US embassy cable - 04TELAVIV2067

C O N F I D E N T I A L SECTION 01 OF 05 TEL AVIV 002067 
 
SIPDIS 
 
E.O. 12958: DECL: 04/05/2014 
TAGS: ECON, EFIN, IS, ECONOMY AND FINANCE, U.S.-ISRAEL RELATIONS 
SUBJECT: NETANYAHU ANNOUNCES MAJOR TAX REDUCTION PROGRAM 
AND HIS DG ASKS FOR CORRESPONDING CHANGES TO LOAN GUARANTEE 
AGREEMENT 2004 TERMS SHEET 
 
 
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Summary: 
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1. (U) On Sunday, April 4th, Finance Minister Benjamin 
Netanyahu held a press conference at which he announced the 
third major tax reduction initiative of his tenure.  It 
foresees the following changes in tax and investment laws: 
-- personal income taxes, primarily for low-income workers, 
would fall significantly by July 2004; 
-- corporate income taxes would fall from 36% to 30% by 2007; 
-- taxes on construction materials such as steel, iron and 
bathroom fixtures would fall, a move aimed to stimulate this 
lagging sector of the economy; 
-- industrial investments would be encouraged through tax 
code changes. 
 
2.  (C) Netanyahu estimated the cost of these changes at NIS 
1.2 billion in 2004 and NIS 2.3 billion in 2005, which he 
said would be more than offset by tax revenue surpluses in 
both years.  Netanyahu's political opponents say the move is 
purely political in nature and sets the stage for a potential 
race for the Prime Minister's job, should PM Sharon falter in 
his Gaza disengagement plan moves.  Most aspects of 
Netanyahu's initiative require government and Knesset 
approval: at the earliest the income tax and corporate tax 
cuts would not go into effect before the second half of 2004. 
 Although most press reaction to the plan has been positive, 
our contacts at the Bank of Israel expressed concern that 
Netanyahu is taking a risk in spending revenues that have not 
yet been booked. 
 
3.  (C) The plan also appears to run counter to 
understandings reached at the 2004 Joint Economic Development 
Group meeting, in which Netanyahu promised U.S. officials 
(including Under Secretary Larson and Treasury Under 
Secretary Taylor) to use extra revenues both to reduce taxes 
 
SIPDIS 
and also to reduce Israel's significant debt levels, which 
have reached 105% of GDP.  This supposition is supported by 
new changes requested by the MoF to the Loan Guarantee 
Agreement (LGA) 2004 Terms Sheet, outlined in paragraph 13. 
End Summary. 
 
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The Plan 
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4. (U) Netanyahu's tax reduction plan is the third since he 
became Finance Minister a year ago.  The first was contained 
in his economic reform plan of March 2003, and accelerated 
the provisions of the Rabinovitch Tax Reform Plan that cut 
upper bracket marginal income tax rates.  The second, which 
was announced February 11, 2004, reduced VAT by 1% from 18% 
to 17%, reduced purchase taxes on consumer durables, and 
eliminated customs on certain food items. 
 
5.  (U) The April 4 plan, according to Netanyahu, is 
primarily intended to put more money in the pockets of wage 
earners in the NIS 4,000 to NIS 10,000 gross salary level, as 
well as bring down corporate taxes over a four year period. 
The main aspects of the plan are: 
 
- Reduction in income tax.  Wage earners earning NIS 4,000 a 
month will receive an additional NIS 59 a month, or NIS 708 
per year.  Those earning NIS 7,000 would receive an 
additional NIS 180 a month, resulting in NIS 2,160 a year, 
and those earning NIS 10,000 would receive an additional NIS 
70, equal to an additional NIS 840 a year.  This part of the 
plan requires Cabinet and Knesset approval.  Netanyahu 
nonetheless said he hoped implementation could go into effect 
by July, 2004. 
 
