Forecasts of Macroeconomic Developments, State Revenues from Taxes and Revenue from Other Sources,

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1 Ministry of Finance Chief Economist - Research, State Revenue and International Affairs June 2013 Forecasts of Macroeconomic Developments, State Revenues from Taxes and Revenue from Other Sources, Highlights This document sets out the forecasts for GDP growth, the labor market, price fluctuations, State revenues from taxes and revenues from other sources in The document is divided into five sections: Section I describes in brief the methodology of the macroeconomic forecasts. Section II lists the key assumptions; Section III presents the macroeconomic forecasts and the reasons for the anticipated changes in the different components. Chapter IV presents the forecasts for State revenues from taxes, and Section V presents the forecasts for revenue from other sources. Section I: Forecasting Methodology The forecast model is an econometric model consisting of two parts. The first part estimates the GDP components in nominal terms and the fluctuations in prices of the GDP components, on a quarterly basis. The second part generates forecasts for aggregates in the labor market. In addition to the model-based forecasting, the forecasts relate to two areas of specific relevance to the budget years: (a) the start of natural gas production from the Tamar reserve; (b) the effect of the fiscal consolidation. 1

2 Start of Natural Gas Production from the Tamar Reserve As of the end of March 2013, natural gas is being produced from the Tamar reserve on an annual scope of 4.5 BCM, with the rate or production expected to increase gradually until 2015, when production will amount to 10.5 BCM per year. Concurrently with the start of production from the Tamar reserve, production from the Yam Tethys reserve is expected to decrease significantly in the coming years. In order to quantify the effect of the production of natural gas on the Israeli economy, the quantities of gas that will be produced during were calculated, taking into account the forecast for domestic demand as determined by the Tzemach Committee. We estimated the savings in consumption of energy substitutes for gas (fuel oil and diesel oil) and quantified the effect of the change in consumption on the GDP. According to our estimate, the production is expected to contribute to growth approximately 0.9 percentage points in 2013 and 0.5 percentage points in Beginning in 2015, the effect of natural gas production on the GDP growth rate will be low (see Diagram 1). Diagram 1: Expected Contribution of Domestic Production of Natural Gas to the GDP, % 2.5% 2.0% 1.5% 1.6% 2.1% 2.2% 2.3% 2.4% 2.5% 2.5% 1.0% 0.5% 0.0% 0.90% 0.50% 0.14% 0.07% 0.12% 0.11% 0.02% ה תרומ ה ל תמ ג ה תרומ rateה לקצ growthב to annual הצמי ח ה ה שנ Contributionתי Contribution to GDP 2

3 Effect of the Fiscal Consolidation on Growth Changes in public expenditure could affect demand in the economy, thus also affecting the growth rate in the short term. The budget for provides for a significant decrease in the deficit (planned for 2014). To estimate the effect of the fiscal consolidation on growth we calculated the expected changes in the cyclically adjusted deficit (henceforth CAD) 1. We estimated the effect of the changes in CAD on the GDP assuming that the fiscal multiplier of the change in CAD is According to our estimate, as a result of the fiscal consolidation in 2014 growth in that year will decrease by 0.4 percentage points. Without consolidation, the high budget deficit could potentially reduce growth to a much greater extent. Section II: Assumptions Below are the main forecasting assumptions used and an explanation of the way in which they were formulated. Relevant International Indicators The assumptions in the model regarding the international environment are largely based on forecasts of the International Monetary Fund (IMF) (see Annex A). The model assumes that the U.S. economy will grow during 2013 and 2014 at rates of 1.9% and 3.0% respectively (see Diagram 2). World trade will recover gradually, expanding in 2013 by 3.6% and in 2014 by 5.3%. The model also relates to changes in oil prices, which are expected to remain at the same level as in The Cyclically adjusted deficit takes into account the amount of the deficit and the position of the economy in the business cycle (boom or recession). 3

