GOI CONSIDERS 2008 BUDGET, COALITION PARTNERS

C O N F I D E N T I A L TEL AVIV 002446

SIPDIS

SIPDIS

E.O. 12958: DECL: 08/05/2017
TAGS: EFIN ECON MASS MCAP EAID PGOV PREL IS
SUBJECT: GOI CONSIDERS 2008 BUDGET, COALITION PARTNERS
SHARPEN THEIR KNIVES

REF: A. TEL AVIV 2365

B. TEL AVIV 2158

Classified By: Ambassador Richard H. Jones for reasons
1.4 (b/d).


1. (C) SUMMARY: On August 5, the Ministry of Finance (MOF)
formally presented the 2008 draft budget to the Government of
Israel (GOI). Prime Minister Ehud Olmert and newly-appointed
Finance Minister Roni Bar-On have made strong public
statements on their commitment to maintaining fiscal
discipline, and initial indications are that the budget
preserves strict limits on spending. Increases for defense,
education, welfare, and wages are offset by cuts to other
sectors. Given the strong performance of Israel's economy,
the 2008 budget is expected to lower debt and reassure
investors and creditors. The GOI is already encountering
strong opposition, however, from those who argue that high
revenues merit increased investment in defense and social
services. Chief among the critics is Labor Party leader and
Minister of Defense (MOD) Ehud Barak, who will likely use the
budget debate to raise his profile in preparation for future
elections. Barak and others have called on the GOI to raise
the expenditure limit, and it remains to be seen whether
Olmert can withstand pressure from governing coalition
partners and various interest groups -- including the
military. MOF Director General Yarom Aviav said that in
complying with loan guarantee agreements with the USG, excess
revenue would be used to reduce debt. Some economists warn
that a sharp increase in spending at this time could send a
negative signal to markets and damage Israel economic
performance. END SUMMARY.

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Economic Success Creates Pressure to Spend
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2. (C) The GOI is heading into the 2008 budget season with
strong economic indicators. Despite the problems of the past
year, including inter alia the inconclusive war in Lebanon,
scandals at the Finance Ministry, and weak public support for
the Olmert government, the BOI forecasts 5.1 percent gross
domestic product (GDP) growth for 2008. The business sector
is growing at a rate of 6-6.5 percent. Israel continues to
register a strong current-account surplus driven by hi-tech
exports and services, Deficits have declined to 1.5-2.0
percent of GDP due to a consistent period of fiscal
discipline. The strength of the economy and high revenues
have prompted Israel's many interest groups and political
parties to advocate for increased spending. This comes at
time when the economy is entering an inflationary cycle, with
higher interest rates and a jittery stock market (ref A). A
recent credit analysis by Standard and Poor's took the
unusual step of linking Israel's credit rating to expenditure
growth, warning that increased spending in 2008 could lower
Israel's favorable score.


3. (C) The MOF budget proposal maintains a 1.7 percent
ceiling on expenditure growth, designed to reduce the
debt-to-GDP ratio to 82 percent in 2008. The total budget is
calculated at NIS 311.6 billion (USD 72.47 billion) including
a 1.6 percent deficit. Despite increased spending in some
sectors, the MOF took a firm stand on controlling
expenditures with proposed cuts worth NIS 6 billion (USD 1.39
billion). Michal Finkelstein, Chief of Staff to the MOF
Director General, explained to Econoff and visiting Treasury
Department International Economist Michael Hirson that the
GOI will officially consider approval of the MOF's draft
budget on August 12, after which it will be presented to the
Knesset. Despite the inevitable negotiations involved in
this process, Finkelstein insisted that Olmert and Bar-On
have no intention of loosening the purse-strings.