- Gradual reduction in corporate income tax from 36% today to 
30% in 2007.  Netanyahu said he was aiming to bring corporate 
tax rates more into line with OECD countries. Taxes would 
decline by 1% in 2004 to 35%, another 1% in 2005 to 34%, and 
2% each year in 2006, and 2007, reaching 30% in 2007.  This 
also requires Government and Knesset approval. 
 
- Cancellation of purchase taxes on construction-related raw 
materials, including steel, iron, and equipment for bathrooms 
and kitchens. This move is meant to stimulate the building 
and construction sector. Netanyahu announced that this step 
would go into effect immediately. 
 
- Reforms in Investment Encouragement Law.  These measures 
would aim to make industrial investments more attractive, and 
would include tax benefits totaling NIS one billion for 
investments in periphery areas.  The new law would require 
new legislation. 
 
--------------------------------------------- ----- 
How He Did It: Excess Revenues Continue Pouring In 
--------------------------------------------- ----- 
 
6. (SBU) How could Netanyahu afford to take this expensive 
step?  The Minister estimated at his press conference that 
GOI tax revenues are likely to be NIS 2 billion higher than 
originally forecast for 2004.  This follows an April 2 MOF 
report on first quarter 2004 tax revenues showing that March 
receipts totaled NIS 13.7 billion, a real increase of 11% 
from March 2003.  Tax revenues for the first quarter of 2004 
totaled NIS 38.6 billion, a real increase of about 12% over 
the NIS 35.2 billion in revenues in the first quarter of 
2003.  This windfall, Netanyahu said, would more than cover 
the costs of the plan, which he estimated at NIS 1.2 billion 
in 2004, and approximately NIS 2.3 billion in 2005.  He broke 
down the 2004 costs as follows: 
-- income tax cut: NIS 650 million; 
-- decline in company tax: NIS 400 million; 
-- construction encouragement: NIS 150 million. 
 
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Netanyahu's Economic Worldview versus David Klein's 
--------------------------------------------- ------ 
 
7. (SBU) Netanyahu's philosophy of using additional tax 
revenue to finance tax reductions is not universally accepted 
in Israel.  Although BOI Governor Klein agrees with Netanyahu 
that additional tax revenues should not be used to increase 
government expenditures, he has repeatedly noted that this 
money should be used to reduce Israel's high level of public 
debt, which totaled 105 percent of GDP in 2003.  This is 
significantly higher than the 78 percent average of OECD 
countries and 73 percent of EU countries.  The BOI expressed 
this sentiment most clearly in a March 4 press release, 
noting that the debt/GDP ratio is one of the key indicators 
of an economy's stability in the eyes of foreign investors. 
Klein followed this on March 30 in his cover letter to the 
BOI's 2003 annual report, in which he wrote that additional 
tax revenues should be used to repay debt rather than further 
reducing taxes, as Israel's tax burden is approximately 39%, 
similar to OECD levels.  In Klein's view, reducing the debt 
burden would result in lower interest payments, enabling 
lower interest, which would encourage investment, and support 
growth.  In addition, Klein said that reduced debt servicing 
would allow for more money to be used for social-economic 
purposes. 
 
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Reaction: Politics, or Good Economics? 
-------------------------------------- 
 
8. (SBU) The political opposition was quick to criticize 
Netanyahu's proposal.  Avraham "Beiga" Shochat, former 
Labor-party Finance Minister, said in a radio interview April 
4 that, although tax cuts are a good thing, the tax windfall 
should have been used to pay salaries to local authority 
workers who have not received salaries in months, as well as 
using it for education, health, and welfare.  This was a 
reflection of the plan's political nature.  Shochat's views 
were echoed by a number of other commentators. 
 
9. (SBU) Yosi Bachar, Director General of the Finance 
Ministry argued in an April 5 radio interview that the 
measure is intended to help lower wage earners.  He said that 
it is MOF policy to return extra tax revenues to Israeli 
citizens. He said the GOI's policy is consistent and clear ) 
to encourage people to go to work, so that they will have 
more assets in their hands, not to increase public 
expenditures. 
 