4 Diagram 2: Growth in the U.S. and the World Trade Volume (annual percentage change) 15% 10% 5% 0% 7.0% 2.9% 12.5% 6.0% 2.5% 3.6% 5.3% 6.1% 6.2% 6.4% 6.5% 2.4% 1.8% 2.2% 1.9% 3.0% 3.6% 3.4% 3.3% 2.9% -5% -3.1% -10% -15% -10.6% Sources: IMF, BEA. U.S. GDP הסחרהעולמי ת הראג במ World trade Domestic factors The forecast model uses three key indicators that affect domestic demand: (a) share indexes (TA 100 and NASDAQ); (b) exchange rates, and (c) interest rates. We assume that the share indexes will rise at an annual rate of 6%, both in 2013 (starting from June) and in 2014; the exchange rates will remain around their current level; the Bank of Israel's interest rate will not change significantly in 2013 and will increase gradually during Labor Market In the labor market, we rely on the demographic forecasts of the Central Bureau of Statistics to forecast the workforce (population aged 15 and over). 4

5 Section III: Macroeconomic forecasts and Analysis of Results In the economy is expected to grow at a slower rate than in previous years. The start of natural gas production from the Tamar reserve will contribute significantly to overall growth figures. Thus, in 2013 the growth rate is expected to stand at 3.8% (including natural gas production), while in 2014 the economy will grow by 3.3%. These growth rates include the contribution of natural gas production, amounting to 0.9 percentage points in 2013 and 0.5 percentage points in The expansion of global demand is expected to boost exports, while investments in capital assets are expected to contract following the completion of large one-off projects. The fiscal consolidation is expected to affect growth mainly in Exports and Imports Exports of goods and services are expected to grow by 5.7% in 2013 and by 4.7 % in 2014 (see Table 1). In 2012, exports of goods slowed due to slowdown in global trade, whereas exports of services (including the sale of startups) continued to grow rapidly. Exports of goods are expected to rebound in , in line with the expansion in global trade. In addition, exports of services are expected to expand in light of the improvement in the capital markets and the growth of the U.S. economy (especially in 2014). Imports of goods and services grew by 7.5% in The growth in imports is expected to slow, mainly due to decrease in energy imports following the start of the flow of natural gas from the Tamar reserve. Private Consumption Private consumption is expected to grow by 3.3% in 2013 and by 3.0% in 2014, following moderate growth in This growth reflects on the one hand the closing of the gap that developed in , during which private consumption lagged behind GDP growth, and on the other hand the anticipated effect of the fiscal consolidation, and mainly the increase in the consumption tax burden in

6 Public Consumption Public consumption is expected to grow by 2.9% in 2013 and by 2.3% in 2014, following higher growth in However, the growth rates in public consumption are relatively higher than in the past. The forecasted increase stems from the expansion of employment in the public services along with an increase in real wages. Investments The years saw rapid growth in investments. Investments in fixed assets in 2012 amounted to 19.2% of GDP a record level compared to previous years. The growth in investments was attributable to one-off projects: the construction of natural gas infrastructure and an upgrading of the Intel production facilities in Kiryat Gat. With the completion of these projects, the rate of growth of investments has slowed. The building sector also is showing some cooling. As a result we foresee limited growth in investments in fixed assets during 2013 and a recovery in the course of % Diagram 3: Investments in fixed assets (percent of GDP) 17.2% average for % 19.1% 18.3%18.2% 15% 10% 6

7 Inflation Prices are expected to rise in 2013 an average of 1.7% however, the rate of increase in prices during the year (year-end to year-end) will be higher. Inflation in 2014 will average 2.3%, affected by consumption tax hikes in the second half of 2013 (year-end effect). Employment and Wages Growth in employment is expected to slow during The number of employees grew at a rapid rate in the past three years, beyond the natural growth in the workforce. As a result, unemployment has declined significantly and there has been a substantial improvement in the participation rate. Nevertheless, the slowdown in economic growth, along with the fiscal consolidation, will impact negatively on the labor market and hinder further improvement in the unemployment and participation rates. It should be remembered that the natural gas sector, which will contribute significantly to growth in , is not labor-intensive. Wages rose at a slow rate in , below the growth in per-capita GDP. In , wage growth is expected to accelerate somewhat, mainly in the business sector. Wages in the public sector will be affected, on the one hand, by the wage agreements that were signed in recent years, and by restraining measures in the budget, on the other. Risks in the Forecast The ongoing crisis in the Eurozone, the uncertainty over the recovery of the U.S. economy and the slowdown in the emerging economies could substantially impact the forecast. There is also considerable uncertainty regarding domestic factors. The start of natural gas production from the Tamar reserve has put upward pressure on the shekel, which, if it persists, could affect the balance of trade and investments. A worsening in Israel's security and in the geopolitical situation also could impede the growth rate. 7

