In the next Within a few weeks, Benjamin Netanyahu, Israel’s prime minister, hopes to get final parliamentary approval for an emergency war budget. It includes more money for settlers in the West Bank, as well as for religious schools, where teenagers study Torah instead of science — part of an effort to unite his fissile political coalition. But it also contains a surprising break with the past. Daily spending on social services (which have long been generous in Israel, due to its socialist foundations) will be cut to fund the country’s armed forces. The military budget will almost double between 2023 and 2024. Israel’s unwritten social contract, which for seven decades has promised both a generous welfare state and a fearsome military, is under threat.
Despite ongoing ceasefire discussions, Netanyahu has made it clear that any pause will be temporary. And even if the ceasefire is eventually extended or he leaves office, there is broad political support for a more powerful military. At the same time, the war turns out to be more expensive than expected. Between October and December, Israel’s economy shrank by a fifth year-on-year, compared to the previous three months – more than twice the contraction predicted by the Bank of Israel. In the same period, more than 750,000 people, or one-sixth of the working population, were unemployed, many of whom were evacuees or reservists. Last month, rating agency Moody’s downgraded the country’s credit rating for the first time ever. All this raises a question. Can Israel afford to go to war?
The core problem is of a fiscal nature. On the eve of Hamas’ attack on October 7, Israel’s debts are upGDP ratio was 60%, well below average in the OECD group of predominantly rich countries. From October to December, the military burned 30 billion shekels ($8 billion) on top of their usual spending, an amount equal to 2% of total expenditures. GDP. And it’s not just a bigger budget for the armed forces; the government is also investing in housing for evacuees, various leave schemes and support for reservists. Israeli policymakers think a debt ratio of 66% would be manageable. Netanyahu’s budget would target an annual budget deficit of 6.6% GDP– enough to build up a debt ratio of about 75%.
For America or Japan, such a loan would be a piece of cake. In Israel, however, there is always the chance that more conflict is on the horizon. Should the country’s technology industry be injured, perhaps in a war involving other regional powers, up to a quarter of the country’s income tax would be at risk. The last time Israel went to war on the current scale, during the 1973 Yom Kippur War, the debt-to-GDP ratio exceeded 100%, leading to a financial crisis. When the central bank printed cash, inflation skyrocketed to 450% in 1985 and the banking sector collapsed. To keep bondholders satisfied, the government needs room to maneuver.
Many now worry that Netanyahu’s budget is too lavish. Although governments can borrow money in times of crisis to keep things going, they would be wise to do so modestly. Given Israel’s desire to increase military spending, spending will not return to pre-war levels anytime soon. As a result, the government needs a plan to stabilize debt while keeping spending high.
Israeli tax revenue in 2022 was worth 33% GDPjust below the OECD average 34%. Yet Netanyahu’s budget includes only modest increases. Value added tax will increase by one percentage point to 18%; a health tax on incomes will increase by 0.15 percentage points. Policymakers worry that raising corporate taxes would cause the tech sector, which is highly mobile and already struggles to find workers, to flee the country. Heavier taxes on households could depress consumption and make life even harder for those already struggling because of the war.
A story about one city
In the suburbs of Jerusalem, secular professional families are suffering, members of which have been drafted and have seen business income plummet. Many in the Arab neighborhoods hardest hit by Netanyahu’s budget say they are no longer welcome at work. But a few kilometers away, ultra-Orthodox households, exempt from military service and dependent on benefits that Netanyahu wants to make more generous, have hardly had to tighten their belts.
The impact on industries is also uneven. The technology sector is holding up quite well. Some companies even think they can make a profit by taking advantage of a new round of military contracts. Many have moved their operations abroad, reducing the impact of losing workers to the fighting. “Our productivity has actually improved,” said Chen Bitan of Cyberark, one of the country’s largest cybersecurity companies. “We told our workers that the war would be won by the economy,” he explains. Although local technology investment has fallen, this is about the same as in Europe – suggesting the war is not to blame.
But the rest of the economy is in trouble. Construction is at a standstill. Farms have lost more than half their workforce. And businesses involved in tourism are suffering. In January, 77% fewer tourists visited Jerusalem than a year ago.
The recovery could be a glassy one, not least because the war has exacerbated long-standing problems. One of these is the economy’s dependence on low-paid Palestinian workers. The West Bank may be importing as many goods from Israel as it did before the war, but its 210,000 day laborers – representing 5% of Israel’s workforce – cannot get out. Their permits were revoked after October 7 and the Israeli government refuses to let them back in. Farms, factories and construction sites are short of workers. Yet many industrialists are in two minds. “We need the Palestinians, but we cannot depend on them,” says one.
The Israeli labor market is already very tight. Bringing in foreign workers is slow and expensive, and the country’s labor force is less than half of the total population. Half of the men in Israel’s Orthodox population, the country’s fastest-growing group, refuse to work for religious reasons. Those who do are often woefully undereducated and have attended religious schools. The same goes for Arab Israelis, the community with the second highest fertility rate. And in January, new rules extended military service from 32 to 36 months for men, further depleting the workforce.
Should debt levels continue to rise while the economy is struggling, things will get tough. But a repeat of what happened after the Yom Kippur War is unlikely. Israeli ministries are full of technocrats. The public is aware that their security depends on a stable economy and that they risk ousting irresponsible politicians. Markets think bankruptcy is unlikely. While borrowing is now more expensive for the government, it still falls far short of the eye-watering prices paid by irresponsible leaders elsewhere. The credit-default swap rate, an indicator of market confidence in a government, rose from 0.5% to 1.4% after October 7 before stabilizing.
Markets appear almost as confident that Israel will not unleash inflation to reduce debt levels. The country’s annual inflation rate is lower than America’s at 3%, and investors expect it to fall to 0.4% by the end of the year. Since the Yom Kippur War, Israel has acquired an inflation-oriented central bank, which has an hawkish streak. After October 7, the country has spent $30 billion in foreign reserves to support the shekel (and has another $170 billion if the currency needs more cushioning). The shekel has barely moved since then.
But even if a financial crisis is unlikely, that doesn’t mean pain will be avoided. It will just come in a different form: through further cuts necessary to guarantee stability. The money that keeps Netanyahu’s coalition together will be protected as long as he remains prime minister. Instead, as the war budget shows, the Israeli welfare state will absorb the blow. Despite having one of the lowest unemployment rates in the US OECDthe country is the fifth largest provider of unemployment benefits. Only the governments of Norway and Iceland spend more GDP on education. This presents a tempting target for a prime minister who needs to find savings and has allies to protect.
The Ministry of Social Affairs, which is also responsible for caring for evacuees and returning hostages, will have to make an 8 percent cut to Netanyahu’s budget – far above the cuts faced by most other civilian ministries. The ministry is already under fire for its lackluster support for 135,000 Israelis evacuated from the north and south of the country. It has done little other than pay their hotel bills; now officials are reportedly pushing for families to return. If Israel remains under Netanyahu’s mismanagement, other ministries will suffer similar treatment. But even if he steps down, Israel will have to make difficult choices between the two pillars of its social contract: its armed forces and its welfare state. ■