analyze the impacts of fiscal consolidation, including its relaxing of the assumptions of Ricardian equivalence and perfect competition. Supply-side effects operate through changes in incentives, as taxes influence the desire to work and the rate of capital accumulation.11 Demand is affected by the degree of agents’ impatience and their planning horizons, the persistence of the consolidation effort, and the amount of public spending on domestically produced goods that would affect the real exchange rate and, thus, net exports.
17. In the first scenario, we compare early and delayed fiscal consolidation achieved through expenditure cuts. Fiscal consolidation is defined as reaching a debt-to-GDP ratio of 60 percent by 2020.12 In July 2005, the Knesset approved a multiyear tax cut, which will be phased out in five years. Therefore, to make our simulations more realistic, we assume that fiscal adjustment occurs through expenditure cuts. Early fiscal consolidation implies adjusting the fiscal deficit by 1 percent of GDP every year until 2010 and gradually increasing the deficit thereafter. Delayed consolidation implies starting the fiscal adjustment only in 2015, necessitating a much sharper reduction in deficits in order to achieve the debt-to-GDP ratio of 60 percent by 2020.
18. The simulations show that there are significant long-term benefits to early consolidation. Early fiscal consolidation results in an initial fall in real GDP as the expenditure cuts dampen demand. This initial loss of output is larger than in the delayed scenario, since in that case, government expenditure does not change for the first five years (Figure 5). However, early consolidation leads to long term increases in output that are double those obtained if adjustment is delayed. This is because the reduction of the government’s interest payments is larger, given the faster pace of debt reduction.
Israel: Effects of Fiscal Consolidation on Real GDP, 2005–45
(Percent deviation from baseline, cumulative)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Israel: Effects of Fiscal Consolidation on Real GDP, 2005–45
(Percent deviation from baseline, cumulative)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Israel: Effects of Fiscal Consolidation on Real GDP, 2005–45
(Percent deviation from baseline, cumulative)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
19. To further assess the benefits of early consolidation, we compare these results with an alternative form of delayed consolidation. The alternative delayed consolidation involves starting the fiscal adjustment in 2015 but not reaching the debt-to-GDP ratio of 60 percent until 2030. The main difference between this delayed scenario and the one considered above is that, although this fiscal adjustment is less pronounced, it has to be maintained for a longer period. As expected, the initial loss of output is much smaller than in the early consolidation case. However, in the long term, early fiscal consolidation generates output increases that are four times higher.
E. Tax Cuts
20. Recently introduced tax cuts have opened the question of the appropriate pace of debt reduction. On July 25, 2005, the Knesset approved a tax plan that outlines Israel’s tax policy for the next five years, including several tax cuts.13 By cutting taxes, the authorities have slowed the pace of debt reduction. This section evaluates the long-term benefits from reducing government debt by delaying tax cuts, using the Fund’s GFM. The simulations examine the consequences of postponing tax cuts in response to reductions in government spending so that public debt declines, allowing larger tax cuts in the future.
21. The impact of tax cuts on real activity depends on the responses of aggregate supply and demand. The supply-side effects of the tax cut come from an increased incentive to work due to higher after-tax wages.14 The increase in aggregate demand, in turn, depends on the extent to which individuals view a larger fiscal deficit as an increase in their permanent income, which also depends on the degree of agents’ impatience and their planning horizons.