8 Table 1: Growth Rates of the Real GDP and Its Components, Real growth rates (percent) Average excl. natural gas contribution 2014 excl. natural gas contribution Actual Actual Actual Forecast Forecast Forecast Forecast Gross domestic product Private consumption Public consumption Gross investment Investment in fixed assets Exports Exports of goods excl. diamonds Exports of services Imports Imports of goods and services excl. diamonds Business GDP Unemployment

9 Table 2: Consumer Price Index and the Labor Market, Actual Actual Actual Forecast Forecast Consumer Price Index Change (annual-average over annual-average, percent) Change (December over December, percent) Wages Average wage in current prices (NIS) Annual change in current prices (percent) Annual change in fixed prices (percent) Israeli employed persons Number of employed persons (thousands) Annual change (percent) Unemployed persons Unemployed persons (thousands) Unemployed persons (percent) Participation rate (percent)

10 Table 3: Real GDP and Nominal GDP, Actual Actual Actual Forecast Forecast Change in real GDP (percent) GDP in current prices (NIS billions) Rate of change in nominal GDP (percent) Date of preparation of the forecasts: May 7, 2013 Annex A Key Assumptions 2012 (Actual) US GDP Growth Model assumptions 1.2% 3.1% IMF (April 2013) 2.2% 1.2% 3.1% OECD (May 2013) 2.1% 2.8% World Trade Model assumptions 3.6% 5.3% IMF 2.5% 3.6% 5.3% OECD 3.5% 5.2% Oil prices (rate of change) 24.4 )-1.5%( 23.2 )-1.6%( 24.1 ) 1.1%( Tel Aviv %- 8.2% 6.1% NASDAQ 11.6% 11.4% 6.3% 11

11 Section IV: Forecast of State Revenues from Taxes 2, The budget forecast for was prepared in May 2013, when the actual collection figures for January-April were already known. The forecast does not include the effect of the Iscar transaction on tax revenues, since the details of the transaction, the amount at which it will be taxed and the timing of the tax were not known at the time. Forecast for 2013 State revenues from taxes in 2013 are projected to amount to NIS billion, broken down as follows: NIS billion in direct taxes, NIS billion in indirect taxes 3 and NIS 5.7 billion in fees (see Table 4). This is a real increase (net of the change in the consumer price index) of 5.7% compared to actual tax revenues in The forecast of revenues for 2013 assumes a real increase of 2.9% in the GDP (excluding natural gas) and an increase of 1.7% in GDP prices (for a complete list of the macroeconomic assumptions see Tables 1 to 3 above). The nominal growth and the increase in macroeconomic variables will add approximately NIS 8.6 billion to tax collection in A net tax increase is expected as well, estimated at NIS 8.7 billion, due to changes in legislation. This amount consists of an additional net tax of NIS 6.0 billion, which has already been implemented, and another proposed tax increase of NIS 2.7 billion 4, assuming that it will be adopted in its entirety by the Knesset. The forecast further assumes that advancing the payment of tax on dividends immediately prior to the tax increase at the end of 2011 raised tax collection by one-time revenues of NIS 2.0 billion in 2012 and will reduce tax collection in 2013 by NIS 1.5 billion. In addition, it was assumed that the taxing of trapped profits will yield one-time revenues of NIS 3.0 billion in The forecast also takes into account that as of 2 These are State revenues from taxes that are collected by the Israel Tax Authority as well as revenues from fees that are collected by the government ministries. The revenues here do not include VAT on defense imports and do not include revenues of other entities in the public sector that also collect taxes and mandatory payments: the National Insurance Institute and the Local Authorities. 3 In 2004 the Income Tax and Land Taxation Department and the Customs and VAT Department were merged as the Israel Tax Authority. In this section we refer to the two former tax departments as "direct taxes" and "indirect taxes," respectively. 4 In 2014, upon full maturity, the increases proposed by the government will add tax revenues of NIS 12.8 billion see Table 6. 11

