War reshapes economic trajectory: IMF warns Israel's growth potential faces structural erosion

The International Monetary Fund (IMF), in its latest *Israel Economic Annual Assessment*, does not focus on short-term market fluctuations but instead outlines how war is quietly reshaping the growth profile of a small open economy. The report notes that while the Israeli economy has shown remarkable resilience through three years of conflict, GDP remains about 9% below the pre-war projected trajectory. This figure is not a static loss but a permanent shift in the potential output path—the IMF has downgraded its 2026 growth forecast from 4.8% pre-war to 3.5%, with a modest recovery to 4.4% expected in 2027. This means the war not only consumes resources in the current period but also resets the baseline for economic expansion.

Narrowing Fiscal Corridor and Inflation Repricing The impact of the war on fiscal discipline has a lag effect. The IMF projects that the government deficit will widen to 6.2% of GDP in 2026, up from 5.2% in 2025, with the public debt ratio expected to rise from current levels to 70.1% and approach 74% by 2031. More alarmingly, Israel's "fiscal space" is narrowing as debt accumulates. The core issue is that civilian expenditure is already at low levels, leaving limited room for further compression, so adjustments must rely more on revenue-side measures. The report recommends merging the lowest two income tax brackets, raising VAT by another 2 percentage points, narrowing tax exemptions (e.g., for tourism services and fruits and vegetables), and reassessing tax incentives under the Capital Investment Encouragement Law. A 2-percentage-point VAT increase alone could generate revenue equivalent to about 0.8% of GDP. However, IBFD data shows that Israel's already high tax elasticity may limit the scope for further tax increases. On inflation, the war transmits pressure through energy prices. The IMF expects annual inflation to rise from 1.9% in the first quarter of 2026 to 2.5% in the fourth quarter, before easing back to 2% in 2027. A strengthening shekel partially offsets imported inflation, but core inflation and expectations remain in the middle of the target range. Notably, the balance between fiscal expansion and monetary tightening will become a key variable in the central bank's subsequent policy decisions."Structural Fault Lines" in the Labor Market Israel's economy has long relied on a high-skilled export sector, but the domestic labor market contains a fault line that has been magnified by the war. The IMF bluntly states that low employment rates—particularly the roughly 55% employment rate for Haredi men and 45% for Arab women—have escalated from a social integration issue to a macroeconomic risk. The employment rate for Haredi men is far below the government's 2030 target of 65%, while the target for Arab women is 53%. This means that when high-skilled industries face global demand fluctuations, the bottleneck in domestic labor force participation will constrain potential growth. The report's recommended solutions are structural: expand core curriculum teaching, strengthen vocational training, and reduce fiscal incentives that discourage employment (such as subsidies for non-workers). These measures point to a deep-seated issue: Israel's economic growth requires not only capital and technology but also a broadening of the employable labor pool. If this fault line is left unaddressed, even if the high-skilled sector remains prosperous, overall per capita income growth will suffer.

The Double-Edged Sword of High-Tech Industries Israel's high-tech sector—the main engine of economic growth—is placed under the magnifying glass of the global AI wave by the IMF. The report believes that Israel is among the best-positioned countries to benefit from the AI revolution, but this advantage is not automatic. A sharp correction in the global AI market could impact Israel through three channels: a slowdown in high-tech product exports, withdrawal of foreign direct investment (FDI), and a reduction in FDI-driven employment. Given Israel's deep integration into the global AI value chain, this risk is not theoretical. Currently, global tech stock valuations are at historical highs, and doubts about the commercialization returns of AI are emerging. If expectations reverse, Israel's economy will face a simultaneous contraction in external demand and internal fiscal tightening.

Erosion of Long-Term Growth Potential: An Invisible Debt The core message of the IMF report is that the risk of an explosive crisis has receded, but the true cost of the war is the gradual erosion of the fundamental elements of growth—human capital, fiscal buffers, and innovation capacity. If Israel cannot find a balance between expanding the labor force, restoring fiscal space, and continuing to invest in science education and digital infrastructure, the growth story in the coming years will no longer be "rebound" but "resetting the lower bound." For macro researchers observing the fragmentation of the global geo-economy, Israel's case serves as a cautionary tale: small countries in prolonged conflicts not only lose current output but also permanently alter the direction of their economic structure's evolution.