22. This section compares the impact of matching a cut in transfers with an immediate tax cut versus a larger delayed tax cut. The simulations assume that scope for tax cuts is provided by a permanent cut in lump-sum transfer payments of 1 percentage point of GDP.15 The results compare the following two policy responses: (1) immediately implementing a permanent cut in tax rates so as to reduce tax revenues by the same amount as the cut in transfer payments (thus not affecting the fiscal balance); and (2) leaving tax rates unchanged for 10 years, followed by a larger permanent cut in tax rates made possible by the lower level of interest costs due to the intervening fall in the government debt ratio. In other words, delaying the tax cut for 10 years allows the government to run a fiscal surplus, which is then used to reduce public debt. The second scenario emphasizes an important trade-off: the government ends up with a permanently lower tax rate and level of government debt, but at the cost of not offsetting the negative short-term impact of the cut in transfers on output.16
23. Simulation results suggest that there are significant long-term benefits to delaying a cut in taxes, but there are also some costs to not offsetting the fall in transfers in the short term. Figure 6 shows that immediately replacing a 1 percentage point of GDP reduction in lump-sum transfers with a cut in wage taxes leads to a cumulative increase in real GDP of about 3.5 percent over the long run. Conversely, delaying the cut in wage taxes by 10 years results in a small fall in real GDP over the short term as the impact on aggregate demand of the reduction in transfer payments is not offset. However, the 10-year delay leads to an eventual tax reduction that is twice as large as in the case of immediate tax cuts. As Figure 6 highlights, once implemented, the larger tax cut promotes real GDP gains that are substantially larger. In fact, the cumulative long-run impact on real GDP is five times larger when tax cuts are delayed.
Israel: Cumulative Effects on Real GDP of Reducing Transfers and Cutting Taxes, 2005–45
(Percent deviation from baseline)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Israel: Cumulative Effects on Real GDP of Reducing Transfers and Cutting Taxes, 2005–45
(Percent deviation from baseline)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
Israel: Cumulative Effects on Real GDP of Reducing Transfers and Cutting Taxes, 2005–45
(Percent deviation from baseline)
Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A002
F. Conclusion
24. Israel has made progress in reducing the size of its public sector but has yet to achieve long-lasting fiscal consolidation. The latest amendment to the Deficit Reduction Law, to limit the fiscal deficit to 3 percent of GDP, is a step in the right direction, but it must be seen as a ceiling, not a target, if the authorities are to realize sustained fiscal consolidation. The limit on real expenditure to no more than 1 percent should facilitate the gradual reduction in the fiscal deficit below the deficit ceiling and help achieve an earlier fiscal consolidation path. This would lead to a more pronounced and consistent decline in the public debt ratio, which will lower future interest costs, raise the economy’s resilience to adverse shocks, and give greater scope to countercyclical fiscal policy, as well as help to deal with the long-run costs of aging.
25. Israel’s vulnerability to large shocks points to the need for early, more ambitious fiscal adjustment. The current fiscal framework, while consistent with fiscal retrenchment, does not portend a significant improvement in the public debt profile over the medium-term, and thus will likely delay the benefits from a faster debt-reduction path. Simulations using GFM show that there are significant long-term benefits to early consolidation. While early fiscal consolidation could lower near-term output faster than otherwise, we find that early, more ambitious adjustment would double output growth in the long term, as reduced interest payments would free up government resources for other, more productive economic uses. Similarly, the cumulative long-run impact on real GDP is five times larger when tax cuts are delayed.
26. A formal medium-term fiscal framework can help anchor fiscal policy, enhance its credibility, and make consolidation more durable. Integrating multiyear budgets and binding expenditure ceilings in a clear and transparent manner is a necessary first step to adopting a medium-term fiscal framework. The authorities stand to benefit from such a framework, as it would raise the government’s credibility and lessen political pressure to deviate from the key 1 percent expenditure rule. Indeed, a more detailed presentation of multiyear budgets, which clearly delineates the path of fiscal consolidation, including when the path is adjusted to cyclical fluctuations, will help anchor expectations, reinforce fiscal consolidation, minimize expenditure growth, and strengthen adjustment. To fully reap the benefits of multiyear budgets, it is important that the fiscal targets set in such a framework be maintained.
APPENDIX I
Public Sector Debt Sustainability Framework, 2000–10
(In percent of GDP, unless otherwise indicated)
Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.
Derived as [(r -π(l+g) -g + αε(l+r)]/(l+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).
