ISRAEL'S 2007 STATE BUDGET ATTEMPTS TO BALANCE

C O N F I D E N T I A L SECTION 01 OF 04 TEL AVIV 003960

SIPDIS

NEA/FO FOR DANIN; NEA/IPA FOR WILLIAMS, WAECHTER; EB/OMA
FOR GARRY; NSC FOR WATERS; TREASURY FOR HIRSON

E.O. 12958: DECL: 10/06/2016
TAGS: ECON EFIN IS PGOV
SUBJECT: ISRAEL'S 2007 STATE BUDGET ATTEMPTS TO BALANCE
WAR-RELATED COSTS WITH CONTINUED FISCAL RESTRAINT


Classified By: Economic Counselor William Weinstein for reasons 1.4 b a
nd d

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SUMMARY
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1. (U) Israel's 2007 state budget, as approved by the Cabinet
on September 12, totals approximately NIS 283 billion (USD 65
billion). This represents year-on-year real expenditure
growth of 3.3 percent over 2006, consisting of the previously
announced 1.7 percent increase plus an additional 1.6 percent
for war-related spending. Despite allocating an additional
NIS 900-995 million (USD 208-230 million) to ministers' pet
projects to secure the Cabinet's support for the budget, the
Ministry of Finance (MOF) has managed to maintain the
budget's 2007 deficit target of 2.9 percent of GDP. In
addition to making these allowances, the government also
appointed a Shas minister to a position within the MOF to
encourage the party's future support for the budget
legislation. The 2007 defense budget amounts to about NIS 48
billion (USD 11 billion) and includes an additional NIS 8.2
billion (USD 1.9 billion),allocated over three years, to
finance the refurbishment of the military after the Lebanon
conflict. The Bank of Israel (BOI) has tentatively endorsed
the 2007 budget and praised the GOI's efforts to continue
reducing Israel's public debt levels, but has echoed concerns
expressed by other financial analysts about the GOI's plans
to increase expenditure levels after 2007. End Summary.

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INCREASING EXPENDITURES BECAUSE OF THE WAR
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2. (U) Israel's 2007 state budget totals approximately NIS
283 billion (USD 65 billion) and is based on assumptions of
4.3 percent GDP growth in 2006 and 3.8 percent growth in

2007. (Note: The BOI forecasts GDP growth of 4.6 percent in
2006 and 4 percent in 2007. End Note.) According to the
MOF, the 2007 budget includes NIS 1.99 billion (USD 460
million) more in social spending than the 2006 budget. These
funds are divided among programs to boost employment
(including NIS 700 million - USD 162 million - for increasing
the minimum wage),increase welfare payments and National
Insurance Institute (NII) allowances, improve spending on
healthcare and the medication basket, expand educational
programs, and improve benefits for the disabled.


3. (U) The year-on-year real expenditure growth of 3.3
percent over the 2006 budget consists of the 1.7 percent
spending increase allowed for in the coalition agreements,
plus an additional 1.6 percent (NIS 4.5 billion or USD 1.05
billion) increase earmarked for financing expenses related to
the Lebanon conflict. In addition, the government plans an
additional .5 percent off-budget spending increase to fund
continuing disengagement-related expenses.


4. (U) The NIS 4.5 billion (USD 1.05 billion) addition to the
budget for war-related expenses will be divided between
military and civilian needs, with NIS 3.5 billion (USD 810
million) allocated to the Ministry of Defense (MOD) and NIS 1
billion (USD 232 million) designated for civilian use.
Another NIS 3.5 billion (USD 810 million) in civilian damage
payments should be reimbursed by the GOI's Property Tax and
Compensation Fund and, therefore, is not financed in the
budget. (Note: Israel's Property Tax and Compensation Fund
is financed by the revenues from a national property tax
levied by the Israeli Income and Property Tax Commission on
businesses. The commission then pays claims on property
damage that is the direct result of a hostile terrorist
attack on the basis of the market value of a property
immediately before the attack. End Note.)