12 April 2013 the Israel Electric Corp. has switched to natural gas instead of diesel oil, which will reduce excise revenues from diesel oil by NIS 0.4 billion in 2013 and by an additional NIS 0.4 billion in Net of legislative changes and net of tax on trapped profits, and discounting the effect of the advancement of dividend tax payments, tax revenues are expected to grow by 2.1% in real terms in 2013 compared to This is a nominal increase of 3.8% in 2013 compared to tax revenues in 2012, below the expected GDP nominal growth rate of 4.7% (excluding natural gas 5 ). Based on the performance figures until April, collection in the first third of 2013 increased at a nominal rate of 3.3% over the same period last year, thus the forecast for 2013 assumes a slightly accelerated increase of 4.3% in collection in May- December 2013 compared to the same period last year. The slow growth in the first third of the year is attributable mainly to high income tax refunds which are not expected to continue at the same rate during the rest of the year. Forecast for 2014 In 2014 State revenues from taxes are projected to amount to NIS billion, broken down as follows: NIS billion in direct taxes, NIS billion in indirect taxes and NIS 6.0 billion in fees (see Table 5). This is a real increase (net of the change in the consumer price index) of 7.4% compared to the forecast for The forecast of revenues for 2014 assumes a real increase of 2.8% in the GDP (excluding natural gas) and an increase of 2.3% in GDP prices, as well as a net tax increase, estimated at NIS 13.3 billion, due to changes in legislation. This amount consists of a net tax increase of NIS 0.5 billion, which has already been decided upon, and another proposed tax increase of NIS 12.8 billion, assuming that it will be adopted in its entirety by the Knesset. In addition, it was assumed that stronger enforcement (which is conditional in part on legislation that has still not been adopted by the Knesset) will yield an initial sum of NIS 2.1 billion in As against this, a 5 The flow of gas from the Tamar reserve is not expected to contribute significantly to tax revenues in the short term. 6 Upon full maturity, the increased enforcement measures will yield approximately NIS 3 billion starting from

13 sum of NIS 3.0 billion was deducted from the forecast base in respect of one-time taxation of trapped profits in Net of legislative changes and net of tax on trapped profits, and discounting the effect of the advancement of dividend tax payments, tax revenues are expected to grow by 4.4% in real terms in 2014 compared to This is a nominal increase of 6.8% in 2014 compared to tax revenues in 2013, above the expected GDP nominal growth rate of 5.2% (excluding natural gas), resulting from increased enforcement in 2014 and the partial closing of the gap between tax collection and GDP growth in 2013, arising from an unusual increase in tax refunds in the first third of the year. Table 4: Collection Forecast for 2013 (rounded NIS billions) Total Direct Indirect Fees 2012 Actual collection Base correction advancement of dividend collection Basis for forecast Implemented legislative changes Nominal growth and increase in macroeconomic variables Switch of Israel Electric Corp. from diesel oil to natural gas as of April Advancement of dividend tax collection Forecast before trapped profits, enforcement and proposed legislative changes Trapped profits Increased enforcement Forecast before proposed legislative changes Proposed legislative changes Budget forecast Table 5: Collection for 2014 (rounded NIS billions) Total Direct Indirect Fees 2013 Forecast before trapped profits, enforcement and proposed legislative changes Base adjustment Advancement of dividend tax collection Basis for forecast Implemented legislative changes Nominal growth and increase in macroeconomic variables Switch of Israel Electric Corp. from diesel oil to natural gas full year Advancement of dividend tax collection Forecast before enforcement and proposed legislative changes Increased enforcement Forecast before proposed legislative changes Proposed legislative changes Budget forecast

14 Legislative Changes In legislative changes will add approximately NIS 19.2 billion NIS 11.7 billion in 2013 and an additional NIS 7.5 billion in 2014 (see Table 6, item 1). Legislative changes include tax on trapped profits, which will add a one-time amount of NIS 3.0 billion in Excluding trapped profits, the additional collection in 2014 over 2012 will stand at the same NIS 19.2 billion, but the breakdown by years will be different NIS 8.7 billion in 2013 over 2012 and NIS 10.5 billion in 2014 over 2013 (Table 6, item 3). Out of the said total of NIS 19.2 billion, NIS 6.5 billion derive from legislative changes that were implemented until May 2013 (including a tax increase on tobacco at the beginning of May Table 6, item 4), while the remaining NIS 12.8 billion have still not been approved by the Knesset. Some of the changes, per the government's proposal, are due to take effect in June and July (VAT increase to 18% and increased purchase tax on alcoholic beverages) and in August (increased purchase tax on residential apartments), adding NIS 2.7 billion already in 2013 (see Table 6, item 5). Table 6: Effect of Legislative Changes on Tax Collection, (NIS millions, year over year and cumulative effect) 2014 Cumulative Total including trapped profits Direct 4,640 4,460 9,100 Indirect 7,030 3,100 10,130 Total 11,670 7,560 19, Trapped profits Direct 3,000-3, Total excl. trapped profits Direct 1,640 7,460 9,100 Indirect 7,030 3,100 10,130 Total 8,670 10,560 19, Implemented until May 2013 (excl. trapped profits) Direct 1, ,100 Indirect 4, ,380 Total 6, , To be implemented Direct 390 7,610 8,000 Indirect 2,280 2,470 4,750 Total 2,670 10,080 12,750 14