-------------------------------------------- 
Bank of Israel Reaction to Plan: It's a Risk 
MOF Responds: No It's Not 
-------------------------------------------- 
 
10. (C) The BOI's Research Division Chief, Karnit Flug, spoke 
to us April 4 about the new plan.  On the one hand, she said 
that it followed "a legitimate path," particularly in view of 
the tendency of "political systems to spend revenue 
surpluses."  She nonetheless highlighted three dangers: the 
GOI would be spending revenues that have not yet been booked; 
the plan precludes needed reductions in GOI debt levels; it 
does not help the very poor, who work but do not pay taxes. 
Although Flug thought the GOI could still meet its 2004 
deficit target of 4% under the new plan, she believed that 
meeting the 2005 deficit target of 3% was a "big problem." 
 
11.  (C) In a subsequent conversation with MoF DG Bachar, who 
called Deputy ECON Counselor to discuss changes to the Loan 
Guarantee Agreement 2004 Terms Sheet (see para. 13) related 
to the new plan, Bachar argued that the plan was necessary 
and timely.  "Our highest priority is to make certain that 
politicians will not spend without control."  He noted that 
the USG and the GOI were "coming from the same place" in 
efforts to reduce taxes.  He also stressed that the 
additional growth resulting from the new tax regime would 
lead to significant additional growth that would do more to 
reduce debt reduction than any other GOI step. (Note: 
presumably including direct debt reduction).  As for 2005, 
Bachar said that the GOI remains committed to attaining its 
deficit target that year, although he admitted doing so would 
require "major expenditure cuts." 
 
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Comment 
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12. (C)  Neither Netanyahu nor his MoF staff provided the 
Embassy advance notice of his tax reduction plan, which 
appears to run counter to promises the MoF made to Under 
Secretaries Larson and Taylor at the recently concluded 2004 
 
SIPDIS 
Joint Economic Development Group meetings in Jerusalem.  At 
the meetings, both the Minister and his DG agreed to use 
additional revenues to achieve two goals, tax reduction and 
debt reduction.  Netanyahu's plan appears to run counter to 
that understanding.  In an April 4 conversation with Embassy 
economic staff, MoF DG Bachar said the MoF desired to make 
more significant changes to the draft 2004 LGA terms sheet to 
take account of the new Netanyahu plan.  He requested that 
Washington approve these changes as soon as possible, as the 
GOI wishes to go to market April 19.  Embassy Economic 
Section staff, which has sent the text of the requested 
changes to Washington for review, noted the extent of the 
changes, and the fact that the language in question had been 
directly negotiated with the Under Secretaries during the 
recent JEDG.  Bachar said he understood and looked forward to 
Washington's reaction to the changes.  He noted that he could 
be contacted until the evening of April 6, at which point he 
would go on leave until April 20.  Bachar noted he was 
designating Budget Director Yuri Yogev to act in his stead 
with regard to the Terms Sheet during Bachar's absence. 
 
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Bachar's Requested Loan Guarantee Agreement Changes 
--------------------------------------------- ------ 
 
13. (C)  On April 4, DG Bachar sent Deputy Economic Counselor 
his edits to the LGA 2004 Terms Sheet.  We have forwarded 
these edits by e-mail to both State/IPA and to Treasury. 
(Note: These are in addition to one change made earlier in 
the month by Minister Netanyahu to the third tic in the first 
section of Appendix 4 referring to reducing the GOI's wage 
bill).  The GOI's proposed Terms Sheet, including Bachar's 
changes, is included below.  Bachar made three changes to the 
Terms Sheet; they are 
1.  Appendix 4, Section 2, Third Tic: Delete second sentence, 
"Due emphasis should be given to deficit reduction." 
2.  Appendix 5, Section 1, Table 1, Defense Consumption: 
Replace NIS 48.1 billion with 48 billion. 
3.  Appendix 5, Section 2, Second Tic, Number 2:  Replace 
phrase "forecasted expenditure growth and to actual 
expenditure outturn" with "original budget plan to the 
previous year." 
 
