OECD Economic Outlook, Volume 2024 Issue 1

Israel

The terrorist attacks and the subsequent war have hit Israel’s economy, which is projected to grow by 1.9% in 2024 before picking up by 4.6% in 2025. Private consumption rebounded quickly and is set to remain an engine of growth, together with government consumption related to the war. Investment and especially construction, which declined sharply late in 2023, are projected to recover only in part, remaining below their October 2023 levels, as influxes of foreign workers do not fully compensate the suspension of Palestinians’ work permits. Inflation is projected to remain at 2½ per cent in 2024-2025, as the impact of the 2025 VAT increase offsets ongoing disinflation.

Disinflation will allow policy interest rates to be cut in 2024. Nevertheless, greater sovereign risk and the rise in government spending call for prudent monetary and fiscal policy. Permanently higher military expenditure needs to be funded by a combination of revenue-generating measures and spending restraint, whilst preserving programmes that underpin future growth such as education and research. The planned value-added-tax rate increase in 2025 should be supplemented with a streamlining of exemptions.

The attacks and subsequent war have wide-ranging economic consequences

The attacks on Israel of 7 October 2023 and the subsequent war have deeply impacted the Israeli economy. Schools and many services closed for three weeks. The suspension of work permits for Palestinians and the departure of many foreign workers halved the number of non-Israeli workers from 6.7% of employment before October 2023 to 3.5% at the end of 2023. Homebuilding consequently declined by 53% in the fourth quarter compared with the previous quarter, and overall investment shrank by 26%. Foreign labour shortages are also weighing on farming. The enlistment of 287,000 reservists (6.6% of employment) weighed on activity across the economy including in the high-tech sector. Government consumption however soared by 17% in the fourth quarter of 2023 due to military operations. Credit card purchases, which expanded strongly in December 2023 and the first quarter of 2024, point to a rapid recovery in private consumption.

Israel: Economic growth and activity indicators

Source: Bank of Israel; OECD Economic Outlook 113 database; OECD Economic Outlook 115 database; and OECD calculations.

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Israel: Demand, output and prices

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Trade was also severely disrupted, with exports and imports both shrinking in the last quarter of 2023. Following resumption of industrial activity after the October production shutdowns, goods exports rebounded in early 2024. Service exports have been more sluggish especially foreign tourism, which has been mostly halted. The 2023 fall in global food and energy prices contributed to the disinflation process prompted by policy interest rate increases from 0.1% until April 2022 to 4.75% in May 2023. The annual consumer price inflation rate was 2.7% in March 2024, down from 5.0% in March 2023.

Israel: Inflation and fiscal indicators

Source: OECD Economic Outlook115 database.

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Economic policy is responding to the war

Fiscal policy is being reviewed to adapt to new requirements. The very large amount of war and associated expenditure has contributed to the move from a budget surplus of 0.4% of GDP in 2022 to a deficit of 4.1% of GDP in 2023. This deterioration, together with greater perceived country risk, led credit rating agency Moody’s to downgrade Israel’s sovereign rating in February. Israel’s sovereign credit default swap rate has remained half a percentage point above its pre-October 2023 levels since November 2023. A key part of the authorities’ response has been to find new sources of revenue including by increasing the VAT rate from 17 to 18% in 2025. There is also restraint in non-military spending, one example being cuts in convalescence pay in 2025. Looking beyond the immediate cost of the war, military spending is set to rise permanently by at least half a per cent of GDP.

Headline and core disinflation together with a stable currency opened the way for the central bank to start an easing cycle. The Bank of Israel cut its main policy rate from 4¾ to 4½ per cent in January 2024. Easing inflationary pressures are anticipated to allow the central bank to implement three further 25 basis point cuts to bring its key rate to 3¾ per cent by the end of 2024 and in 2025.

Consumption is driving the recovery

Output is set to expand over 2024-2025 under the impetus of strong government and private consumption and a partial recovery of investment. Construction is projected to recover only partly from the depths at the end of 2023, holding back investment and imports, as foreign workers replace only some of the Palestinians whose work permits have been suspended. Homebuilding is anticipated to account for about 4% of GDP by end 2025 against 7% in the third quarter of 2023. Labour shortages are also set to weigh on farming activity. Foreign tourists are assumed to start returning to Israel towards the end of 2025. Prices are projected to keep mildly decelerating, as the economy operates slightly below full capacity and lower global energy and food prices pass through the economy, even if the VAT increase is going to push up headline prices.

Risks are high. The opening of a northern front in the current conflict would halt consumption and further disrupt economic activity, generating a slump similar to the one observed in late 2023 and considerably exacerbate budget pressures. Furthermore, failure to attract enough foreign workers could result in the construction and investment recovery being weaker than projected. On the other hand, construction and overall investment could expand considerably more than projected if influxes of foreign workers are large enough to compensate the shortages that followed the suspension of Palestinian work permits, or if this suspension is reversed. A peaceful resolution of the conflict would also boost growth, including through the resumption of foreign tourism and stronger investment, while easing budgetary pressures through lower military expenditure and a reduced sovereign risk premium.

Fiscal adjustment and monetary stability are needed to keep the economy on track

The large government spending shock created after the attacks and the subsequent war can only in part be absorbed through higher debt. Permanently higher military spending calls for new tax revenue and spending restraint. In this regard, the choice of raising the general VAT rate in 2025 is welcome, as the current rate of 17% is relatively low by OECD standards and VAT is a form of taxation that implies comparatively limited economic distortions. This measure should be accompanied by efforts to remove VAT exemptions, starting with the one applicable to certain online purchases. Increasing residential property tax rates would also bring revenue whilst creating a more level playing field for municipalities between commercial and housing development. Expenditure restraint would best preserve future prosperity by using spending reviews to identify programmes to cut, scale back or reform. Examples to consider for cuts include subsidies that weaken incentives to join the labour market. Spending restraint however ought to leave sufficient funding for areas, such as education, that are particularly important to a country with strong demographic growth and an economy whose dynamism depends on the knowledge-fuelled high-tech sector. Whilst disinflation leaves space for some monetary easing, monetary policy must remain prudent to maintain favourable funding conditions for the government and the economy.