Economy is the next front of Israel's existential war, and it's losing - analysis

Among the fronts on which Israel has been fighting since October 7, there is one where it is clearly failing to meet the challenges it faces – the economy.

This is a front that is no less of a threat to any on which Israel is fighting militarily. No country can function without an economy that is strong enough to support it, without a medical system, welfare system, education system, and any of the other necessary functions a state must provide for its citizens. And it cannot do so without a working economy.

While this is not a new front – economists have been issuing warnings for years as politicians have kicked necessary changes down the road – the war has poured lighter fluid on the slow burn of the existential economic threats Israel faces. This threatens to accelerate a damaging brain drain, to damage the trust of investors in the country irreparably, and to blow up the country’s deficit.

Israel’s sectoral budget priorities and pork barrel politics, which mean that coalition funding and the funding of narrow interests take priority over national ones, have contributed to a productivity gap between Israel and other G7 countries that has tripled since the mid-’70s, Tel Aviv University Prof. Dan Ben-David, who heads the Shoresh Institution explained. In terms of its economic growth, Israel is not keeping up with the countries to which it wants to be compared.

An example of such a sectoral policy is the ultra-Orthodox draft in the past decades, which has meant that if young haredi men study Torah full-time and stay out of the workforce, they are exempt from the draft.

Unsustainable practices

Without going into the morality of such a system, the economic challenges posed by a system that disincentivizes both workforce participation and military service for the country’s fastest-growing sector are significant.

It leaves a smaller and smaller part of the country’s population to support a growing part that does not contribute effectively through military service, tax contributions, or through the workforce under such a policy. This is clearly not sustainable in the long term, and economists have warned that such a system will not be able to continue for years.

This is one example of many sectoral interests that are promoted at the expense of national ones under the country’s coalition-focused economic policy.

Protectionist policies, ineffective regulation, and lacking public infrastructure are also among the economic challenges faced by the country, consultancy firm McKinsey noted in a 2023 report on the productivity gap between Israel and OECD countries.

Israel is facing slipping into a cycle in which sectoral policies and continuing to delay overhauling ineffective systems slow growth, lowering the quality of life for Israelis, and speeding a brain drain that exacerbates slowed growth – and on and on as the country’s economy deteriorates.

Around 50% of the population does not pay income tax because they don’t make enough to reach the lowest rung on the tax ladder. Just 20% of the population pays 93% of all income tax, according to the Shoresh Institution. This means that not many people need to leave Israel to drastically impact the country’s tax income and with it the economy.

Effects of a Brain Drain 

As of 2022, there were 44,840 registered doctors, just 33,558 of whom were under 67, according to government data. This again shows how a minimal brain drain can have a huge impact on the country and its ability to provide services to its citizens.

Those who are first to leave a country in which the quality of life is deteriorating are those who have the education and skill to have good opportunities abroad – exactly those people whose absence will be quickly felt in the economy.

The war has brought these existential challenges, simmering under the surface, to a rolling boil. The burden of reserves has fallen disproportionately on Israel’s more productive populations as the country needs to invest billions into the war effort and caring for those impacted. This is not a one-off expense, as Israel’s security costs are expected to be much higher in years forward.

Israel’s leadership has been failing to address the war’s impact on the economy since its first reactions.

The government did not cut sectoral budgets or close redundant ministries to cover the war costs when adjusting the 2024 budget to meet the war’s needs. Necessary economic policy proposals meant to contend with the war’s repercussions, such as tax increases, have stalled.

An extended IDF service and reserves service was proposed by the government, putting a heavier burden on the country’s productive population and placing even more strain on households, freelancers, and small businesses. Government aid programs for those hurt by the war have been slow and insufficient. Preparations for the 2025 budget have not advanced, increasing uncertainty at a time when creating certainty in the economy is vital.

Calling Israel's bluff

In response to criticism of their failed policy, the government’s party line has been that the country is at war and that once the war is won, the economy will spring back.

Moody’s called this bluff last week, explicitly stating that the damage of the war to the economy is going to be more durable, that Israel’s economic reputation will not spring back with the end of the war, and listing how Israel’s government has failed.

The government needs to address its failures and turn things around on this front before the situation deteriorates further. As the country continues along the track it’s on, recovery will only become more difficult.

Beyond handling the immediate needs created by the war, Israel’s leadership must address these issues from the root. Getting the country back on a slower deterioration track to avoid political third rails such as a haredi draft is insufficient.