The real interest rate contribution is derived from the denominator in footnote 2/as r - π (1+g) and the real growth contribution as -g.
The exchange rate contribution is derived from the numerator in footnote 2/ as αε(l+r).
Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.
Derived as nominal interest expenditure divided by previous period debt stock.
The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.
The implied change in other key variables under this scenario is discussed in the text.
Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).
Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.
Public Sector Debt Sustainability Framework, 2000–10
(In percent of GDP, unless otherwise indicated)
| Actual | Projections | |||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | ||||||||
| I. Baseline Projections | Debt-stabilizing primary balance 10/ | |||||||||||||||||
| 1 | Public sector debt 1/ | 90.9 | 95.8 | 104.5 | 106.4 | 105.4 | 101.8 | 100.7 | 99.0 | 97.7 | 96.4 | 95.1 | 0.8 | |||||
| o/w foreign-currency denominated | 27.9 | 26.5 | 27.0 | 26.6 | 25.5 | 25.0 | 25.0 | 25.0 | 25.0 | 25.0 | 25.0 | |||||||
| 2 | Change in public sector debt | -9.7 | 5.0 | 8.6 | 2.0 | -1.0 | -3.6 | -1.1 | -1.6 | -1.3 | -1.3 | -1.4 | ||||||
| 3 | Identified debt-creating flows (4+7+12) | -7.9 | 5.3 | 6.3 | 3.0 | 0.0 | -2.9 | -1.3 | -1.7 | -1.5 | -1.5 | -1.6 | ||||||
| 4 | Primary deficit | -3.9 | -1.9 | -1.1 | 0.4 | -1.0 | -3.4 | -2.4 | -2.4 | -2.4 | -2.4 | -2.4 | ||||||
| 5 | Revenue and grants | 48.4 | 49.1 | 50.1 | 46.7 | 46.4 | 47.6 | 45.5 | 44.5 | 43.5 | 42.5 | 41.5 | ||||||
| 6 | Primary (noninterest) expenditure | 44.5 | 47.2 | 48.9 | 47.1 | 45.5 | 44.2 | 43.2 | 42.2 | 41.2 | 40.2 | 39.2 | ||||||
| 7 | Automatic debt dynamics 2/ | -3.3 | 7.0 | 4.4 | 2.2 | 1.3 | 0.0 | 0.6 | 0.0 | 0.2 | 0.2 | 0.1 | ||||||
| 8 | Contribution from interest rate/growth differential 3/ | -2.6 | 4.3 | 2.4 | 4.3 | 1.7 | 0.0 | 0.6 | 0.0 | 0.2 | 0.2 | 0.1 | ||||||
| 9 | Of which contribution from real interest rate | 4.4 | 4.1 | 1.3 | 6.1 | 6.3 | 5.1 | 4.7 | 3.9 | 3.9 | 4.0 | 4.0 | ||||||
| 10 | Of which contribution from real GDP growth | -7.1 | 0.2 | 1.1 | -1.8 | -4.5 | -5.1 | -4.1 | -3.9 | -3.8 | -3.8 | -3.9 | ||||||
| 11 | Contribution from exchange rate depreciation 4/ | -0.7 | 2.7 | 1.9 | -2.1 | -0.4 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | ||||||
| 12 | Other identified debt-creating flows | -0.7 | 0.1 | 3.0 | 0.4 | -0.4 | 0.6 | 0.6 | 0.8 | 0.8 | 0.8 | 0.7 | ||||||
| 13 | Privatization receipts (negative) | -1.3 | -0.5 | -0.6 | 0.0 | -0.1 | -0.1 | -0.5 | -0.4 | -0.4 | -0.4 | -0.4 | ||||||
| 14 | Recognition of implicit or contingent liabilities | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.2 | 0.2 | 0.2 | 0.1 | 0.1 | ||||||
| 15 | Other (specify, e.g. bank recapitalization) | 0.6 | 0.6 | 3.6 | 0.4 | -0.3 | 0.7 | 0.9 | 1.0 | 1.0 | 1.0 | 1.0 | ||||||