4. (C) Gil Bufman, Senior Vice President and Chief Economist
for Bank Leumi, was more skeptical on this point. In a
meeting with Hirson and Econoff, Bufman said that given
increased security concerns and the weakness of the current
government, he expected the spending ceiling to increase to
2.2 percent. He was doubtful that Bar-On, with little
experience in economics, would be an effective force for
fiscal restraint. Bufman noted that to some extent, the MOF
had already relaxed fiscal discipline by choosing a
relatively optimistic revenue forecast of 4.2 percent as the
basis for budget calculations, leaving little room for a
positive surprise in revenues. In contrast, MOF calculated
the 2007 budget based on 3.8 percent growth -- at the low end
of economic estimates. Aviav told EconCouns that excess
revenue is intended to reduce the debt-to-GDP ratio.

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Pressures on Expenditures: Military First in Line
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5. (C) MOD demands for increased funding are a normal
occurrence in the Israeli budgeting process, but recent
developments -- the war in Lebanon and the appointment of a
strong Minister of Defense in Barak -- give them even greater
weight. The 2008 budget promises an NIS 3 billion (USD 697
million) increase in defense spending for a total of NIS 50.5
billion (USD 11.74 billion). This includes NIS 1.3 billion
(USD 302 million) for implementing the recommendations of the
Brodet Committee (ref B). Barak has indicated on several
occasions, however, that these measures are insufficient to
improve the preparedness of the Israel Defense Forces, and
demanded an additional NIS 6 billion (USD 1.4 billion) for

2008. The details of the defense budget remain largely
opaque, involving various manipulations of future budgets,
expenditures conditioned on arms sales, and the expected flow
of FMF assistance from the United States. Some items remain
entirely off-budget, including one-time expenditures of NIS
2.2 billion (USD 511 million) for the Lebanon War and NIS 1.1
billion (USD 256 million) for Gaza disengagement.


6. (C) Dr. Michael Sorel, Chief Economist of Harel Insurance
and Finance (and a former MOF official),said that surplus
revenues for 2007 were used to cover these additional items
while preserving the 1.7 percent ceiling. In Sorel's view,
this was a responsible short-term solution to a national
emergency, but in the long-term the MOD must adopt a more
rational budgeting process. Karnit Flug, Director of
Research at the Bank of Israel and a member of the Brodet
Committee, said that the GOI will address this problem by
setting aside NIS 800 million per year for emergency
situations, releasable only with GOI approval. If the funds
are not used by the end of the budget cycle, they are
reinvested in armament or other essential security needs.

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Civilian Sectors Resist Cuts, Demand Increases
-------------- -


7. (C) The MOF budget proposal includes a six percent budget
cut across the board in all ministries. The MOF outlined
approximately NIS 6 billion (USD 1.4 billion) in specific
spending cuts, to include reductions in water subsidies and
reduced investment in transportation infrastructure, and
proposed a service charge for housekeepers on health and
social security. There are additional indications that the
Prime Minister's Office will seek to postpone commitments to
increase the minimum wage and improve the status of temporary
workers. The cuts are expected to meet fierce resistance
from Members of Knesset (MKs) when the budget reaches the
Knesset, with calls for increased spending for universities,
the elderly, health care, and minimum wage earners. Some
groups have already engaged in highly publicized battles with
the GOI over spending. Elderly holocaust survivors took to
the streets August 5 in front of the Prime Minister's
residence, protesting what they perceived to be a paltry
government stipend (the Hebrew daily Maariv reported that the
GOI will meet their demands). The Histadrut, Israel's
national labor federation representing 700,000 public sector
employees, launched a general strike in July, demanding a
10.4 percent wage increase retroactive to 2001. The two
sides finally agreed on an increase of five percent
stretching from 2005-2009, which was generally viewed as a
strong showing for Bar-On. Nevertheless, the wage agreement
creates additional pressure on the expenditure ceiling.

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Budget Process Pits Labor v. Kadima
--------------


8. (C) While some sectors face cuts, the three primary
ministries held by the Labor Party -- defense, social
welfare, and education -- are all slated for budget
increases. The MOF budget promises NIS 3 billion (USD 697
million) for education, NIS 1.9 billion (USD 442 million) for
welfare, and NIS 1.6 billion (USD 372 million) for
employment. (NOTE: Finkelstein made clear that the latter
remains a high priority for the Prime Minister, who has
promised to reduce poverty through an aggressive job creation
initiative. END NOTE.) Despite these concessions, Barak and
Labor are expected to offer strong opposition to the budget,
both within the government and on the Knesset floor. As
Defense Minister and future contender for the office of Prime
Minister, Barak has staked out a position in favor of
increased spending on defense and a minimum wage increase,
among other issues.


