Israeli Prime Minister Benjamin Netanyahu defended his tax increases… (Sebastian Scheiner, AFP/Getty…)
JERUSALEM — Israel's once-envied economy, which dodged the recent credit crunch and grew even amid the international recession, is heading toward choppier waters.
The government is taking steps to avert a slump, and is already facing criticism over the moves.
After assuring Israelis for nearly three years that their economy was outperforming the rest of the world, Prime Minister Benjamin Netanyahu surprised many this month by abruptly pushing through a platform of austerity measures, including higher income taxes for top earners, new levies on cigarettes and beer, and raising the VAT, a kind of sales tax, from 16% to 17%.
"Israel's economy has handled the crisis pretty well up to this point, but there is a significant risk that things are not going as well as the government has tried to convince us," Hebrew University economist Omer Moav said.
Israel appears on track this year to expand its gross domestic product — a key measure of economic health — by more than 2.8%. That's down from last year's impressive 4.7%, but it's still almost twice the recent growth rate reported in the U.S. and far better than Europe's contracting economies.
Yet the latest economic indicators point to challenges ahead.
Unemployment hit 7.2% in June, up from about 5.5% a year earlier. Exports, which make up a big chunk of Israel's economy, recorded their steepest decline in three years during the second quarter, according to the Israel Export Institute.
And Israel's budget deficit has doubled over the last year, leading economists to predict that the government won't meet its 2013 goal of keeping the deficit at 3% of GDP. The Bank of Israel issued a stern warning this month that missing the deficit target could erode international confidence in Israel's fiscal policy, which the bank said had been crucial to the country's economic success in recent years.
The austerity measures came despite the social protests that swept through Israel last year, an unprecedented reaction to the country's cost of living.
Netanyahu defended the tax increases as a preemptive step to keep the nation on a responsible fiscal path. He told Israelis that there was no "free lunch," a comment that immediately drew attacks from opposition leaders who accused the prime minister of being out of touch with the financial struggles of the middle class.
Pollsters say the tax increases may already be hurting Netanyahu's popularity. A poll published this month in the left-leaning newspaper Haaretz found that the prime minister's approval rating had sunk to about 31%, down from the low 50s earlier this year.
Bank of Israel Governor Stanley Fischer called Netanyahu's austerity measures "courageous," but he warned that they may not be enough, particularly if the debt crisis worsens in Europe — the destination of many of Israel's exports.
"If it snowballs, we'll be in big trouble," Fischer told Israeli TV station Channel 2 this month.
But some economists say the government is using Europe as a scapegoat, insisting that the bigger problem is Israel's increased government spending in recent years. Since lifting a fixed 1.7% cap on annual spending increases in 2010, government expenditures have ballooned, particularly for defense and social services.
"What has me most concerned is the very rapid growth in expenditures," said Jonathan Katz, an economist at Leader Holdings and Investments in Tel Aviv. He said government spending so far this year was running nearly 9% above the same period last year.
Fears about Iran's nuclear program and regional instability led Netanyahu to earmark an additional $800 million for the military this year, reversing his previous pledge to cut defense spending.
Special government perks for West Bank settlers added $270 million more, according to Israeli media. And in response to last year's nationwide social protests, the government increased spending on education and housing.
"The government has written a lot of checks for the future, and the future is here," said Hebrew University's Moav.
He said the spending and tax increases were surprising because Netanyahu opposed such measures as finance minister a decade ago and instead advocated cutting benefits, lowering taxes and privatizing government functions to increase efficiency.
Worse, critics say, the approved austerity measures provide only about a third of the revenue Israel needs to meet its deficit target. That's partly because Netanyahu backed down on several provisions, including a middle-class tax increase and cuts in benefits for religious families, amid opposition from his coalition partners.
As a result, passing a new budget will rise to the top of the political agenda this fall, and many predict failure to agree will add to the pressure to call for early elections.
"There's a real question about whether this government will be able to get it done," Katz said. "The next one may have more of a chance."