Economist warns: Israel's war costs could reach 10% of GDP, raising urgent challenges

Hod Goite had recently returned home near the Gaza border after his long trip abroad following the completion of his mandatory army service. He had plans to study at Ben-Gurion University, but October 7 dramatically changed them. 

After his entire community was evacuated to Eilat and he returned to the IDF to serve as a reservist, Hod’s plans to go to university were no longer feasible. Once he completed his reserve duty, Hod found himself in need of new life plans. He eventually opened the bar Tinsky_43 in Ramat Gan with a friend. 

“We’re breathing, but it was supposed to be much better. People still need to be able to have a good time during this difficult period. We have fewer customers than we hoped because the war makes people not want to go out as they’re sad or afraid, but we’re doing alright,” he told The Media Line.

As Israel approaches the one-year mark since October 7, the resilience of Israelis like Hod stands as a symbol for a country that is balancing existential threats and financial stress. “We keep going because keeping our dreams, daily jobs, and desires alive is the real winning,” said Hod. “Our job is important because it helps many people keep going. If we stop our lives, we’re losing.” 

Hod is dealing with the situation the best he can and moving forward despite uncertainties. Meanwhile, amid these uncertainties, Israeli Finance Minister Bezalel Smotrich recently introduced plans for Israel’s national budget for 2025, which include reducing expenses while funding the war effort. This has further raised concerns, especially regarding financial and non-financial benefits given to Haredi populations.

According to Smotrich, the 2025 state budget will involve significant spending cuts as the government grapples with the financial demands of its ongoing war on seven fronts. However, critics point out that superfluous expenses benefiting Prime Minister Benjamin Netanyahu’s supporters are being protected to maintain the current coalition together, an attitude seen as a red flag by some financial experts.

With war expenses estimated at NIS 200-250 billion (US$54-$68 billion), the budget is aspiring to balance fiscal responsibility with the necessity of sustained war funding until victory is secured. Despite current inflation at 3.2%, seen as temporary and driven by war-related factors, the budget aims for a deficit target of up to 4% of GDP in 2025, down from the 6.6% forecast for 2024. This requires NIS 35 billion (US$9.5 billion) in spending adjustments, including freezing tax rates, benefits, and wages. The plan also includes support for the high-tech sector, improving public sector efficiency, and preventing tax evasion.

Although the ongoing war with Hamas is causing unprecedented financial strain on Israel’s finances, the Jewish country’s strong pre-war economic performance and low debt-to-GDP ratio seem to be providing room to navigate the crisis. Still, a significant loss of wealth may be observed in the country. 

Second war of independence

Prof. and Dr. Alon Eizenberg, the William Haber Chair in Economics at the Hebrew University of Jerusalem, explained to The Media Line that the war has “a first-order impact on the Israeli economy. It is not unlike a second war of independence. And unlike the Yom Kippur War of 1973, which lasted three weeks, its end is not in sight.”

On the positive side, Israel's economy nowadays is nothing like that of the 1970s, Eizenberg highlighted. “It is much more of a modern, robust, and open economy. While we should be vigilant, there is also room for optimism that a ‘lost decade’ is not in the cards for Israel's economy this time around. Israel's economic performance in the years leading up to the war has been strong, allowing it to achieve low debt-to-GDP ratios. This allows the nation to assume higher debt levels now,” he said.

Dr. Yannay Spitzer, an assistant professor specializing in Economic History and Applied Microeconomics in the Department of Economics at the Hebrew University of Jerusalem, explained: “The long-term implications of the war's costs primarily involve a significant loss of wealth. We're likely talking about hundreds of billions of shekels, roughly 10% of the annual GDP. This represents a substantial loss of wealth that will need to be paid one way or another. One of the key challenges the government faces is determining how to distribute this burden across the public, both in the short and long term. If handled correctly, it shouldn't harm Israel's long-term economic growth.”

Chen Herzog, the Chief Economist Officer of BDO, a leading public accounting, tax, and advisory consultancy, told The Media Line that it is important to understand the broader economic context beyond the direct NIS 250 billion cost of the war. “We’re seeing negative per capita growth this year in 2024. The government expects 1.1% growth, but with a 2% population increase, that translates to nearly -1% growth per capita. The business sector’s GDP is shrinking even faster, with a reduction of over 5%. The government has increased military spending, which technically contributes to GDP, but that doesn’t create sustainable growth,” Herzog explained to The Media Line.

“We need a budget that not only deals with the direct economic cost of the war but also the indirect costs. Investments are declining, foreign direct investment are sinking, the appetite for investors to provide capital to Israel is declining, and credit rating companies are lowering the country’s grades. Israel is facing the risk of recession in this overall economic environment,” Herzog warned.

When presenting Israel’s new budget, Smotrich stressed that while increasing taxes isn’t ideal during wartime, the government plans to freeze public sector wages, merge lower income tax brackets, and tax previously exempt “trapped profits” of corporations in an effort to avoid increasing public debt.

Dr. Eizenberg explained that the government's aim to drop Israel’s deficit from 6.6% in 2024 to 4% in 2025 is an ambitious goal but will be secondary to the primary objective for economic policy in wartime to keep the economy running to support the war effort. “This means not only funding direct war spending but also providing ample support to households and businesses nationwide. In a prolonged and asymmetric war of attrition, Israel's ability to prevail depends crucially on the perseverance of its large reserve army and its civilian society,” he said. 