9. (C) Much depends on Barak's brinksmanship, said Sorel, and
whether he is willing to topple the government over the

budget. In an August 3 column in the daily newspaper
Haaretz, Yossi Verter commented that it is unlikely that
Barak would force new elections over the budget, but that he
would like to wrest as many concessions from Olmert as
possible to improve his standing with the electorate. In
Bufman's view, protracted uncertainty regarding the future of
this government is worse for the markets than early
elections. Investors would welcome more stable leadership,
said Bufman, as the current government has been largely
ineffective at implementing economic policy, and done little
in the way of reform.

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Debating the Expenditure Limit
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10. (C) Sorel argued that from a strictly economic
perspective, there is nothing wrong with exceeding the 1.7
percent ceiling. Several years ago, said Sorel, Israel's
public expenditure as a percentage of GDP was very high.
Following Likud Party leader Benjamin Netanyahu's tenure as
Finance Minister, however, and successive budgets with
limited expenditure increases, this is no longer the case.
With 4-5 percent GDP growth, argued Sorel, the expenditure to
GDP ratio is shrinking quickly and now stands at the median
of OECD countries. If one takes into account Israel's
disproportionately high military spending, then Israel now
has one of the lowest ratios among industrialized countries.
In addition, Israel now boasts low tax rates and declining
public expenditure as a percentage of GDP. In both political
and economic terms, said Sorel, Israel cannot be expected to
maintain the current spending limits for more than another
year or two. Sorel noted that even Olmert's Chief Financial
Advisor, Manuel Trajtenberg, is in favor raising the limit to
2.5 percent in 2008.


11. (C) The risk of increased spending is not immediate
fiscal damage, said Sorel, but that once the lid is off
spending will spiral out of control. According to Bufman,
the markets could react quite negatively to such a decision,
fearing "fiscal slippage" in the GOI's policy, the crowding
out of private bonds by an increase in public debt, and a
decline in Israel's credit rating. On the other hand, Sorel
warned that in the long run, an overzealous adherence to
expenditure ceilings can result in negative consequences for
budget transparency. Over time, the GOI will shift more
payments to the revenue side of the balance sheet by offering
tax refunds and incentives, thereby creating distortions in
real expenditure measures. The trick, said Sorel, is to
increase expenditures in a rational framework that does not
convey a lack of fiscal discipline to the markets.


12. (C) Bufman noted that over the next few years fiscal
discipline will be additionally challenged on the revenue
side by the absence of major privatization initiatives. The
privatization of the Haifa refineries produced NIS 7 billion
(USD 1.63 billion) in revenue this year, while only NIS 4.5
billion (USD 1.05 billion) is expected in revenue for the
coming year, including privatization of the remaining ten
percent of Bank Leumi and the Postal Bank. The GOI recently
released plans to privatize other sectors, including
electricity, but Bufman said this was several years off.
Bufman pointed to a number of sectors in which there is a
deep need for efficiencies and reform, including local
government, prisons, energy, and infrastructure. He also
warned that additional tax cuts promised by the government
would be a further blow to revenues. "There is so much to
do," said Bufman, "but this government is caught up in trying
to survive."

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Comment: FMF Expectations Complicate Budget Planning
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13. (C) The GOI's attempts to maintain fiscal discipline and
cut expenditures are ongoing, but the MOF's decision to
assume USD3 billion per year in FMF funding has put its
budget's credibility in doubt. GOI press leaks have already
indicated that the MOD will argue that any diminution in its
allocation would affect readiness and major weapons
purchases. It is hard to establish a baseline for targeted
military expenses since the MOD budgeting process is opaque.
In the past, the GOI has found funding alternatives to budget
shortfalls through increases in revenue growth and by taking
big-ticket items off-budget.

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