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Text of Appendices 4 and 5, as Amended by MoF DG Bachar 
--------------------------------------------- ---------- 
 
(SBU) Begin Text of Appendix 4 
 
Modifications to and Determinations of Specific Reforms 
Details in Annex II of the Loan Guarantee Commitment Agreement 
 
The Joint Economic Development Group (JEDG), as the joint 
consultative mechanism referred to in Section 5.03 of the 
Loan Guarantee Commitment Agreement, and proceeding under 
Section 4.02 of the Loan Guarantee Commitment Agreement, 
determines and modifies the specific reforms referred to in 
Section 4.02 by appending the following as Appendices 4 and 5 
of Annex II. 
 
 
CONDITIONS FOR DISBURSEMENT OF THE SECOND TRANCHE OF 
SUPPLEMENTAL ASSISTANCE 
 
The second tranche of bond guarantees in the amount of up to 
$3.0 billion will be released on determination of completion 
of the following: 
 
1.  Progress on Reform Plan: Progress on the main measures of 
the GOI economic reform plan.  This plan includes, among 
other things, reforms related to: 
 
-- Acceleration of tax reform: Continued progress on final 
implementation of tax reforms (legislated in the Knesset in 
2002) by January, 2006; 
-- Pension Reform: Continued long-term reduction in issuance 
of special government bonds for pension funds; 
-- Continued reduction of public sector,s budgetary expense 
on the wage bill as a percentage of GDP, to be achieved 
mainly by reducing public sector employees. 
 
2.  Meet Spending and Budget Deficit Targets. 
-- Commit to expenditures (defined in Appendix 5) in 2004 of 
no more than 226.1 billion New Israeli Shekels, with the firm 
goal of keeping the budget deficit to 4.0 percent of GDP or 
less. 
 
-- Public dissemination and GOI commitment to a detailed, 
multi-year fiscal plan, including a commitment to limit real 
expenditure growth (defined in Appendix 5) to 1 percent per 
year from 2005 to 2010.  Furthermore, commitment to maintain 
budget deficits to a level of less than 3 percent of GDP and 
aim to implement further reductions in the operational 
deficit of at least 0.5 percent of GDP every year until the 
deficit reaches 1 percent of GDP. 
 
-- Any revenues in excess of those foreseen in the 2004 
budget would be allocated to deficit and tax reduction. 
 
3.    Proceed with Privatization Plan 
-- Further progress on the main measures of the Israeli 
government,s privatization plan.  Future privatization steps 
should focus on the twin goals of increasing competition as 
well as reducing government involvement in the economy. 
 
4. Implement Structural Reforms: 
-- Increase competition in the economy by: 
--    Implementing liberalization of the domestic 
telecommunications market through a regulatory environment 
that facilitates the introduction of competitive local 
landline services within the timeframe of this agreement; 
--    Working to increase competition within the ports, 
financial markets, and electricity sectors; 
--    Reduce governmental regulation with the aim of 
promoting economic growth. 
--    Continue efforts to further strengthen IPR protection 
in Israel. 
 
5. Undertake Infrastructure Investments 
-- Commitment to, and progress on $1 billion in 
infrastructure spending as discussed in the GOI,s economic 
reform plan. 
 
6. Other 
-- The amount of guarantees that may be issued shall be 
reduced by an amount equal to the amount extended or 
estimated to have been extended by the GOI during the period 
from the last deduction to the date of issue of the 2004 
guarantee, for activities which the President determines are 
inconsistent with the objectives and understandings reached 
between the United States and the Government of Israel 
regarding implementation of the loan guarantee program. 
-- Commit to working with the U.S. Government to resolve 
outstanding procurement issues. 
 
