Political structure: Israel has a parliamentary system of representative government. The formal head of state is the president, who is elected by the legislature for a five-year period, but his powers are largely ceremonial. The Knesset, a 120-seat unicameral parliament, is elected at least every four years under a proportional representation system. The leader of the party most likely to marshal a Knesset majority is called on by the president to form a government.

Policy issues: Security issues remain Israel's top priority. Successive governments have also made substantial progress in liberalising and stabilising the economy and government finances, although poverty remains an issue.

Taxation: Corporate tax on profits is 33%, but this is to be cut to 25% by 2010, and the top rate of income tax will fall from 49% to 44%. Personal income tax exemptions are allowed as part of the Capital Investment Encouragement Law. Foreign investment, venture capital and expenditure on research and development are eligible for extensive tax benefits. Taxation on interest and capital gains is 15%, but is to rise to 20%; dividends and royalties are taxed at 25%.

Foreign trade: After falling sharply in 2001-02, exports have recovered strongly since 2003, reaching US$43.3bn in 2006.. Imports have also increased strongly, to US$46.9bn in 2006. The current-account surplus was US$6.8bn in 2006, equivalent to 4.9% of GDP.

• The ruling coalition, which consists of five parties with significant ideological differences, is highly unlikely to hold together until the scheduled next election date in 2010. The future of Ehud Olmert's young party, Kadima, also looks uncertain, as does his own survival as prime minister, as his popularity has waned amid criticism of the handling of the mid-2006 Lebanon war and sleaze allegations.
• The weakness of the coalition poses a particular risk to the government's ability to make difficult political decisions, for instance over territorial withdrawals. However, public and party consensus on the importance of maintaining macroeconomic stability, including a low fiscal deficit, is far greater than in the past, which limits the risks to economic policy.
• The government has suspended its preferred option of"unilateralism"on land and security, given the persistent security risk from Gaza, from which Israel withdrew unilaterally in 2005. Nonetheless, the prospects for productive negotiations with the Palestinians are poor, and violent conflict is likely to continue. Israel will maintain contacts with the Palestinian president, Mahmoud Abbas, but his ability to deliver will still be undermined by deep tensions between his own party, Fatah, and Hamas, the Islamist movement that won the 2006 Palestinian legislative election. Combined with the weakness of the Israeli government, this suggests that final-status talks will continue to be deferred.
• Real GDP growth is forecast to average 4.4% a year in 2007-11, barring a major security deterioration. Robust goods and services export growth will partly offset the impact of import expansion and rising income debits, ensuring that the current account remains in surplus throughout the forecast period. The New Israeli shekel will continue to be vulnerable to concerns over economic policy and political instability, but, overall, the currency will stay relatively stable over the forecast period, as net capital inflows are expected to remain high.
• Government spending will rise in 2007 as a result of the conflict in Lebanon, but the resulting fiscal deficit is expected to remain manageable at 2-3% of GDP, and will narrow from 2008. Moreover, the government's overall policy of greater fiscal discipline should not be seriously compromised. With the Bank of Israel (the central bank) likely to raise interest rates gradually in order to maintain price stability, consumer price inflation should average 1.8% in 2007-11.

Forecast
Apr 27th 2007
From the Economist Intelligence Unit
Source: Country Forecast

The domestic political scene in Israel remains uncertain, with the long-term survival of the five-party governing coalition threatened by a combination of internal ideological differences and public disaffection. The prime minister, Ehud Olmert, has become increasingly unpopular as his decision-making during last year's Lebanon war has been criticised and as various members of his government are investigated for corruption. Despite this, Mr Olmert's coalition has a strong majority of 78 seats in the 120-seat Knesset (parliament), and has demonstrated its ability to pass sometimes controversial legislation, including a bill to partly privatise the country's most powerful state monopoly, the Israel Electric Corporation. Nonetheless, Mr Olmert could yet face a rebellion within his own party, particularly if he is heavily criticised by the government-appointed inquiry into the conduct of the war, the Winograd Committee, which will issue two reports this year. Moreover, the ruling coalition faces a leadership election in its second-largest party, Labour, which will be held at the end of May and could potentially lead to Labour leaving the coalition. Little progress is expected in the peace process with the Palestinians. Economic growth will remain healthy over the outlook period, with demand for Israel's high-tech exports expected to remain strong. Inflation will stay low, with a strong New Israeli shekel helping to contain price pressures, and the current account will remain in surplus.

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