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CUTTING TO KEEP DEFICIT IN CHECK
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5. (U) In order to finance both the regular and war-related
budget increases while still maintaining the 2.9 percent
deficit constraint, the GOI had to cut NIS 3.85 billion (USD
891 million) from other parts of the budget. Accordingly,
the GOI has frozen some NII payments, shelved plans to
improve Israel's rail system, postponed some elements of the
coalition agreements with Shas and the Pensioners Party, cut
other miscellaneous budget items, and shaved 2 percent from
some ministries' procurement budgets. Contrary to some press
reports, the GOI is not planning to cut child allowances and
other transfer payments but is delaying cost-of-living
increases in the allowances. (Note: This year, the GOI is
suspending a 1.65 percent inflation-linked increase in
transfer payments, for a savings of NIS 700 million (USD 162
million). End Note.) The GOI is hoping to fund additional
war-related compensation and rehabilitation programs with
donations from Jewish communities overseas, which Vice
Premier Peres, who is spearheading the fundraising effort,
estimates could amount to USD 300 million.


6. (U) The GOI so far has managed to uphold the 2007 deficit
target of 2.9 percent of GDP. It plans to increase spending
by 2.7 percent in 2008 (consisting of the 1.7 percent planned
increase plus an additional 1 percent, approximately NIS 2.2
billion (USD 509 million),for the defense budget) and return
to a "regular" 1.7 percent hike in 2009. The GOI estimates
the deficit target in 2008 will be 2.5 percent of GDP and 1.7
percent in 2009.

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GOI BUYS CABINET SUPPORT FOR THE BUDGET
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7. (U) In order to secure the Cabinet's approval of the 2007
budget legislation on September 12, the MOF allocated an
additional NIS 900-995 million (USD 208-230 million) in
funding for Cabinet ministers' pet projects. According to
the MOF, these additions do not break the 1.7 percent
expenditure increase constraint or the 2.9 percent deficit
target. (Comment: We presume this means that no other
off-setting is required in order to keep the budget within
the framework, though these outlays do reduce the amount of
funding the MOF has available for buying support in future
rounds of debate on the budget in the Knesset Finance
Committee and the plenary. End Comment.) According to the
MOF, these additional funds will be financed from reserves
(pools of funds kept by the MOF to be used to buy support for
the budget later in the approval process) and funds
originally intended to aid the post-war rehabilitation of
northern Israel.


8. (U) In exchange for the Cabinet's support of the budget,
the MOF allocated additional funding to culture, education,
allowances to the elderly, immigrant absorption, agriculture,
public housing, the police and prisons service, and tourism.
In addition, the GOI added NIS 150 million (USD 35 million)
to the budget for the development of the Negev, after Peres,
whose office directs the GOI's efforts to develop the Negev
and Galilee, threatened to vote against the budget if the
Negev received no development funds.


9. (U) To maintain the budget framework while making these
additional expenditures, the budget for the Chief Scientist's
Office in the Ministry of Industry, Trade, and Labor was cut
by NIS 150 million (USD 35 million) and NIS 150 million (USD
35 million) worth of coalition promises to Shas were
postponed until 2008. (Note: Shas's four Cabinet members
opposed the budget in the Cabinet vote on September 12. End
Note.) To encourage the party's support of the budget in the
future Knesset plenum votes, the GOI agreed to make Shas
Knesset member (MK) Mehulam Nahari a minister in the MOF with
authority for Haredi education and welfare issues. The
future support of the Pensioners Party was encouraged by
Prime Minister Olmert's agreement to establish a Pensioners
Ministry, as promised to the party in coalition agreements,
as a unit within the Prime Minister's office with an initial
budget of NIS 15 million (USD 3.5 million).

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DEFENSE GETS MORE MONEY
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10. (U) The 2007 defense budget amounts to about NIS 48
billion (USD 11 billion),roughly 17 percent of the total
state budget for the year. To finance the refurbishment of
the military after the Lebanon conflict, the defense
establishment will receive an increase of NIS 8.2 billion
(USD 1.9 billion),allocated over three years. In addition,
part of the funds allotted to the defense budget include a
NIS 1.15 billion (USD 266 million) supplement described by
the GOI as "compensation" to the defense establishment for
U.S. disengagement assistance that never materialized, and an
extra NIS 1 billion (USD 231 million) for rehabilitating
northern Israel after the Lebanon conflict. (Note: The
Lebanon war forced the GOI to scuttle plans to cut the
defense budget by some NIS 2 billion (USD 465 million) over
the next few years in order to free up funds for increased
social welfare spending. End Note.) Olmert, for now, has
delayed judgment on a post-war MOD request to increase the
base defense budget by NIS 30 billion (USD 6.9 billion) over
three years to improve the IDF's preparedness and training.
Instead, Olmert has appointed a committee, headed by his new
economic advisor, Professor Manuel Trajtenberg, to examine
the MOD's demands.