15 Tax Burden To summarize, the government tax burden, which is the percentage of total State revenues from tax in the GDP (including natural gas), which stood at 23.5% of GDP in 2012, is expected to increase to 23.9% of GDP in 2013 and to 24.8% of GDP in 2014, i.e. an increase of 1.3% of GDP over two years (see Diagram 4-A). The development of the tax burden was impacted by frequent changes in the tax laws. Thus, the downward trend in tax rates during was reversed starting in Furthermore, collection in will be affected by the advancement of tax payments on dividends at the end of Diagram 4-B shows the tax burden net of legislative changes and net of the advancement of dividend tax payments. This is an estimate of the tax burden as it would have been had the tax rates of 2014 been applied from 2001 until 2014, and it provides a picture of the tax system's performance. The tax burden in this definition follows the business cycle until 2011 it increases in periods of rapid growth and decreases in crisis periods. For example, the tax burden fell to a low in 2009, due to the global crisis, and recovered as expected in , although at a lower intensity than in the previous cycle. However, despite growth rates of around 3% since then, the tax burden declined again in , even below its level in Only in 2014 will the tax burden increase by 0.2% of GDP compared to

16 Diagram 4-A: Tax Burden in and Forecast for (State revenues from taxes as a percentage of GDP) Original data Diagram 4-B: Tax Burden Net of Legislative Changes and Timing Differences in and Forecast for (as a percentage of GDP) Original data 16

17 Section V: Forecast of Revenue from Other Sources The forecast of revenue from other sources is impacted mainly by economic developments in Israel and the world and by demographic changes. This forecast includes five revenue items: loans from the National Insurance Institute, military grants, VAT on defense imports, income from interest, and other revenues (comprised mainly of income from dividends of government corporations and royalties on natural resources). The forecasts were prepared using econometric models of NII revenues and expenses and the other revenues component, as well as simulations. This section presents the forecast of revenue from other sources discounting the effect of the policy measures proposed in the State budget for these years. In the wake of the global economic crisis, government revenue from other sources declined significantly. Thus, whereas the average revenue from other sources in stood at NIS 33.2 billion per year, in this average declined to only NIS 27.7 billion per year. Since 2008 there has been a significant decline in all components of revenue from other sources as a percentage of GDP. Diagram 5: Development of Other Revenue Components (as a percentage of GDP) Loans from the National Insurance Institute Grants from the U.S. Other revenues. VAT on defense imports Interest 17

18 The forecast of revenue from other sources for is based on macroeconomic forecasts, current developments in 2013 and demographic forecasts of the Central Bureau of Statistics. In we foresee a continuation of the uptrend in real wages that began in 2010, although at a more moderate rate compared to Thus, real wages are expected to grow in 2013 by 0.8% and in 2014 by 0.9%, compared to growth of 1.2% in Furthermore, we assume that the participation rate in will stand at 63.7%. As to the demographic forecasts, we assume that the population will grow at a rate of 1.4% in each of the years 2013 and 2014, slightly below the growth rate in previous years. As to the composition of the population, we assume that the rate of growth of the population aged 65 and over will stand respectively at 3.8% and 3.7% in 2013 and In light of the economic and demographic developments, revenue from other sources in 2013 (discounting policy measures to be approved in the budget framework) is expected to total NIS 28.9 billion, NIS 900 million more than in This increase stems mainly from an expected rise in loans from the National Insurance Institute. In 2014 we foresee a more substantial increase of NIS 2.0 billion in revenue from other sources, which will stand at NIS 30.9 billion. Table 5: Forecast of Non-Tax Revenues, (NIS billions) Actual Actual Actual Actual Forecast Forecast VAT on defense imports Interest Loans from the National Insurance Institute Defense aid Other revenues Total other revenues

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