How We Pay for The War Will Affect the Israeli Economy for Years to Come

Despite the recent recovery in the Israeli stock market and the value of the Shekel, the costs associated with this prolonged war have already been substantial. How policymakers decide to finance these costs could result in higher government deficits, debt, interest rates and prices, and lower economic growth through the rest of this decade, if not longer. These are no ordinary times and policymakers would be wise to begin developing plans for dealing with recent and future increases in defense and non-defense government expenditures in order to minimize their impact on the Israeli economy.

Defense spending is estimated to have increased by more than $70 billion NIS in 2023 and 2024 combined and by at least another 30 billion NIS in 2025. Assuming its growth rate returns to its average annual rate during the 5 years prior to the war, defense spending can be expected to average 10 percent of GDP each year for the rest of this decade. One needs to go back to the early 1990s to find the last time defense spending comprised such a large share of the Israeli economy.

US military assistance accounted for approximately 5 percent of Israel’s annual government defense spending prior to October 2023. The $8.7 billion in supplemental aid which the United States provided in April 2024 accounted for only approximately 12 percent of the increase in defense spending which Israel incurred in 2023 and 2024. Given President Trump’s aversion to foreign aid and his repeated comments that he thinks Israel might already be receiving too much assistance from the United States, Israel opt not to request another aid supplement to help offset the additional costs of its 12-day war with Iran and instead request a higher amount of annual aid when it negotiates its next 10-year agreement with the United States.

Assuming non-defense spending continues to grow at the same rate it did during the 5 years prior to October 2023 (which is probably optimistic given the additional health care costs needed to provide rehabilitation to the 25,000 people injured during the war, as well as to rebuild and repair the thousands of structures damaged or destroyed throughout the country, it can be expected to reach an average of approximately 38 percent of GDP each year between 2026 and 2029, 3 percentage points higher than its pre-COVID average.

By contrast, assuming that government revenues, which fell in both 2023 and 2024 as a consequence of the economic slowdown, remain flat in 2025 and 2026 – due to the continued economic slowdown this year and the fact that elections are scheduled to be held next year, before returning to their pre-COVID average growth rates, and grow along with the growth of the economy after 2027, they will still be considerably insufficient to cover the recent and projected increases in defense and non-defense expenditures. The resulting government budget deficit can be expected to reach an average annual rate of 14½ percent of GDP and public debt can be expected to reach an average annual rate of 66½ percent of GDP throughout the rest of this decade. The increase in public debt could prompt a further downgrade in Israel’s credit rating, thereby making it more expensive to borrow money, setting off a downward spiral in deficits and debt, similar to the one the Israeli economy experienced during the economic turbulent days of the1980s.

These projections show that the costs of this prolonged war can quickly unravel years of fiscal discipline. The recent and anticipated increases in defense expenditures, without a commensurate decrease in other public spending and/or increase in government revenues, can be expected to divert capital investment away from productive investments necessary to create private sector jobs and contribute to economic growth.

Unlike the recent experience with COVID, the economic consequences of the prolonged war are expected to be felt over several years, depending on how the government responds to them. Policymakers need to appreciate these potential consequences and begin developing ways to mitigate their impact on the economy.

These projections are based on an assumption that Israel’s economy grows by 2 percent this year, before returning to 3½ percent each year for the remainder of the decade. Claims that higher economic growth will reduce the impact on the economy of the fiscal shock from the prolonged war are certain to prove to be overly optimistic. For example, adding 1/2 percentage point each year to the growth rates presented above, thereby restoring economic growth to what it was in the decade before COVID, hardly reduces the projections for government expenditures and revenue, the budget deficit and debt presented above.

The Israeli economy faces other challenges in addition to the fiscal pressures due to the war which are expected to put additional downward pressure its economic growth over the next few years. For example, the tourism sector, barely recovering from the COVID pandemic, has all but disappeared due to the prolonged war. It will likely take the tourism industry several years, if ever, to return to its performance prior to COVID and the war.

Exports and imports, which together account for more than half of Israel’s GDP, fell in 2023 and 2024 and have experienced only modest gains during the first quarter of this year. President Trump’s imposition of tariffs is likely to further hurt Israeli exports going forward. In an apparent effort to curry favor with the President, Prime Minister Netanyahu suggested that Israel should be able to “eliminate” its trade surplus with the United States. Given that diamonds, semiconductors, medical and optical instruments and pharmaceuticals account for almost two-thirds of Israel’s exports to the United States, it seems difficult to imagine how PM Netanyahu plans to achieve his commitment without causing significant damage to the Israeli economy.

According to recent press reports, the United States is pressuring Israel to remove its import barriers on agricultural products, which Israel has historically maintained to protect its farmers. Opening the Israeli market to US agricultural products is certain to place additional pressure on the sector, which has already been trying to cope with the loss of foreign workers since the outset of the war. Framers can also be expected to demand compensation, thereby exacerbating efforts to curb government non-defense spending.

Just as people have been calling for a “day after strategy” for reconstituting Gaza, Israeli policymakers must begin looking for creative ways to at least limit, if not reduce the projected growth in public defense and non-defense spending over the coming years, without jeopardizing the health and welfare of those citizens with legitimate needs. As work begins on the government’s 2026 budget, policymakers might begin by publicly committing not to use scarce public resources to buy political favors, as they have often done in the past.