Budget delay, canceling VAT hike jeopardize Israel’s credit rating

The Finance Ministry is busy preparing the state budget for 2025, but the work is getting more complicated every day. While the ministry’s top officials are trying to promote a balanced financial plan to deal with high defense spending, politicians, led by Prime Minister Benjamin Netanyahu and his economic adviser, Prof. Avi Simhon, are pushing for tax cuts and are in no hurry to move forward with the new budget.

One of the main disputes is over the increase in value-added tax from 17% to 18%, which is set to go into effect in January 2025. The measure, which the Knesset already approved as part of the 2024 state budget last March, is seen by the Finance Ministry as a key pillar of the fiscal plan for the coming years. However, Simhon is pushing to cancel the increase, proposing instead to use the expected revenues from the plan to unlock the profits of the beleaguered companies he promotes.

This situation is causing great concern in economic circles, especially due to the recent downgrades of Israel’s credit rating. In February, Moody’s downgraded Israel’s credit rating for the first time in history, and in April Standard & Poor’s followed suit. Both rating agencies praised the VAT hike as a positive step that would enhance Israel’s financial stability. In fact, the VAT hike was the main measure that the Finance Ministry and the Bank of Israel promoted to the rating agencies in their efforts to prevent the downgrade.

Earlier this year, Moody’s said: “The government’s willingness to raise taxes is a positive sign regarding the strength of state institutions, as previous governments have avoided raising taxes in the past.” Moody’s added: “As long as these measures are fully implemented, they could offset increased defense spending and higher interest rates.”

In its latest update on Israel two months ago, Moody’s said of the VAT hike that it “views it as an important step in responding to the deterioration in the fiscal position, which will help limit its vulnerability from 2025 onwards.” Standard & Poor’s echoed this view, saying: “The State of Israel has taken several measures to contain the fiscal impact in the long term by raising the VAT rate from 2025.”

Moody’s warning

Attempts to reverse the VAT hike raise serious concerns that Israel is crossing the red line set by credit rating agencies. Both agencies have already given Israel a negative outlook and downgraded its rating, suggesting further downgrades are on the way.

Matters are further complicated by concerns over further delays in the budget process. The budget is usually approved by August. Given the delays in recent weeks by the prime minister’s advisers, which have prevented the budget framework and progress with various ministries, it is doubtful that they will be able to meet the August deadline.

Finance Ministry officials believe that the prime minister and his advisers may be seeking to avoid passing the budget and do what they did during the Covid pandemic by linking the current budget to “additional payments.” All of this could exacerbate economic uncertainty.

While Professor Simhon claims that “the economic situation is good and there is no need to raise taxes,” senior Finance Ministry officials warn that without major measures, the fiscal deficit could exceed previous projections. They are proposing a package of tax cuts and increases of at least NIS 30 billion, with the aim of reducing the deficit to around 4% next year.

But is Israel’s credit rating at risk of a downgrade? There is no reason to speculate, as Moody’s Investors Service reported in May “factors that could lead to a downgrade.” Among these factors are “indications that Israel’s institutional capacity has been reduced to a greater extent than the agency currently assesses due to the need to focus on the country’s security, which would also be negative. In addition, the increased likelihood of a much greater negative impact on the country’s economic and fiscal strength in the medium term than the agency currently expects would put pressure on the rating.”

Simply put, Moody’s says that Israel’s institutional capacity is, among other things, the ability of a country to make tough decisions and stand behind them. And the VAT hike, as analysts at credit rating agencies have pointed out, is the most prominent of these decisions.

If the government backtracks on this issue, Moody’s could see this as “indicating that Israel’s institutional capacity is more limited than the company estimates.” This would be even worse if the government refrains from passing a well-organized budget, in an attempt to avoid politically painful cuts and measures. In such a case, the other scenario that Moody’s also warns against would materialize: “an increased likelihood of a more negative impact on the country’s economic and financial stability in the medium term.”

November or before

According to the official schedule, the next round of credit rating announcements for Israel by Moody’s and Standard & Poor’s will be in November. But recently there have been “spontaneous” early publications by the credit rating agencies due to the turmoil in Israel – the war and, before that, the judicial reform. The credit rating agencies follow what is happening in Israel closely, and may advance their announcements if they see that Israel is crossing the red line they have drawn.

A credit rating reflects the risk that a country (or business) will default on its debts. One of the most important indicators that analysts use when calculating a country’s risk is its debt-to-GDP ratio. In Israel, this ratio is relatively low compared to Western countries. However, it has been on a dangerous upward trend since last year. According to Standard & Poor’s forecasts, which calculate the figure slightly differently from the Finance Ministry, Israel’s debt is expected to jump from 60.5% of GDP in 2022 to 69.3% of GDP in 2025, and remain unchanged in 2026.

Standard & Poor’s rating for Israel is A+, down from AA-. Moody’s rates Israel one notch lower at A2, which is equivalent to A on the S&P scale. A third rating agency, Fitch, gives Israel an A+ rating. All three agencies have a negative outlook on Israel.

This article was published in Globes, Israeli Business News – en.globes.co.il – on July 25, 2024.

© Copyright Globes Publisher Itonut (1983) Ltd., 2024.