Public finance and fiscal policy

Economic Survey of Israel 2009: Assessing the macroeconomic policy framework

 

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The following OECD assessment and recommendations summarise chapter 2 of the Economic Survey of Israel published on 20 January 2010.

The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.

Contents

Monetary policy is set to become better anchored through new legislation

While Israel was among the first countries to adopt inflation targeting, it was never enshrined in law. Recently, the Bank of Israel and the Ministry of Finance reached final agreement on the details of useful new legislation governing the Bank. The draft law not only specifies inflation as the primary target of policy but also alters the conduct of policy. Most notably, policy-rate decisions will no longer be made solely by the governor but by majority vote in a new monetary committee. In addition, a board of directors will be appointed to manage the Bank. The Bank will retain its role of official advisor to the government on economic policy.

A "clean float" policy on the shekel should be readopted

Until 2008, the Bank had been following an orthodox approach of non intervention in the foreign exchange market. In March that year it began pre-announced, daily foreign-currency purchases of a fixed amount on the grounds that the strong position of the shekel provided an ideal opportunity to build up low foreign-exchange reserves. But intervention continued after reserve targets were met, and the Bank’s press releases increasingly referred to concerns about the level of the exchange rate. Regular interventions were stopped in early August 2009, but simultaneously the Bank announced a policy of discretionary intervention, and foreign-currency purchases have continued. Markets began to consider that there is a “dirty float” policy on the exchange rate and speculate as to what the Bank’s intervention price is. In October the Bank attempted to clarify its position, stating that current conditions are considered exceptional and that the market is expected to return to a situation where intervention is only rarely required.

The build-up of international reserves proved useful, attenuating external vulnerabilities when concerns about the downturn were at their greatest. However, reserves are now more than adequate, and hence a "clean float" should be readopted as soon as possible. Although the intervention has not been incompatible with inflation targeting thus far, the risk that it becomes so is greater the longer it is sustained. To wit, the pick-up in economic activity is likely to prompt monetary tightening at some point and in these conditions continued heavy intervention would work against the policy-rate hikes and would thus damage transparency and credibility in policy. Other objections to sustained intervention are the opportunity cost of holding extra reserves and the risk of associated capital losses.

Fiscal policy should not overplay rate cuts in corporate and personal-income tax

Cuts in the headline rates of corporate tax and the upper rates of personal-income tax are a central theme in the current government’s policies, based on a belief that they significantly boost competitiveness and, in some quarters, that they are largely self-financing. However, while such tax cuts have beneficial effects on incentives, some caution is in order. Tax burdens are not the only concern of investors (who are also put off by red tape), nor are headline rates the only determinant of effective tax rates. Rate cuts are generally not self-financing, and positive feedbacks on revenues are anyway neither immediate nor certain. Moreover, as mentioned, creating some budgetary headroom for structural reforms that would enhance competition and achieve social goals would be advantageous. Accordingly, a decision to go ahead with rate cuts in 2010 was surprising under the prevailing macroeconomic circumstances. However, in 2010 the cut will be smaller than originally planned, and the schedule of cuts for subsequent years was pushed out, which is welcome in light of the uncertain fiscal outlook for that year.

Trade-offs in fiscal policy would be eased by making the recent temporary increase in the rate of VAT to 16.5% permanent. Also, the abolition of some VAT exemptions should be revisited, notably those on some tourist services (including those for the town of Eilat) and for fruit and vegetables. This said, the continued imposition of high purchase tax on cars lacks strong justification. The schedule of rates has been recently adjusted to reflect environmental considerations, but the attractive revenue-raising properties of such taxation probably remain the primary motivation. The environmental returns would be better sought by targeting car use (for instance, through more use of road pricing) rather than ownership. Increased revenues should also be sought by casting a wide net to weed out low-priority tax expenditures. There is room for some cutback in the context of welfare policy (see below). And tax support for the “advanced training funds” (Kranot Hishtalmut), which encourage medium-term saving, makes little sense, especially as, despite the name, the savings can be used for a wide variety of purposes. Finally, international comparison suggests there is room for simplifying tax procedures.

… and should reform the "spending rule" and budget processes

While the current budgeting rule that limits real public spending increases to 1.7% per year has played an important and constructive role in fiscal control, it should be replaced in the not-too-distant future. Complexities and discretionary leeway in its application undermine its outward simplicity, and the rule makes little sense for the long term. With annual population growth also at around 1.7% and only marginal decline in prospect, increases in GDP per capita of any substance imply public spending as a share of GDP will be continually eroded. Any new rule should be simple, credible and robust. The alternative rules currently being discussed that anchor spending increases to an explicit debt-to-GDP goal and accommodate cyclical considerations would certainly be an improvement. "Top down" fiscal discipline should be augmented by other measures. Particular consideration should be given to: requirements on spending ministries to submit more comprehensive multi-year spending plans; greater transparency in the budget material presented to the Knesset; and, obligatory periodic reporting on the long-term sustainability of public finances.

At present the Ministry of Finance not only has strong powers in directing aggregate fiscal policy, but it is also the progenitor of most economic reforms. In principle, a more even balance of expertise and influence across ministries may lend itself to better policymaking. On this basis, and with the budgeting reforms suggested above, line ministries ought to be given more leeway, for instance by cutting the number of budget lines. But caution is required. In the Israeli context the Ministry’s powers are arguably a necessary foil to the idiosyncrasies of Israel’s democratic system. Minor coalition parties are often relatively powerful because their Knesset seats are necessary to the government retaining office. In light of this, a more devolved structure might be more workable if a fiscal council were introduced, such as those in Austria, Sweden, Canada and the Netherlands, although other bodies already monitor public finances.

How to obtain this publication

The complete edition of the Economic Survey of Israel is available from:

Additional information

For further information please contact the Israel Desk at the OECD Economics Department at eco.survey@oecd.org

The OECD Secretariat's report was prepared by Philip Hemmings and Charlotte Moeser under the supervision of Peter Jarrett. Research assistance was provided by Françoise Correia.

 

 

 

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