| 16 | Residual, including asset changes (2-3) | -1.8 | -0.3 | 2.4 | -1.0 | -1.0 | -0.8 | 0.1 | 0.0 | 0.2 | 0.2 | 0.2 | ||||||
| Public sector debt-to-revenue ratio 1/ | 187.7 | 195.2 | 208.7 | 227.8 | 227.0 | 213.9 | 221.0 | 222.3 | 224.5 | 226.7 | 228.8 | |||||||
| Gross financing need 5/ | 12.0 | 14.4 | 15.5 | 18.1 | 16.7 | 14.4 | 13.1 | 14.3 | 14.2 | 14.0 | 13.9 | |||||||
| in billions of U.S. dollars | 13.9 | 16.3 | 16.2 | 20.0 | 19.5 | 10-Year | 10-Year | 17.8 | 17.1 | 19.9 | 20.9 | 22.0 | 23.1 | |||||
| Historical | Standard | Projected | ||||||||||||||||
| Key Macroeconomic and Fiscal Assumptions | Average | Deviation | Average | |||||||||||||||
| Real GDP growth (in percent) | 7.7 | -0.3 | -1.2 | 1.7 | 4.4 | 3.4 | 2.8 | 5.2 | 4.3 | 4.2 | 4.1 | 4.1 | 4.3 | 4.2 | ||||
| Average nominal interest rate on public debt (in percent) 6/ | 6.5 | 6.5 | 5.8 | 5.9 | 6.0 | 6.4 | 0.4 | 5.9 | 6.1 | 6.2 | 6.3 | 6.4 | 6.5 | 6.3 | ||||
| Average real interest rate (nominal rate minus change in GDP deflator, in percent) | 4.9 | 4.6 | 1.4 | 5.9 | 6.1 | 1.3 | 3.9 | 5.2 | 4.9 | 4.2 | 4.3 | 4.4 | 4.5 | 4.5 | ||||
| Nominal appreciation (increase in US dollar value of local currency, in percent) | 2.8 | -8.5 | -6.8 | 8.2 | 1.6 | -3.3 | 6.7 | -0.1 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | ||||
| Inflation rate (GDP deflator, in percent) | 1.5 | 1.9 | 4.4 | 0.0 | -0.2 | 5.1 | 4.1 | 0.7 | 1.2 | 2.0 | 2.0 | 2.0 | 2.0 | 1.9 | ||||
| Growth of real primary spending (deflated by GDP deflator, in percent) | 4.6 | 5.9 | 2.4 | -2.1 | 0.8 | 3.1 | 3.2 | 2.2 | 1.9 | 1.8 | 1.6 | 1.6 | 1.7 | 1.7 | ||||
| Primary deficit | -3.9 | -1.9 | -1.1 | 0.4 | -1.0 | -1.7 | 1.2 | -3.4 | -2.4 | -2.4 | -2.4 | -2.4 | -2.4 | -2.4 | ||||
| A. Alternative Scenarios | II. Stress Tests for Public Debt Ratio | Debt-stabilizing primary balance 10/ | ||||||||||||||||
| A1. Key variables are at their historical averages in 2006–10 7/ | 101.8 | 98.7 | 95.8 | 93.1 | 90.5 | 87.9 | -1.1 | |||||||||||
| A2. No policy change (constant primary balance) in 2006–10 | 101.8 | 99.6 | 96.9 | 94.6 | 92.2 | 89.7 | 0.8 | |||||||||||
| B. Bound Tests | ||||||||||||||||||
| B1. Real interest rate is at baseline plus one standard deviations | 101.8 | 102.5 | 102.8 | 103.4 | 104.0 | 104.5 | 2.7 | |||||||||||
| B2. Real GDP growth is at baseline minus one-half standard deviation | 101.8 | 102.7 | 103.7 | 105.6 | 108.1 | 111.1 | 2.4 | |||||||||||
| B3. Primary balance is at baseline minus one-half standard deviation | 101.8 | 101.3 | 100.3 | 99.6 | 98.9 | 98.1 | 0.8 | |||||||||||
| B4. Combination of B1-B3 using one-quarter standard deviation shocks | 101.8 | 102.6 | 103.0 | 103.7 | 104.4 | 105.0 | 2.5 | |||||||||||
| B5. One time 30 percent real depreciation in 2006 9/ | 101.8 | 112.1 | 110.4 | 109.2 | 107.9 | 106.5 | 0.8 | |||||||||||
| B6. 10 percent of GDP increase in other debt-creating flows in 2006 | 101.8 | 110.7 | 109.0 | 107.8 | 106.5 | 105.1 | 0.8 | |||||||||||
Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.