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BANK OF ISRAEL TENTATIVELY ENDORSES 2007 BUDGET
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11. (U) BOI Governor Fischer on September 12 told reporters
that the budget approved by the Cabinet is "basically a good
one." Despite his overall satisfaction with the legislation,
Fischer said he would have preferred that the Cabinet offset
increased expenditure by raising the Value Added Tax (VAT) to
16.5 percent, which would have augmented the government's
revenues by NIS 3.5 billion (USD 810 million),and that the
war-related spending increases be limited to one year. The
BOI is cautioning the government against increasing the
deficit and, as a result, the country's already very high
debt burden, since it could undermine investors' confidence
in the economy and possibly lead to an increase in Israel's
country risk. This could push up medium- and long-term
interest rates in the capital markets and, in turn, increase
financing costs for the government, business sector, and
households. This could be further exacerbated by the BOI's
trend of increasing interest rates in line with Federal
Reserve interest rate decisions.

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MIXED REACTION TO BUDGET OUTSIDE THE GOI
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12. (U) Following the Cabinet's approval of the budget,
international credit rating agency Fitch said that despite
concern about the increasing expenditure levels in the
budget, Israel would still be able to continue reducing its
debt burden as a share of GDP and thereby maintain or improve
its sovereign rating. The agency said that although progress
in reducing Israel's public debt would slow due to the cost
of the war in Lebanon, it would nevertheless continue,
provided the fiscal framework endorsed by the Cabinet is
upheld. Fitch cautioned, however, that the need to modify
the budget to accommodate the cost of the Lebanon war
emphasizes once more the vulnerability of Israel's public
finances to unexpected and costly shocks emanating from the
security situation. This vulnerability, in Fitch's view,
means Israel's high public debt ratio is even more of a
constraint on its rating than simple comparison with rating
peers would suggest.


13. (U) Fitch reported that Israel's overall public debt
level fell sharply in the first half of 2006, reaching 91
percent of GDP in June, a five-year low, compared to 97
percent of GDP at the start of the year. Fitch now expects
this ratio to increase slightly to 93-94 percent of GDP by
the end of 2006 as the budget deficit increases and economic
growth slows as a result of the Lebanon war. In 2007, Fitch
expects Israel's public debt to decline towards 90 percent of
GDP, provided the fiscal parameters adopted by the Cabinet
are maintained.


14. (U) Ratings agency Standard and Poor's (S&P),in
critiquing the budget passed by the Cabinet, also emphasized
the importance of Israel continuing to reduce its public debt
levels despite the increased expenditures necessitated by the
Lebanon war. Accordingly, for S&P, the anchor for fiscal
policy in 2007 lies in the deficit ceiling of 2.9 percent of
GDP and a return to a deficit of 1 percent by 2009, despite
the 3.3 percent real expenditure increase in 2007. At the
International Monetary Fund (IMF) meetings in late September,
S&P analysts expressed concern about Israel's plans to
increase expenditures in both 2007 and 2008, remarking that
the GOI seems prone to finding a reason for 'one-time'
expenditure increases year after year. S&P analysts said
such a trend eventually could have a negative influence on
Israel's credit rating.

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NEXT STEPS
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15. (C) The GOI probably will bring the budget to the Knesset
for a first reading by October 31. After the Knesset first
approves the legislation, the budget and the accompanying
Economics Arrangements Bill will be returned to the Finance
Committee, where additional changes will undoubtedly be made.
Following the Finance Committee's final approval, the bills
will return to the Knesset plenum, where the second and third
readings will take place with the goal of passing the
legislation by December 31, 2006. If the Knesset's approval
cannot be secured by the end of the year, the GOI has until
March 31, 2007, to pass the budget, or the government will be
dissolved and new elections held if another coalition cannot
be formed.

COMMENT
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16. (C) The rest of the approval process for the budget and
the Economic Arrangements Bill that accompanies it will not
be easy. Despite pledges before the IMF meetings in late
September to maintain the government's commitment to
continuing fiscal restraint and structural reforms, Finance
Minister Hirchson will have a difficult time fending off
calls from ministers to increase their own budgets, from
partners in the Cabinet to uphold their original coalition
agreements, and from the organized labor unions of the
Histadrut to suspend privatization and restructuring plans.
It is safe to assume many other changes will be made to the
budget before it passes, and the high price paid for the
Cabinet's approval on September 12 may leave the MOF with few
remaining funds to buy the support of wavering MKs. End
Comment.

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