* Defence Ministry seeks $3.1 billion for 2015
* Economy Minister opposes increasing budget deficit
* Central bank chief wants spending restraint, tax rises
By Steven Scheer
JERUSALEM, Sept 4 Days after Israel reached a ceasefire after 50 days of war against Hamas in Gaza, the finance ministry and the central bank are at odds over how to cover hefty defence costs in next year's budget.
Discussions on the 2015 spending package have just begun but Finance Minister Yair Lapid and Bank of Israel Governor Karnit Flug have already gone public with their opposing views.
The Gaza conflict, which ended on Aug. 26, has underpinned hefty budget demands by the Defence Ministry of 11 billion shekels ($3.1 billion) for 2015. The finance minister has said the 9-billion-shekel cost of the latest fighting can be absorbed in this year's budget with only a slight breach of the 3 percent deficit target.
But covering extra military costs by raising taxes or cutting expenses in civilian areas such as education or health - especially when economic growth is softening - are politically difficult options.
Prior to the conflict, gross domestic product (GDP) was expected to grow 2.9 percent this year. It is now more likely to grow 2.4 percent due to the economic disruption of the conflict.
Lapid, who plans to submit the budget framework to the cabinet next week, has given few details other than suggesting raising the deficit target to at least 3 percent of GDP from 2.5 percent while rejecting any tax increases.
He has said the economy cannot bear the burden of tax hikes and spending cuts, a view challenged by Israeli financial commentators who point to the euro zone crisis as a lesson in the importance of holding down national debt.
"Raising the deficit is imposing taxes on our children," Economy Minister Naftali Bennett told an economic conference, urging the Defence Ministry to use its funds more efficiently.
Flug advocates both spending restraint and tax increases and would accept a deficit of 3 percent to cover to a one-time boost in defence spending. But she warned of economic harm and a loss of credibility if the deficit were any higher.
"If the military gets a higher budget, then 3 percent is not attainable," Budget Director Amir Levy told Reuters. "It's going to be between 3 and 3-point-something, like 3.2, 3.3," he said.
Alex Zabezhinsky, chief economist at the Meitav Dash brokerage, believes even that is too optimistic due to commitments including hiking public sector wages and exempting some first-time home buyers from paying the 18 percent value added tax.
"If the government doesn't take any steps then the budget deficit could go to 4.5 and 5 percent of GDP," he said, assuming economic growth next year of 3 percent.
Such a scenario could have consequences on Israel's credit rating but Standard & Poor's - which rates Israel A+ - believes the 2015 budget expansion will likely be a one-time deviation from a recent trend of falls in the deficit and debt burden.
"If the deficit is moved to 3.1 percent (of GDP) then it's not a big shift but if it's 4 percent-plus, then that's a bigger story," said Elliot Hentov, S&P's primary analyst for Israel, adding that having a "vigorous debate" over the budget is healthy.
Some analysts believe Flug lacks the influence of former central bank chief Stanley Fischer, who last year was able to convince Lapid to backtrack after the minister sought to raise the 2013 deficit target to nearly 5 percent of GDP.
Lapid, who seeks to return to a lower deficit in 2016, was tapped as finance minister last year after his new Yesh Atid (There is a Future) party became the second largest political faction on the promise of lowering the cost of living for the middle classes.
The former TV presenter, who has admitted he had no knowledge of economics, has been criticised as populist for some of his proposals including a "zero VAT" plan.
"Lapid is not really thinking about what has to be done about Israel's economic problems. He is thinking about what he has to do in order to get to the next elections in a better situation than his current one," financial commentator Avi Temkin wrote in the Globes financial newspaper, adding the same applied to Prime Minister Benjamin Netanyahu.
Netanyahu, analysts agree, will ultimately have to decide how much of its wish list the defence ministry gets next year.
"It depends on whether Netanyahu is afraid of the geopolitical situation," said Modi Shafrir, chief strategist at Mizrahi-Tefahot Bank's finance division. "Eventually, Netanyahu will probably decide something in the middle - between what Lapid and Flug ask for."
That probably means a deficit target of about 3.25 percent next year, he said.
"We hope we will find a way to balance the military's needs and the civil needs," Levy said.
(1 US dollar = 3.5771 Israeli shekel) (Reporting by Steven Scheer; Editing by Ruth Pitchford)