Derived as [(r -π(l+g) -g + αε(l+r)]/(l+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).
The real interest rate contribution is derived from the denominator in footnote 2/as r - π (1+g) and the real growth contribution as -g.
The exchange rate contribution is derived from the numerator in footnote 2/ as αε(l+r).
Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.
Derived as nominal interest expenditure divided by previous period debt stock.
The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.
The implied change in other key variables under this scenario is discussed in the text.
Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).
Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.
Public Sector Debt Sustainability Framework, 2000–10
(In percent of GDP, unless otherwise indicated)
| Actual | Projections | |||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | ||||||||
| I. Baseline Projections | Debt-stabilizing primary balance 10/ | |||||||||||||||||
| 1 | Public sector debt 1/ | 90.9 | 95.8 | 104.5 | 106.4 | 105.4 | 101.8 | 100.7 | 99.0 | 97.7 | 96.4 | 95.1 | 0.8 | |||||
| o/w foreign-currency denominated | 27.9 | 26.5 | 27.0 | 26.6 | 25.5 | 25.0 | 25.0 | 25.0 | 25.0 | 25.0 | 25.0 | |||||||
| 2 | Change in public sector debt | -9.7 | 5.0 | 8.6 | 2.0 | -1.0 | -3.6 | -1.1 | -1.6 | -1.3 | -1.3 | -1.4 | ||||||
| 3 | Identified debt-creating flows (4+7+12) | -7.9 | 5.3 | 6.3 | 3.0 | 0.0 | -2.9 | -1.3 | -1.7 | -1.5 | -1.5 | -1.6 | ||||||
| 4 | Primary deficit | -3.9 | -1.9 | -1.1 | 0.4 | -1.0 | -3.4 | -2.4 | -2.4 | -2.4 | -2.4 | -2.4 | ||||||
| 5 | Revenue and grants | 48.4 | 49.1 | 50.1 | 46.7 | 46.4 | 47.6 | 45.5 | 44.5 | 43.5 | 42.5 | 41.5 | ||||||
| 6 | Primary (noninterest) expenditure | 44.5 | 47.2 | 48.9 | 47.1 | 45.5 | 44.2 | 43.2 | 42.2 | 41.2 | 40.2 | 39.2 | ||||||
| 7 | Automatic debt dynamics 2/ | -3.3 | 7.0 | 4.4 | 2.2 | 1.3 | 0.0 | 0.6 | 0.0 | 0.2 | 0.2 | 0.1 | ||||||
| 8 | Contribution from interest rate/growth differential 3/ | -2.6 | 4.3 | 2.4 | 4.3 | 1.7 | 0.0 | 0.6 | 0.0 | 0.2 | 0.2 | 0.1 | ||||||
| 9 | Of which contribution from real interest rate | 4.4 | 4.1 | 1.3 | 6.1 | 6.3 | 5.1 | 4.7 | 3.9 | 3.9 | 4.0 | 4.0 | ||||||
| 10 | Of which contribution from real GDP growth | -7.1 | 0.2 | 1.1 | -1.8 | -4.5 | -5.1 | -4.1 | -3.9 | -3.8 | -3.8 | -3.9 | ||||||
| 11 | Contribution from exchange rate depreciation 4/ | -0.7 | 2.7 | 1.9 | -2.1 | -0.4 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | ||||||
| 12 | Other identified debt-creating flows | -0.7 | 0.1 | 3.0 | 0.4 | -0.4 | 0.6 | 0.6 | 0.8 | 0.8 | 0.8 | 0.7 | ||||||
| 13 | Privatization receipts (negative) | -1.3 | -0.5 | -0.6 | 0.0 | -0.1 | -0.1 | -0.5 | -0.4 | -0.4 | -0.4 | -0.4 | ||||||
| 14 | Recognition of implicit or contingent liabilities | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.2 | 0.2 | 0.2 | 0.1 | 0.1 | ||||||
