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Saturday, February 24, 2007

Reducing Israel's public debt

What is more important, reducing public debt? reducing foreign aid from the United States, maintaining defenses or building a strong infrastructure?

In debt to the future
By Jorg Decressin and Natan Epstein

For much of the first 60 years of Israel's independence, policymakers' key task was to build the state and foster economic development. This costly process had to be shared with future generations through the accumulation of public debt. It was a fair trade-off since future generations would benefit from established statehood and a flourishing economy. Now Israel ranks among the most advanced countries, both with respect to the quality of public institutions and economic competitiveness. It also faces the same set of economic challenges, notably those related to an aging population. Today there are four people in the Israeli labor force for every person older than 65 years. By 2050, that number may only be between two and three. The message is clear: Funding the needs of future generations will become much harder. This has significant implications for fiscal policy and public debt.
Just over two weeks ago, the International Monetary Fund concluded its annual consultation on economic policies with Israel. These consultations have been taking place since the country became a member of the IMF in 1954. The fund praised Israel's economic achievements, but - as it has done before - it also emphasized the need to reduce the public debt.
Why this concern about debt? First, despite much recent progress in reducing the government's fiscal deficit, Israel's debt still amounts to the equivalent of about 88 percent of GDP. Only a handful of other advanced economies have a ratio of debt to income that is similar or higher than that of Israel. This represents a heavy burden on future generations. Second, lowering the public debt reduces real interest rates, thereby boosting investment and economic growth. Third, if the economy hits a rough patch, the government will have little room to offer its citizens more support without raising questions among international investors about the stability of public finances and the attractiveness of Israel as a destination for investment. This was the case only five years ago, when the collapse of the global high-tech bubble and heightened geopolitical risks culminated in Israel's longest recession. Fourth, servicing the public debt consumes the equivalent of almost half of the central government's welfare expenditures. Therefore, it is essential to reduce interest spending if the government hopes to combat inequality and poverty. And fifth, Israel's population is aging and its needs for social support-health care, long-term care and possibly income support will grow appreciably over the next half century.
How should the public debt be significantly reduced? By continuing on the path of fiscal consolidation: The IMF is advocating to move close to a balanced government budget over the next five years through a range of measures, notably cutting tax exemptions. However, this would require sacrifices that demand political support that is always difficult to muster.
Indeed, the demands of diverse political constituencies often foster excessive government spending and debt. Again, among advanced economies Israel is hardly unique in this respect. But many other countries are combating the tendencies toward deficit spending with more transparency about fiscal policy, notably better analysis and planning, as well as stronger checks and balances.
In Israel, what is needed is a more forward-looking, risk-based analysis of fiscal policy that is integrated into the budget process. Fiscal policy is about more than budgeting one or three years ahead. What Israeli budget documents could usefully include is a long-term fiscal sustainability analysis that lays out the public spending needs 50 years ahead. Similar reports for other advanced economies show that health-care spending, for example, will rise markedly over the next half century as populations age. They illustrate how public finances and the economy would evolve under a variety of policy responses - saving through public debt reduction, raising tax revenue, cutting other spending or reforming health care. Israeli budget documents also need a risk analysis that explains how the public finances would evolve under less favorable economic scenarios over the short and long run. Such an analysis would, for example, reveal what is needed to sustain welfare support when government tax revenue falls during recessions.
Many countries have found this added fiscal transparency useful to nurture public debate about the role of the state and to foster a constituency for debt reduction. In Israel, long-term and contingency planning appear all the more necessary given the volatile setting in which the economy operates. Furthermore, if such planning and analysis were to be audited or produced by independent, nonpartisan experts, it could greatly help the public to understand the policy challenges that lie in the more distant future, and nurture trust in policymakers who make the case for fiscal consolidation.
Jorg Decressin is the IMF Israel mission chief and Natan Epstein is the IMF Israel Desk economist.

Copyright - Original materials copyright (c) by the authors. Originally posted at Please do link to these articles, quote from them and forward them by email to friends with this notice. Other uses require written permission of the author.


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