UPDATE 1-Israel needs $3.6 bln more in taxes for defence costs -central bank

By Steven Scheer

JERUSALEM Feb 4 (Reuters) - Israel will need tax hikes of up to 14 billion shekels ($3.6 billion) in the next few years to meet rising defence costs if it is to hit its budget deficit targets, the Bank of Israel said on Wednesday.

Before a snap election was called in December, Israel's cabinet had approved a 2015 budget draft that boosted spending, mostly on defence, by raising the deficit target to 3.4 percent of GDP from 2.5 percent - a move that angered the central bank.

Israel paid for a 50-day Gaza war in 2014 without exceeding its 2.8 percent budget deficit target only by cutting public spending, the central bank said.

That, the bank said, allowed it to cut interest rates in July and August, narrowing the gap with other countries' rates.

The next government - to be elected on March 17 - will face pressure to raise spending to help ease the rising cost of living and boost education and healthcare.

It will have to decide whether lowering the deficit will be based on further cuts to public spending as a share of GDP - which is lower than most other advanced economies - or raising taxes, also lower than in other countries.

Meeting the targets would lower Israel's debt-to-GDP ratio to 61 percent by 2020 from about 67 percent, the bank said, unless extra taxes of 8-14 billion shekels were imposed.

If tax hikes or spending cuts totalling 1.5 percent of GDP were not made "the deficit is expected to grow to more than 3 percent of GDP, and the debt-to-GDP ratio is expected to be about 70 percent of GDP", it said, noting that its estimates assume economic growth of 3 percent from 2016 and beyond.

Prime Minister Benjamin Netanyahu favours higher taxes but should the centre-left Zionist Union form the next government, taxes are likely not be raised.

A new 2015 budget is not expected to be approved until the middle of the year, after a new governing coalition is in place.

The central bank is hoping the new government will contain spending enough to hit a 2015 deficit of 2.6-2.7 percent of GDP. (Editing by Louise Ireland)