Shorter Papers and Comments

Fiscal Restraint and Social Expenditure: Israel’s Experience in the 1980s
Author: Yaakov Kop1
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

The development of Israel’s government social expenditures during the economic stabilization period of the mid-1980s is analyzed, with specific-reference to the changing needs for such expenditure arising from demographic changes. The results reveal a real cut in direct services. The implicit strategy relied, for some two to three years, on restraint of total expenditures on direct services in real terms, with real erosion in services arising from growth in the size of beneficiary groups. [JEL 322]

Abstract

The development of Israel’s government social expenditures during the economic stabilization period of the mid-1980s is analyzed, with specific-reference to the changing needs for such expenditure arising from demographic changes. The results reveal a real cut in direct services. The implicit strategy relied, for some two to three years, on restraint of total expenditures on direct services in real terms, with real erosion in services arising from growth in the size of beneficiary groups. [JEL 322]

Israel’s economic environment in the first half of the 1980s was characterized by high inflation, stagnant economic growth, and a deteriorating balance of payments. Inflation gradually became a dominant concern as it became more hyperinflationary in character (Barkai (1987. p. 3)).

Curbing inflation thus emerged in the mid-1980s as the principal target of economic policy. In November 1984 a “package deal.” consisting of agreed price controls and a wage freeze, was signed by the government, the trade unions, and the employers’organizations. When this agreement expired, another followed. In a sense these agreements were an overture to the stabilization program adopted in July 1985 (see Bruno and Piter-man (1987. p. 4)), which called for a drastic cut in the government’s budget deficit, which amounted to 17 percent of gross national product (GNP) in 1984 (Barkai (1987. p. 15)).1 Government spending was sharply cut, and tax revenue increased. The current deficit turned into a surplus in the second half of 1985, reaching 6 percent of GNP (the domestic component at 1 percent, and the external component at 5 percent; Israel, Bank of Israel (1987. p.63)).

The social implications of a restrictive policy stance are likely to have three dimensions. First, changes in the tax system will affect the “fiscal welfare” of the population. Second, reduced commodity subsidies will have an impact on the consumption of necessities. Third, expenditures on social services may be restrained, particularly those on transfer payments through the social security system and direct services (for example, education and health). This paper concentrates on the third dimension, examining the impact of fiscal restraint on government expenditures on social services.

I. Expenditure Estimates in Real Terms

To evaluate the demographic pressures on social services, the increase in expenditures needed to compensate for population growth and changing age structure are estimated. When age-specific, service-specific expenditures are held constant and increasing social needs attributable to demographic causes are taken into account, total social expenditure should have grown to a level of 108 in index terms (1980 = 100) in 1984, to 110 in 1985, and to 113 in 1986 (Table 1). Comparison of these results with the amounts actually spent in recent years shows that in 1984, before the new economic policy was implemented, real expenditure reached an index of 114 (1980= 100), thus exceeding the demographically “justified” figure (108) by 6 percent. The next year, 1985, was the year during which a major budget cut was implemented. The level of real expenditure declined to 106—that is, an 8 percent decline from the preceding year. In subsequent years, however, social expenditure in real terms regained its previous levels, rising to 116 in 1986 and to 121 in 1987.

Table 1.

Projected and Actual Government Social Expenditure in Israel, 1984-87

(Index: 1980= 100)

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Source: Author’s calculations. For an explanation of procedures, see Kop (1988).

CPI, deflated by the consumer price index; GCP, deflated by the government civilian consumption price index.

What explains these fluctuations? One major factor to consider is the deflator used to estimate the real outlays. The expenditure estimates mentioned above were deflated by the consumer price index, which provides a measure of the change in the real opportunity cost to private consumers of the resources required to finance public expenditure. An alternative deflator might have been the increase in the cost of production of social services, with the change in the cost of the various inputs to the production process taken into account. A government-civilian consumption price index—for the deflation of expenditures on education, health, and other direct services—combines changes in the average wage per employee in the public sector with price changes for goods purchased by the government sector.

This procedure yields estimates of the volume of services provided to the public. Transfer payments to families and individuals are still deflated by the consumer price index, a yardstick that reflects the cost of goods purchased by the recipients of transfer payments, thus providing an estimate of the volume of services effectively provided through transfer payments.

Estimates based on this alternative set of deflators suggest an actual real expenditure index in 1984 of 106 (1980= 100), lagging 2 percent behind the 8 percent increase warranted by demographic requirements (Table 1). Much of the higher increase (114) implied by the earlier estimate (deflated by the consumer price index only) appears to have reflected the rising real wages of public sector employees, and only part of the increase facilitated an increase in the volume of services. In other words, in 1980-84, because of wage increases in the public sector, a real budget increase of 14 percent (1984 over 1980) was needed to increase the real volume of services by only 6 percent.