| 15 | Other (specify, e.g. bank recapitalization) | 0.6 | 0.6 | 3.6 | 0.4 | -0.3 | 0.7 | 0.9 | 1.0 | 1.0 | 1.0 | 1.0 | ||||||
| 16 | Residual, including asset changes (2-3) | -1.8 | -0.3 | 2.4 | -1.0 | -1.0 | -0.8 | 0.1 | 0.0 | 0.2 | 0.2 | 0.2 | ||||||
| Public sector debt-to-revenue ratio 1/ | 187.7 | 195.2 | 208.7 | 227.8 | 227.0 | 213.9 | 221.0 | 222.3 | 224.5 | 226.7 | 228.8 | |||||||
| Gross financing need 5/ | 12.0 | 14.4 | 15.5 | 18.1 | 16.7 | 14.4 | 13.1 | 14.3 | 14.2 | 14.0 | 13.9 | |||||||
| in billions of U.S. dollars | 13.9 | 16.3 | 16.2 | 20.0 | 19.5 | 10-Year | 10-Year | 17.8 | 17.1 | 19.9 | 20.9 | 22.0 | 23.1 | |||||
| Historical | Standard | Projected | ||||||||||||||||
| Key Macroeconomic and Fiscal Assumptions | Average | Deviation | Average | |||||||||||||||
| Real GDP growth (in percent) | 7.7 | -0.3 | -1.2 | 1.7 | 4.4 | 3.4 | 2.8 | 5.2 | 4.3 | 4.2 | 4.1 | 4.1 | 4.3 | 4.2 | ||||
| Average nominal interest rate on public debt (in percent) 6/ | 6.5 | 6.5 | 5.8 | 5.9 | 6.0 | 6.4 | 0.4 | 5.9 | 6.1 | 6.2 | 6.3 | 6.4 | 6.5 | 6.3 | ||||
| Average real interest rate (nominal rate minus change in GDP deflator, in percent) | 4.9 | 4.6 | 1.4 | 5.9 | 6.1 | 1.3 | 3.9 | 5.2 | 4.9 | 4.2 | 4.3 | 4.4 | 4.5 | 4.5 | ||||
| Nominal appreciation (increase in US dollar value of local currency, in percent) | 2.8 | -8.5 | -6.8 | 8.2 | 1.6 | -3.3 | 6.7 | -0.1 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 | ||||
| Inflation rate (GDP deflator, in percent) | 1.5 | 1.9 | 4.4 | 0.0 | -0.2 | 5.1 | 4.1 | 0.7 | 1.2 | 2.0 | 2.0 | 2.0 | 2.0 | 1.9 | ||||
| Growth of real primary spending (deflated by GDP deflator, in percent) | 4.6 | 5.9 | 2.4 | -2.1 | 0.8 | 3.1 | 3.2 | 2.2 | 1.9 | 1.8 | 1.6 | 1.6 | 1.7 | 1.7 | ||||
| Primary deficit | -3.9 | -1.9 | -1.1 | 0.4 | -1.0 | -1.7 | 1.2 | -3.4 | -2.4 | -2.4 | -2.4 | -2.4 | -2.4 | -2.4 | ||||
| A. Alternative Scenarios | II. Stress Tests for Public Debt Ratio | Debt-stabilizing primary balance 10/ | ||||||||||||||||
| A1. Key variables are at their historical averages in 2006–10 7/ | 101.8 | 98.7 | 95.8 | 93.1 | 90.5 | 87.9 | -1.1 | |||||||||||
| A2. No policy change (constant primary balance) in 2006–10 | 101.8 | 99.6 | 96.9 | 94.6 | 92.2 | 89.7 | 0.8 | |||||||||||
| B. Bound Tests | ||||||||||||||||||
| B1. Real interest rate is at baseline plus one standard deviations | 101.8 | 102.5 | 102.8 | 103.4 | 104.0 | 104.5 | 2.7 | |||||||||||
| B2. Real GDP growth is at baseline minus one-half standard deviation | 101.8 | 102.7 | 103.7 | 105.6 | 108.1 | 111.1 | 2.4 | |||||||||||
| B3. Primary balance is at baseline minus one-half standard deviation | 101.8 | 101.3 | 100.3 | 99.6 | 98.9 | 98.1 | 0.8 | |||||||||||
| B4. Combination of B1-B3 using one-quarter standard deviation shocks | 101.8 | 102.6 | 103.0 | 103.7 | 104.4 | 105.0 | 2.5 | |||||||||||
| B5. One time 30 percent real depreciation in 2006 9/ | 101.8 | 112.1 | 110.4 | 109.2 | 107.9 | 106.5 | 0.8 | |||||||||||
