Funding the rising cost of Israel's defense expenses won't be easy

"It is very likely that the government's expenses will increase due to a permanent increase in defense expenses and an increase in interest payments. These expenses are expected to be much smaller than the current costs of the fighting, but as mentioned, they are significant because they will last for a long time," Bank of Israel Governor Prof. Amir Yaron explained at the press conference following the last interest rate decision.

All the economic bodies, including Moody's, S&P and the International Monetary Fund, which analyzed the consequences of the October 7 attack and the war, note that Israel's defense expenses will increase in the medium and long term. That is, although everyone emphasizes the uncertainty surrounding the current security events, there is a consensus that a jump in Israel's defense spending is a fait accompli. This is a far-reaching change for Israel's economy and budgetary policy, since Israel's defense expenditures, although increasing every year, are decreasing in terms of their weight in GDP. If 30 years ago, defense expenditures made up about 8.2% of GDP, last year they dropped dramatically and stood at about only 4.2% of GDP.

Despite the decrease, this weight is still the highest in the West and among the highest in the world. The average in the OECD is 1.5% of GDP, in the Eurozone it is around 1.3%, and in global powers such as the USA the defense expenditure is 3.5% of GDP.

The estimates that defense expenses will rise are not exclusive to Israel, especially after the Russia-Ukraine war. In the U.S., it is expected that as early as 2029, defense spending will cross the trillion dollar mark, compared to about $860 billion in 2023. Even in European countries, such as the countries that border Russia including Poland, a sharp jump in defense spending is already visible.

For the sake of illustration, in 2023 the Israeli government allocated another NIS 30 billion to defense expenses following the war, an amount equivalent to 1.5% of GDP, which takes the military burden to about 5.7% of GDP. Estimates are that this jump was a one-off, while the permanent level will increase by 0.5-1% of GDP, that is, by 10-20 billion shekels per year. There is broad agreement that a greater investment in security is required after the attack that led to the war, the model of a small and smart army collapsed on October 7 and will have to change in the years to come.

The additional allocation expected after the war raises a series of questions, centered on the issue of what the funds will be used for and especially the source of the money, that is, where to put the money and how the Israeli governments will finance the increase in the near and distant future.

The Ministry of Finance has four ways to finance the permanent addition to the defense budget: raising taxes or increasing revenues; Diversion of civil expenditure in favor of defense expenditure; Streamlining within the IDF; and increasing the deficit and debt. These ways are not contradictory events, which means that it is likely that the treasury will have to resort to some of them, if not all of them, since they all have advantages and disadvantages.

Increasing the deficit: the most dangerous option

The most dangerous option is to increase the deficit and the debt. In terms of public policy, this is an alternative known as "do nothing". That is, the defense expenditure increases while no adjustment was made on the expenditure side or on the income side, therefore the deficit increased, and therefore the debt also increased. This is an unsustainable step: the Israeli government cannot increase the debt permanently, consistently and continuously after the war. The fiscal strategy must be reversed and a policy of debt-to-product reduction must be formulated over the years.

Diversion of civil expenditure: Harms the lives of the citizens

Another way to finance the increase is to shift civilian spending to defense spending. This is also a very problematic way: although public spending in Israel (without interest) is 3% lower than the OECD average of 49.7% of GDP. When defense spending is excluded, civilian spending in Israel is extremely low compared to the average in the West: 40% of GDP in Israel compared to more than 47% of GDP in the OECD. Civil spending includes health, education, social insurance and relief, culture, housing and community services, public order and environmental protection. If Israel was an average developed country, it should have invested another NIS 140 billion per year in these areas.

The lack of investment in these areas is extreme and well known. Further damage to these services will be intolerable, since a significant part of the fields are under extreme budgeting constraints, the most prominent example of which is the field of health.

Raising taxes: a simple solution, but not really

The simplest way to finance the increase in security is to increase the state's revenues. According to the OECD's State Revenue Report for 2023 published last week, the tax weight in Israel rose to 32.9% of GDP last year compared to 32.4% in 2021, but still remains below the organization's average of 34%. Contrary to the common feeling among the public, Israelis do not pay a lot of taxes compared to other developed countries, and in order to bring Israelis level with citizens in developed countries, the Israeli government must increase tax revenues by approximately NIS 21 billion per year.

The big problem is that the current government will not raise taxes and after 17 years of Netanyahu's governments, who treated raising taxes as a sin, the chances of such a move are extremely slim.

There is also another problem: during a period of slowdown in activity, as is expected in Israel in the coming years, it is not worthwhile to raise taxes. What is worthwhile is to abolish tax exemptions and the list of unjustified benefits is long: the forecast of tax benefits for 2023 according to the state budget is about NIS 84 billion, which is about 19% of the state's tax revenues and about 4.5% of GDP. Of this, approximately 82% are benefits in income and real estate taxes. The permanent candidates for removal are the cancellation of the tax exemption for education funds and the cancellation of tax benefits for children up to the age of 18. However, after the last year, in which unprecedented portions of public money were directed to the ultra-Orthodox and the extreme right, the public and even the professional support for these cancellations is non-existent. After all, these are tax benefits that go to the population that works hard, also serves (and is now in the reserves), and pays most of the taxes. This is actually the last benefit left for them and its cancellation, even if it is not justified, is the continuation of the current government's trend: Transferring funds from the silent, serving, working and paying majority to sectors that do not serve and do not work or earn enough to reach the tax threshold.

The last and probably the Treasury's favorite way is a proposal for streamlining and diverting funds within the IDF. It is important to clarify, virtually no one believes that the IDF can become more efficient by 9-10 billion shekels without harming the security situation. The purpose of the move is to strengthen the security system and the IDF following the security challenges. In addition, the IDF is already in the process of streamlining. It is possible that the process is slow and still not enough, but cuts were made and they are evident today - for example, the reduction of manpower in the standing army which will still undergo a thorough examination due to the failures on October 7.

The in-depth discussion regarding the money that the defense system will receive will probably officially begin only after the end of the war, since the questions here are in the public domain. For example, should the increase in security be for the first round of the fighting, that is, for the war against Hamas and Hezbollah, or should the resources be directed to a more distant round. In addition, the conscripted service, which has already been agreed to be shortened, will be extended again as Defense Minister Yoav Galant and Chief of Staff Herzi Halevi have already hinted. This move will also incur additional increases.

There are questions to which the answer is clearer: it will be necessary to establish many protection projects. Also, one of the conclusions from the Hamas surprise attack is that the forces in the army must increase. The expansion should also be carried out through additional populations, such as women and ultra-Orthodox, which requires additional resources.