SUBSEQUENT DISBURSEMENTS 
 
Subsequent disbursements of bond guarantees will be 
conditioned upon determination and implementation of the 
GOI,s macroeconomic, structural and other targets developed 
through the USG-GOI joint consultative mechanism.  Fiscal 
targets and implementation of the reform plan will be the 
main foci.  In particular, disbursements of the third tranche 
of bond guarantees will be conditioned on achievement of the 
spending and budget deficit targets for 2004 and 2005.  The 
extent to which other commitments made for the 2004 
disbursement are met will also be an important consideration. 
 
End Text of Appendix 4 
 
Begin Text of Appendix 5 
 
DEFINITION OF 2004 EXPENDITURES TARGET 
 
1.  Definition of 2004 expenditures target 
-- For the purpose of releasing the second tranche of bond 
guarantees, as described in Appendix 4 Annex II (as amended) 
of the Loan Guarantee Commitment Agreement, the 2004 
expenditures target of 226.1 billion New Israeli Shekels 
shall be defined as: 
 
GOI gross expenditures, as set forth in the annual budget 
law, less the repayment of principal on debt (except for the 
repayment of principal on debt related to social security), 
plus expenditures on government hospitals.  (Footnote 1: In 
terms of expenditure classification, a corresponding 
definition of the 2004 expenditures target comprises of 
 Total Expenditures and Credit Granted as defined in the 
GOI,s Gross Expenditures by Economic Classification plus 
expenditures on government hospitals.) 
 
-- Based on this definition, the projected 2004 expenditures 
target is outlined below: 
 
Table 1: Composition of 2004 expenditures target (by 
expenditure category) 
 
2004 Expenditures Target            226.1 
 
1. Total Expenditures and Credit    221.1 
Civilian Consumption                 42.6 
Defense consumption                  48.0 
Transfers and subsidies              68.6 
Investments and credit               14.7 
- Direct investment                   8.7 
- Credit                              6.0 
Interest payments                    35.7 
Payback of principal to NII           6.4 
Change in Contingency Reserves        5.1 
 
2. Government Hospitals               5.0 
 
Source: Ministry of Finance 
 
2.  Definition of real expenditures growth. In accordance 
with Appendix 4 Annex II (as amended): 
-- The increase in the sum of the government,s expenditures, 
excluding hospitals, in every year between 2005 and 2010, 
shall not exceed 1% in real terms relative to the sum of 
government expenditure in the preceding year. 
-- Calculation of real expenditure growth for this purpose 
shall be based on the following parameters and assumptions: 
1.Nominal Expenditure shall be defined in accordance with the 
definition set out in Appendix 5 section 1. 
2.The 1% real expenditure growth limit shall apply to 
original budget plan to the previous year. 
3.Calculation of forecasted real expenditures growth shall be 
based the annual average CPI forecast as established in the 
GOI budget. 
4.Calculation of actual real expenditures growth shall be 
based on the annual average CPI published by the Central 
Bureau of Statistics. For this purpose the GOI will provide 
actual budget results. 
 
3. Forecasted indicative expenditures targets 
-- Below are the forecasted expenditures targets for 2005 and 
2006, based on the expenditures target definition as above. 
 
Table 2: Forecasted indicative expenditure targets for 
FY05-06 ( current NIS million) 
 
                             2004            2005      2006 
                       (original budget) (forecast) (forecast) 
Expenditures                226.1      234.6      243.1 
1. Total Expenditures and   221.1      229.4      237.7 
Credit granted 
Thereof: Credit granted       6.0        6.2        6.5 
Revenue-dependent            12.3       12.7       13.2 
Net expenditure without     202.8      210.4      218.0 
credit 
Interest                     42.1       43.7       45.2 
Ministries                  160.7      166.7      172.8 
2. Gov. Hospitals             5.0        5.2        5.4 
Forecast of CPI Changes                  2.7%       2.6% 
 
Source: Ministry of Finance estimates 
 
End Text of Appendix 5 
 
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