By Steven Scheer and Tova Cohen
TEL AVIV (Reuters) - In the heated debates on war and peace that have marked campaigning for this month's parliamentary election in Israel, it is easy to forget the vote was triggered by a more workaday problem - the budget.
Ending the deadlock over an austerity package that forced him to dissolve his coalition prematurely will be a priority for Benjamin Netanyahu after the January 22 ballot, which polls predict will give the right-wing prime minister a new term in office.
Fearful of a voter backlash against more spending cuts and tax hikes, coalition allies balked at approving a 2013 budget, prompting Netanyahu to hold the election nine months early.
With the vote out of the way, whatever coalition partners he chooses from among Israel's highly fragmented party system, a budget compromise is likely with 45 days of the new government taking office, since a failure would trigger a new election.
Most Western leaders would envy the task of Netanyahu's finance minister, with the economy growing at about 3 percent, a massive new natural gas field about to come onstream and a budget deficit only slightly above a targeted 3 percent of GDP.
But the economy is slowing down as trading partners stagnate and the Bank of Israel governor, internationally renowned economist Stanley Fischer, has warned politicians of the risk of hitting a recession that could rapidly double the deficit if the budget is not managed tightly during the present good times.
Defense takes 17 percent of Israel's budget - 10 times what typical European states spend - and is unlikely to shrink by much amid upheavals across the Middle East; arguments may focus on raising tax and structural reductions in welfare for a fast-growing ultra-Orthodox community where many men do not work.
The outgoing government has let spending swell beyond a legal cap while a slowing economy has dented tax revenues.
Analysts reckon the new parliament will need to cut spending by 14-15 billion shekels (some $4 billion), or about four percent, and also raise taxes by as much as 5 billion shekels to keep the deficit to 3.5 percent of gross domestic product.
"It's not good, but it's not the end of the world," said Zvi Eckstein, dean of the School of Economics at the Interdisciplinary Center in Herzliya. "They can easily do it."
Eckstein, a former deputy to Fischer at the central bank, expects personal income taxes to go up - with each 1 percent increase bringing in 4 billion shekels - along with a small rise in corporate taxation and a tightening of some tax breaks.
"It will have a negative economic impact in the short term but I don't think it will be substantial," he said, noting it might shave half a percentage point from 2013 GDP growth.
Last year, parliament approved a series of tax increases - including on income - for 2012 and 2013 and budget cuts that aimed to boost state coffers by more than 14 billion shekels.
Netanyahu's finance minister, Yuval Steinitz, expects Israel to meet its fiscal targets in 2013, noting similarly tough measures taken in 2003 and 2009.
Those targets, however, are not without their critics. Fischer and other Bank of Israel officials were irked when the outgoing government doubled the acceptable budget deficit to 3 percent of GDP in June. Estimates put the final 2012 deficit at above 4 percent, despite a one-point rise in value added tax.
Fischer, who has previously warned of inflationary effects from higher public spending, urged the incoming parliament to pass a responsible budget immediately after the election:
"We are now close to full employment and we have a budget deficit around four percent," he said last month. "If we go into a recession, the deficit will climb to six to seven percent and then the government will have financing difficulties."
The Bank of Israel has lowered its key interest rate - the last move a quarter-point cut to 1.75 percent on December 24 for its second reduction in three months - amid tame inflation and slowing economic growth mainly from weakening exports.
Economists doubt the central bank's monetary policy committee will change its dovish stance in the coming months unless the new government fails on a credible budget.
"We hold a relatively constructive view on the 2013 fiscal outlook and think that the new government will enjoy enough post-election political power to deliver most of the required measures, probably through a combination of spending cuts and tax hikes," said Credit Suisse Economist Nimrod Mevorach.
"The main risk to our view is a surprising election outcome, especially if Netanyahu joins forces with some of the left-wing parties after elections," he wrote in a note to clients.
Some left-wing parties seek to raise social spending while increasing taxes on higher income earners and companies. Small, right-wing parties that have backed Netanyahu also defend strong welfare spending for their religious supporters.
Netanyahu is not expected to invite in leftists unless he has a poorer showing than polls predict. His Likud, along with Yisrael Beitenu, is forecast to win about 30 percent of seats, with eight or nine other groups also getting into parliament.
"If the government can't cut as much as is needed, especially if defense doesn't participate, either we will have a higher deficit ... or else taxes will have to be raised even more," said Ayelet Nir, chief economist at Psagot, a Tel Aviv brokerage.
Nir said a higher deficit would have repercussions for the sovereign credit rating and risk premium.
For now, Israel's A+ credit rating and stable outlook from Standard & Poor's is safe. The agency expects the government to stick to its debt reduction commitment that began a decade ago.
"Regardless of who wins this election, there remains a political consensus that increasing government debt is a bad thing," Elliot Hentov, a sovereign credit analyst at S&P, told Reuters, noting that Israel's budget cut needs are less than those in Europe. "The challenges are manageable."
He expressed confidence that starting in 2014, Israel's debt to GDP ratio, at 74 percent, would resume its decline. Much depends on economic growth, however.
Israel's economy grew an estimated 3.3 percent in 2012 and is projected to grow around 3 percent in 2013. That excludes the start to natural gas production at the Mediterranean Tamar well, which may add as much as a point to GDP growth in 2013 and also start to contribute to state revenues in the coming years.
Hentov forecast a deficit in 2013 of at least 3.3 percent of GDP but warned that the outlook for Israel's credit rating could turn negative if government debts rose suddenly or growth looked to slow significantly. And, in a violent region, Israel's buoyant economy would also remain vulnerable to risks of war:
"The (ratings) outlook would change if public debt suddenly went up again or if growth prospects crashed in the medium term," Hentov said. "Or if there was a geopolitical crisis." ($1 = 3.78 shekels)
(Editing by Alastair Macdonald)