As Israelis are looking closely to which part of society will have cuts in benefits or increased taxes in the 2025 budget, Israel’s prime minister and finance minister are hesitant to cut obvious budget areas, like subsidies for the ultra-Orthodox. Such hesitancy “raises concerns about their commitment to long-term fiscal stability, especially with the need to cover war costs and increased security spending. Structural changes are essential, but the government appears unwilling to address even the easiest areas for cuts, such as political transfers and redundant ministries,” Dr. Spitzer added. 

Herzog also agrees that the challenges are much greater than avoiding the government’s deficit and promoting sustainable economic growth. “The Bank of Israel has already said this. We need to change the priorities of how expenses and benefits are distributed. The government needs to prioritize growth investments that increase the participation in the labor force. We don’t see this in this budget. There is no change in its priorities. The economy needs a substantial shift because today, Israel risks inflation and stagnation. After the Yom Kippur War in 1973, Israel went through a ‘lost decade’ of low growth and hyperinflation. We’re in a much stronger position today, but we can’t let that slip away,” Herzog analyzed.

“Increasing military expenditure is a given at this moment, but the question is how do we cut unnecessary expenses in other areas that aren’t promoting growth. Beyond the geopolitical and military risk, Israel now also faces an economic risk. Having national resilience isn’t simply about military strength, it's also about economic strength. In a weakened economy, our national security is also weakened,” BDO’s Chief Economist told The Media Line.

While reducing subsidies to ultra-Orthodox students could help, it won’t be sufficient to solve the broader budgetary challenges. Dr. Spitzer explained that there are also redundant roles in Netanyahu’s government that exist to accommodate political interests. “This reluctance of the government to cut these most obvious expenses related to its base of supporters gives the market the wrong signals,” he said.  

Similarly, Herzog believes that the budget needs to be “reprioritized.” According to him, “We’re in a situation that all parts of the society must take a part of the burden in financing Israel’s security and creating growth. The Bank of Israel has called for a budget reprioritization, which includes making cuts using coalition-based agreements. All parts of society must share the burden of financing the war and promoting growth.” 

Continued Herzog: “If certain groups are exempt from military service or do not contribute economically, it becomes a moral issue and an economic one. Expanding military service to include groups currently not participating could increase Israel’s productivity by NIS 10 billion per year. Otherwise, extending the military reserve duty for those already serving could cost the economy an additional NIS 5 billion annually. Economically, it’s becoming necessary to have everyone contribute to military service without discrimination.”

As more liberal parts of Israel’s society are already dissatisfied with Netanyahu’s government and its management of the war, the combination of increased taxes and reduced public transfers could impact essential parts of the Jewish country’s economy. “Every government ministry will need to identify where cuts can be made, and much of it will be painful. The government’s extreme policies are already signaling to educated, mobile, liberal Israelis—who are crucial to the high-tech industry—that they may need to prepare an outside option,” according to Dr. Spitzer.

According to the Israel Innovation Authority, the high-tech industry constituted 18.1% of Israel’s GDP in 2022 – a figure that positions it as the sector with the largest economic output. “The government claims to support it, though this support often feels like empty promises. The government can try to subsidize the industry, but in my opinion, that's not sustainable economics. The government's main role should be to ensure Israel remains a liberal, democratic, and safe country—something that the current coalition seems to be neglecting,” Dr.  Spitzer concluded.

Dr. Eizenberg raised the possibility that the high-tech sector could be entering a new phase, suggesting that, despite the importance of Israeli high-tech, the country “should bear in mind that this sector grew disproportionately during the years when inflation and interest rates were near-zero. Some, but not all, observe this decline as merely a healthy return process to a long-run trend.”

However, many disagree that the high-tech sector is entering the phase described by Dr. Eizenberg. According to Herzog, growth in this essential part of the Israeli economy would be possible if conditions were met. “The high-tech sector, traditionally a growth driver, relies heavily on international cooperation and foreign investment. The longer the war drags on, the higher the risk premium for doing business with Israel. The high-tech sector will not be resilient enough to sustain this, threatening the entire economy. The government must consider these economic factors when making strategic decisions about the duration of the war. Beyond the direct costs, each month of conflict increases indirect costs exponentially,” said BDO’s chief economist.

However, strategic sectors in the Israeli economy also include agriculture. Beyond helping to maintain Israel’s food security, it also helps keep inflation controlled with food prices. Herzog highlighted Israeli food back Leket’s most recent report that showed that 30% of the agricultural areas in Israel are in conflict areas. “This increased the need to import food by 60,000 tons and caused double-digit increases in the prices of agricultural products. All of this is making everyone less wealthy in Israel.”

The combination of inflation and a looming recession adds to the uncertainty for business owners like Hod Goite and for Israel’s economy as a whole. The war’s toll, along with inflationary pressures and potential recessive trends, threaten to weaken Israel’s financial stability. As military expenditure rises and sectors like agriculture and high-tech face disruptions, the government’s ability to manage these risks becomes critical. Without strategic economic decisions, Israel could face a dangerous mix of stagnation and rising prices, which would make recovery from both war and economic downturns even more challenging.