| B6. 10 percent of GDP increase in other debt-creating flows in 2006 | 101.8 | 110.7 | 109.0 | 107.8 | 106.5 | 105.1 | 0.8 | |||||||||||
Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.
Derived as [(r -π(l+g) -g + αε(l+r)]/(l+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).
The real interest rate contribution is derived from the denominator in footnote 2/as r - π (1+g) and the real growth contribution as -g.
The exchange rate contribution is derived from the numerator in footnote 2/ as αε(l+r).
Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.
Derived as nominal interest expenditure divided by previous period debt stock.
The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.
The implied change in other key variables under this scenario is discussed in the text.
Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).
Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.
APPENDIX II
Negative Income Tax 1
There are a number of critical considerations to be considered in contemplating a NIT. In general, the effectiveness of a NIT depends on:
Goals of the NIT. The two usual goals are to ensure adequate income for low earners and promote employment. The primacy given to each of these goals will influence the design of the NIT.
Interaction with social welfare, tax and labor market policies. If other social welfare benefits are dependent on income, then incentives to work created by an NIT may be offset by reductions in other benefits caused by an increase in income. In this case, the NIT could have negligible beneficial effects. The overall level of taxation is also important. The higher are existing marginal tax rates, the more costly it is to impose high phase-out rates.2 Labor market policies such as minimum wages must also be considered. High minimum wages mean that a greater proportion of workers are likely to be covered by the scheme resulting in a greater cost.
Tax administration and compliance. The cost of administering an NIT will depend on the level of filing and reporting, and system of assessment for the personal income tax.3 A further concern is the potential for noncompliance, particularly in systems based on self-assessment.
There are also a number of difficult design issues that need to be considered, including who is eligible—single workers, families, families with children, self-employed; whether benefits should be more generous for larger families; whether to have a threshold for eligibility, and if so, whether to specify it in terms of earnings or hours worked; and the mechanism and timing of providing the credit. Those with low incomes will often move in and out of employment and their need for support will be highly volatile. It is necessary to match payments to these volatile levels of need without excessive administrative costs and without causing short term over or underpayments.