In 1985 the trend was reversed. As part of the new economic policy, a drastic wage cut was executed, inducing a 7 percent decline in real expenditures (using the consumer price index deflator); this time, however, the reduced budget provided a 3 percent increase in the volume of social services, bringing the volume index of expenditures almost to the “demographically projected” level.

Because the government and the labor unions agreed that the wage cut was to be temporary, this development was reversed in 1986. Restoring the average real wage called for an increase of the real budget by almost 10 percent (using the consumer price index deflator), but corresponding to an increased volume of services of less than 3 percent. Preliminary figures for 1987 indicate that this trend continued, and at an even stronger pace—the level of actual expenditure is estimated to have risen by about 4-5 percent (depending on the deflator), significantly in excess of the increase in demographically warranted expenditures (less than 2 percent).

II. Services in Kind and in Cash

The above analysis relates to aggregate government social expenditure. The picture of developments in social expenditure becomes more complicated when these totals are disaggregated into the different social service and transfer programs. Major differences are revealed when a distinction is made between income-maintenance payments (in cash) and direct services (in kind). As Table 1 indicates, demographic factors should have led to a 10 percent increase in income-maintenance expenditures between 1980 and 1985. whereas real expenditure rose by approximately 30 percent over the period. This trend continued in 1986 and 1987.

The opposite is true for direct expenditures providing services in kind. By 1984, such social services increased in real terms by 11 percent over the 1980 expenditure, but only because of real wage increases: the volume of services appears to have remained largely unchanged. Moreover, per capita outlays appear to have declined, as reflected in the increase in real projected expenditures needed as a result of demographic changes. This divergence between the growth in demographically required expenditure and the real decline in total outlays was characteristic of the 1984-87 period.

III. Budget Cuts and Cost Containment

An evaluation of the performance of fiscal policy based on budget restraint has to consider the movement of actual outlays relative to the amount that would be required if account is taken of changes in the population—its overall size as well as its age structure. The underlying assumption is that budget planning, while aiming at various fiscal policy goals, should consider the changing need for services.

An illustration of such a perspective can be found in Table 2. which computes a ratio between actual and demographically projected outlays.2 At an aggregate level, actual and projected social expenditures were relatively balanced in 1984, as indicated by an index of 99 for the computed ratio. This balance implies that, even before the new economic policy was adopted, the relative budget was restrained. For direct services the situation was less favorable: the index was only 92 in 1984, and it deteriorated further by 1986. bringing actual expenditure to only 86 percent of that projected by demographic needs.

Table 2.

Relative Development of Actual Versus Projected Government Social Expenditure, 1984-87

(Index = 100, when actual equals projected)

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Source: See Table 1.

This decline was due primarily to budget restraint in the education sector, where the relative level of expenditure declined from 96 percent of the demographically projected amount in 1984 to 84 percent in 1986 (although it was expected to rise to 87 percent in 1987). In contrast, in the health sector, the level was quite steady at 88-89 percent in 1984-86. although a decline to 83 percent was expected in 1987.

Social transfers tell a different story. Already by 1984 the growth of actual payments for income maintenance had exceeded the demographically projected figure by 12 percent. This relativity index rose in 1986 and 1987 to 130 and 140, respectively. This development contributed to a major change in the mix of in-kind and in-cash social service outlays; the in-cash share grew from one third in 1979 to almost half of the total by 1987.

IV. Share of Social Services in GNP

The analysis above has focused wholly on government expenditures, neglecting changes in private sector outlays. Using a broader measure, such as the total share of GNP allocated to a particular social service sector, may, for instance, expose a shift in the financing of services from the public to the private sector as the governments involvement is reduced. This section examines the two “direct” social services, education and health.

Education

In the 1970s Israel, like most Western countries, witnessed a rapid expansion of all social services, including education. The share of GNP devoted to the education sector increased less than the share of other services, but still this share rose from 7.4 percent in 1970 to 8.6 percent in 1979. Because the share of the school-age population did not increase significantly, one might deduce that the increasing share of education in GNP reflected a rising cost per recipient. This, however, is not the case, since enrollment rates rose at the same time.

The share of education in GNP rose further in the 1980s (after some decrease between 1977 and 1980), but preliminary estimates for 1985 and 1986 indicate a clear reduction—to 7.6 percent and 7.8 percent. respectively.3 This decrease might be explained in part by the decline in the government’s share in financing national expenditure on education, which fell from 75 percent in 1979-82 to 69 percent in 1983 (no later estimates are yet available, but it is conceivable that the trend has continued).

Government expenditure on education as a percentage of total gross domestic product (GDP) went down from 5.3 percent in 1980 to 4.6 percent in 1986 (Table 3). Comparison with the results of Heller, Hemming, and Kohnert (1986) for the seven major industrial countries indicates that, for education, the rate in Israel in 1980 (5.3 percent) was lower than that in Canada (8.1 percent), the United States (6.6 percent), and Japan (6.3 percent); it was similar to that of the United Kingdom, and higher than that of France. Germany, and Italy. Because the share of children in Israel’s population is larger than in other Western countries, this comparison suggests that Israel may lag behind the others in terms of GDP spent on education per recipient.

