Israel's economy defies war costs as IMF lifts growth forecast to 4.5%

IMF lifts 2026 growth forecast to 4.5%, fastest in OECD

Israel is gaining steam even as the fighting continues. Inflation is cooling, the technology sector is thriving, and the International Monetary Fund now expects the economy to expand 4.5% this year, up from a July forecast of 3.5% and the fastest projected rate among the members of the Organization for Economic Cooperation and Development, a group of mostly wealthy countries.

Karnit Flug, a former governor of the Bank of Israel who is now a senior fellow at the Jerusalem-based Israel Democracy Institute, said the headline numbers conceal the strain beneath them. “The economy is performing strongly but underneath, there are big challenges ahead,” she said. “The next government will face difficult choices.” The resilience gives the next government options, but none are easy: how much it spends on the military, whether it broadens military service and whether it raises taxes or cuts spending on education and infrastructure will influence both Israel’s ability to confront its enemies and its economy’s capacity to pay for them.

Those choices are sharper because of uncertainty over American support. The U.S. provides $3.8 billion annually in military aid, about 0.5% of Israel’s gross domestic product, plus billions more in emergency wartime assistance. President Trump said Tuesday that the U.S. would cut off military aid to Israel by the end of the year, suggesting a phaseout of American financial assistance could occur much faster than expected. Prime Minister Benjamin Netanyahu had previously proposed that America eliminate direct military aid over the next decade.

Flug said Washington’s contribution goes well beyond money, citing military and intelligence cooperation. “It’s very hard to actually assign to it a dollar value, but it’s extremely valuable as a part of our defense strategy,” she said.

During the election campaign, national security, the fallout from the Oct. 7, 2023, attacks and questions over Israel’s political future dominated the debate. Kitchen-table anxieties still weighed on voters: in an October poll conducted for Israel’s public broadcaster Kan, 34% of respondents named the economy and cost of living as the most important issues influencing their vote, compared with 32% for national security.

Those worries stand in contrast to a macroeconomic rebound that has defied years of multifront conflict, from the post-Oct. 7 fighting to this year’s war with Iran.

The rebound itself rests on a combination of business adaptability and financial muscle. Israeli businesses, hardened by past crises, quickly adjusted to wartime disruptions. The country entered the conflict with a relatively low debt load, giving the government room to borrow to fund the military, compensate reservists and keep households and businesses afloat. Well-capitalized banks kept credit flowing, the central bank — which had roughly $237 billion in foreign-exchange reserves as of September — stepped in to steady financial markets, and domestic offshore natural-gas fields helped keep electricity prices relatively insulated from global energy shocks.

The wars have nonetheless eaten into the cushion that helped Israel withstand them. In April, the central bank estimated government spending and other fiscal costs related to the conflicts at 405 billion shekels, or roughly $130 billion, for the period from 2023 through 2026.

Public debt is forecast to reach 68% of GDP this year, up from around 60% before the 2023 war. The budget deficit is expected to reach 4.4% of GDP this year, compared with a surplus of 0.6% in 2022. Military spending now absorbs about 8% of economic output, roughly double its prewar share, Flug estimated.

If that higher level of military spending persists, the government will have to raise taxes, cut civilian services or accept more borrowing — each with its own economic cost. Flug said further cuts to education, healthcare and infrastructure could weaken the very foundations of Israel’s future growth. “I don’t think we can afford higher deficits,” she said. “We need the fiscal space to be able to respond to shocks.”

The trade-offs are already playing out. On Oct. 18, Netanyahu’s cabinet approved about $840 million in cuts to ministry budgets, including education, health and transportation, to fund urgent military purchases. The move drew criticism from opposition politicians and public-sector professionals who warned of damage to essential services. The government said the purchases were needed for national security.

London-based research firm Capital Economics said military spending could remain higher under a Netanyahu-led government after the elections, further crowding out civilian investment. Israel has yet to form a government, and it remains unclear what Netanyahu’s chief rival, Gadi Eisenkot, would spend on the military should he come to power.

Israel has financed most of its war costs through budgetary revenues and borrowing. Capital Economics said the country’s low borrowing costs and a large domestic investor base make sustained military spending manageable; the bigger challenge is what civilian spending must be sacrificed to pay for it. “There is a tension between higher security and defense spending, putting the public debt ratio on a declining path, and preserving growth-enhancing policies,” said Liam Peach, senior emerging markets economist at Capital Economics. “This tension is likely to grow over time.”

Growing diplomatic rifts threaten the international ties that have helped power the economy. Britain, France and Canada have announced plans to ban trade in goods from Israeli settlements in the occupied West Bank. While those measures stop short of sanctioning the broader Israeli economy, economists warn that deepening diplomatic isolation could jeopardize the trade, investment and research partnerships that underpin Israel’s export-driven model.

Another dividing line in the election with key economic implications is the role of Israel’s ultra-Orthodox community. Netanyahu’s government has sought to preserve military-service exemptions for ultra-Orthodox religious students despite a Supreme Court ruling that authorities must begin drafting eligible men. Expanding the draft could reduce Israel’s costly reliance on reservists, many of whom must leave their civilian jobs to serve; the Bank of Israel estimates that recruiting an additional 7,500 ultra-Orthodox men annually could reduce the need for reservists, eventually saving the economy at least 9 billion shekels a year, or 0.4% of GDP.

Capital Economics expects an opposition-led government to be more likely to recruit ultra-Orthodox men to serve and to reduce their incentives for staying out of the workforce. If successful, those changes could lift Israel’s potential annual economic growth by as much as half a percentage point by the 2030s, the firm estimates.