1/ Prepared by Peter Mullins (FAD).2/ Personal tax rates in Israel are higher and more progressive than in other countries, which means that in setting phase-out rates, care should be taken to avoid high marginal effective tax rates.3/ These costs could be substantial in the case of Israel given that about 50 percent of its workers do not file tax returns.References
Bayoumi, T., and D. Botman, 2005, “Jam Today or More Jam Tomorrow? On Cutting Taxes Now Versus Later,” in Canada—Selected Issues, IMF Country Report No. 05/116, by T Bayoumi and others (Washington: International Monetary Fund).
Broida, K., 2003, “The Effects of Demographic Trends on Long Run Public Spending,” Bank of Israel (Hebrew).
Elekdag, S., D Laxton,. and D. Rose, 2005, “Some Recent DSGE Modeling Work at the Fund to Support Analysis on the Israeli Economy” (unpublished; Washington: International Monetary Fund).
Hercowitz, Z. and M. Strawczynski, 2000, “Public-Debt/Output Guidelines: the Case of Israel,” Discussion Paper Series 2000.03 (Bank of Israel).
International Monetary Fund, 2004a, “Israel: report on Observance of Standards and Codes—Fiscal Transparency Module,” IMF Country Report No. 04/112 (Washington: International Monetary Fund).
International Monetary Fund, 2004b, IMF Country Report No. 04/158 (Washington: International Monetary Fund).
Strawczynski, M., and J. Zeira, 2002, “Reducing the Relative Size of Government in Israel after 1985,” in The Israeli Economy, 1985–1988: from Government Intervention to Market Economics, MIT Press (Cambridge, Massachusetts).
Prepared by Selim Elekdag, Natan Epstein, and Marialuz Moreno-Badia.
Forecast errors are defined as the difference between the reported actuals and budget projections. A negative (positive) value implies the outcome underperformed (exceeded) budget expectations.
The 1 percent rule refers to growth in real expenditure from budget to budget.
Subsidies to the business sector decreased significantly as part of the stabilization program.
Because U.S. aid has remained at US$3 billion dollars since 1985, its real value has declined since then, and its size relative to GDP fell dramatically to about 2 percent in 2004. In recent years U.S. aid to Israel has been reduced annually. In 2006 it will amount roughly to US$2.5 billion.
In this analysis, we assume that the subnational governments run a collective annual budget deficit of 0.5 percent of GDP, which is in line with the authorities’ projections.
For more details on these scenarios, see Appendix I.
In both scenarios, we assume that no new tax cuts will be introduced.
For details on the pension reform in Israel, see IMF (2004b).
For details on the model specification and calibration, see Elekdag, Laxton, and Rose (2005).
The structure of this model, however, does not make it suitable to analyze short-term dynamics.
According to Hercowitz and Strawczynski (2000): “The Maastricht guidelines of public-debt/output ratio of 60 percent is mentioned in the budget publications for the years 1997–2000 as important to achieve, and policymakers often refer to the Maastricht guideline as a model to imitate”.
The plan expands on some of the measures introduced in the 2003 tax reform. The key measures are (1) lowering the top marginal income tax rate from 49 percent to 44 percent by 2010; (2) cutting the corporate tax rate from 34 percent to 25 percent by 2010; (3) reducing the VAT rate from 17 percent to 16.5 percent; (4) establishing a uniform 20 percent capital gains tax rate; and (5) widening the tax base and strengthening enforcement through a proposal for taxing trusts.
These simulations consider only cuts in labor income taxes since cuts in corporate taxes yield similar results. See Bayoumi and Botman (2005) for a similar analysis of Canada.
Lump-sum transfers have no impact on incentives and allow us to focus on tax rate-related distortions. It is also important to highlight that, since the GFM is a perfect foresight model, the government knows the exact amount it needs to decrease taxes to offset the decline in transfers in order to keep the fiscal balance unchanged—including any endogenous effects whereby a decline in tax rates may actually increase the revenue intake of the government.
While such scenarios are clearly stylized, they help illustrate the effects of choosing to cut taxes or reduce debt in an intuitive manner. One reason to reduce government debt would be to prepare for the future pressures on government spending from an aging population.