Table 3.

Share of Government Social Expenditure in GDP, 1980-86

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Sources: Author’s calculations based on the following: Israel, Central Bureau of Statistics, Statistical Abstract of Israel (various years) and Statistical Bulletins (various issues); Israel, Ministry of Finance, The Account ant-General, Annual Report (various years): and Israel, Ministry of Finance, Bureau of the Budget. Budget Law 1987/88.

Health

Government expenditure on health increased by a rate less than that warranted by demographic changes (see Table 2). National expenditure figures imply that this was only partially offset by shifting the financing to the private and the nonprofit sectors. The share of total GNP devoted to health increased from 7.1 percent in 1980 to 7.2 in 1982, to 7.3 in 1982-83, and to 7.5 in 1984. A reversal of the trend in 1985 restored the absolute level of the share of health expenditure in GNP to the rate that prevailed in 1980. If this rate is still in force (there are no estimates for later than 1985), then the Israeli economy will have succeeded in containing health service costs, a common target of almost all Western economies.

During the 1980s there was a clear shift in the financing of health services from the government to the private sector. Financing by the government (including local authorities) decreased from 59 percent of total national expenditure on health in 1980 to 53 percent in 1983-85 (with a temporary reduction to 51 percent in 1984).

Government expenditure on health as a proportion of total GDP fluctuated between 3.6 and 3.2 percent during 1980-86 (Table 3). The gap between Israel and the other Western countries is wider in health than in education, possibly reflecting structural and organizational aspects of the Israeli medical care system. Most of the Israeli population is covered by a comprehensive health plan (sick funds) through the major labor unions, which is financed through taxation of employers and employees. In many ways this plan is comparable to a national health service, such as that of the United Kingdom. It is publicly owned and administered, although it is not a government service. If the cost of the sick funds is added to government outlays on health, the share of total health expenditure in GDP would approach that of the United Kingdom. Japan, and, possibly, Italy. Note, however, that here the demographic structure leads to the opposite of what was observed with respect to education: the share of the elderly, who are intensive consumers of health services, is smaller than that in European countries, although not much less than that in the United States and Canada.4

V. Concluding Remarks

One of the lessons that might be learned from the Israeli experience is the strategy of budget cuts. As shown in this paper, if measured properly—taking demographic structure into account—the direct services were cut, on an age-adjusted per capita basis, by some 15 percent. Such a reduction would be quite difficult to introduce formally or explicitly. The implicit strategy relied on the restraint, for some two to three years, of total expenditures on direct services in real terms—with real erosion in services arising from the growth in size of the beneficiary groups. Holding total expenditure constant for two to three years, while the specific age group continued to grow, eroded expenditure per recipient or per capita to a desired level. This strategy proved attainable, even though it took more time than an alternative shock-like strategy that would have had little, if any, chance of being implemented.

REFERENCES

  • Barkai, Haim, “Israel’s Attempt at Economic Stabilization,” Jerusalem Quarterly (Jerusalem), No. 43(Summer 1987).

  • Bruno, Michael, and Sylvia Piterman, “Israel’s Stabilization: A Two-Year Review,” paper presented at the Conference on Inflation Stabilization, Toledo, Spain, June 1987.

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  • Heller, Peter S., Richard Hemming, and Peter W. Kohnert, Aging and SocialExpenditure in the Major Industrial Countries, 1980-2025, Occasional Paper 47 (Washington: International Monetary Fund, 1986).

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  • Israel, Bank of Israel, Annual Report 1986 (Jerusalem, May 1987).

  • Israel, Bank of Israel, Central Bureau of Statistics, Statistical Abstract of Israel and StatisticalBulletin (Jerusalem,various years).

  • Israel, Bank of Israel, Ministry of Finance, The Accountant-General, Annual Report (Jerusalem, various years).

  • Israel, Bank of Israel, Ministry of Finance, Bureau of the Budget, Budget Law 1987/88 (Jerusalem).

  • Kop, Yaakov, “Fiscal Restraint, Demographic Change, and Social Services in Israel, 1985-87, and Application of the Methodology to Latin America,” IMF Working Paper WP/88/58 (unpublished; Washington: International Monetary Fund, 1988).

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Mr. Kop is Director of Research at the Center for Social Policy Studies in Israel. This paper is part of a longer study (Kop (1988)) prepared while he was a visiting scholar in the Fund’s Fiscal Affairs Department in November-December 1987.

1

All references to years are to fiscal vears (from April 1 to the following March 31).

2

The figures in Table 2 were obtained by dividing the actual index figures in Table 1 by the projected ones.

3

Government statistics in the 1980s switched to gross domestic product (GDP) instead of GNP. The relevance of this shift is negligible.

4

See Heller, Hemming, and Kohnert (1986) for data on social expenditures in the G-7 (Group of Seven) countries.