This is the third in a series of volumes discussing the various aspects of the development of Israeli economy over the last four decades. The first volume, The Israeli Economy: Maturing Through Crises, edited by Reference Ben-PorathYoram Ben-Porath (1986), discussed the aftermath of the 1973 Yom Kippur War, the slowdown in growth, and the fast inflation. It covered the period from 1973 to 1984 and stopped just before the Stabilization Program brought the hyperinflation to a stop.Footnote 1 The second volume, The Israeli Economy, 1985–1998: From Government Intervention to Market Economics, edited by Reference Ben-BassatAvi Ben-Bassat (2002a), described the economic developments following the 1985 Stabilization Program and the great influx of immigrants from the former Soviet Union in the 1990s. It analyzed the structural reforms undertaken in the commodity market and in the financial markets to make the economy more competitive, the shift of resources from the government to the private sector, the acceleration in growth, the reduced inflation, the reduction of public debt, and the increased competitiveness of Israeli companies in the international market.
This volume brings the story up to date. Like its predecessors, it is a collection of articles written by leading scholars in their fields, describing the various aspects of the Israeli economy over the period 1995–2017.
The last two decades signaled the fulfillment of many of the hopes raised in the previous books: inflation was finally vanquished, the deficit in the balance of payments turned into a surplus, the ratio between public debt and GDP declined to an acceptable level, Israel turned from a debtor vis-à-vis the rest of the world to a creditor, the labor force participation rate (specifically that of males), which had been on the decline, changed direction and has risen to international standards, and the unemployment rate has declined to a historical low. Still, the economy suffers from many of the maladies mentioned by Ben-Porath and Ben-Bassat: the productivity level in most industries is among the lowest in the developed world, and up to quite recently inequality among the various socio-economic groups has been on the rise.
In the face of this threat to future growth and social cohesiveness, the question arises: has not the reliance on market forces gone too far, and has not the government retreated from its traditional tasks, tasks the private sector cannot (or does not) perform.
1.2 The Background: Demography, the Geopolitical Situation, and the Global Economy
Throughout the first fifty years of its existence, Israel’s economy has been shaped by demographic and political factors. From the day of its establishment, Israel has been a country of immigration. Over the period 1948–2017, Israel’s population grew elevenfold, net migration contributing one-third of this growth.Footnote 2 The Jewish population (or more accurately, the non-Arab population) grew at about the same rate, constituting about 80 percent of the population both in 1948 and in 2017.Footnote 3 Net immigration has contributed over 40 percent of this growth.Footnote 4 As Reference Ben-PorathBen-Porath (1986, p. 3) observes, “Immigration drove the growth of the Jewish economy sector of Mandatory Palestine and of Israel for the fifty years or so ending in the early 1970s.” But Ben-Porath’s conclusion was premature. After a lull in immigration in the 1980s, it resumed in the 1990s. The new wave, which followed the collapse of the Soviet Union, increased the population of Israel by almost one-fifth, and the process of absorption shaped the economy throughout that decade.Footnote 5 Subsequent immigration, though far from negligible (contributing about 15 percent of population growth), played, perhaps for the first time in Israel’s history, only a minor role in the process of economic growth.
The second factor that has played a major role in Israel’s growth process over the years and seems to have lost some of its importance in the last decade is the geopolitical environment. Ben-Bassat, discussing the period following the peace accord with Egypt in 1979, noted the effect of the “peace dividend” on the economy: the gradual reduction in the defense budget, the access to new markets barred earlier by the Arab boycott, and a stream of new foreign investment. This trend strengthened following the peace accord with Jordan in 1994 and the agreements with the Palestinians in 1993 and 1995. Still, security tensions played an important role in the years 1995–2002, culminating in the Second Intifada and the economic crisis of 2001–2003. Surprisingly, the effect of security tensions on the economy in later years has been only minor. As shown by Klor and Zussman, in Chapter 6 of this volume, in spite of a minor war (the 2006 Second Lebanon War) and three extensive operations in the Gaza Strip in 2008/2009, 2012, and 2014, operations that were accompanied by massive rocket attacks, mostly targeting southern Israel, economic activity was hardly affected.
In contrast to the decline in the sensitivity of the economy to demographic and geopolitical changes (in particular toward the second part of this period), its vulnerability to the global economic environment increased (Figure 1.1). The integration in the global economy had its price: the bursting of the dot-com financial bubble in 2000 reinforced the destructive effect of the Second Intifada to push the economy into the worst crisis it had ever suffered – a recession that lasted for over three years, GDP per capita declining by more than 5 percent.
Globalization was also associated with the second crisis the economy went through during this period. The breakdown of trade, following the global financial crisis in 2008, caused a slowdown in economic growth. The slowdown in this case was relatively brief (the decline in GDP per capita lasting for only four quarters), but the decline in the growth rate of world trade slowed the growth of the Israeli economy throughout the following decade.Footnote 6
1.3 Economic Policy
The last two decades have witnessed a continuation of the shrinkage of the public sector and the simultaneous growth of the private sector. The pace of this process, which started with the Stabilization Program, was, however, far from even. The share of the private sector in GDP, which was 69 percent in 1995, hardly changed for the next seven years (Figure 1.2). The private sector share resumed its growth following the change in fiscal policy in 2001–2003 – which was part of policy changes intended to pull the economy out of the recession – and in 2011 the share reached 74 percent. The 2003 decision to cut the public sector (referred to as the “Fat Man” in a famous slogan coined by the then minister of finance, Benjamin Netanyahu) in favor of the private sector (the “Thin Man”) was manifested over the period 2002–2011 both in a decline in public sector expenditures, from about 50 to 39 percent of GDP, and in a decline in public consumption, from 27 to 22 percent of GDP.Footnote 7 This trend ended in 2011, following mass demonstrations that protested the high cost of living and housing prices, and called, in the name of “Social Justice,” for a more socially balanced economic policy.
None of the public expenditure items escaped the cut: the share of defense expenditures declined from 8 percent of GDP in 1995 to 6 percent in 2015; the decline in public debt, accompanied by the fall in global interest rates following the financial crisis, reduced government interest payments from 6 percent to 3 percent of GDP; and the share of government social expenditures (education, health, and welfare) declined from 24 percent to 22.5 percent.Footnote 8 Government investment in physical capital suffered even sharper cuts, its share in GDP falling from 3.8 percent to 1.4 percent. The reduction in government investment in the country’s infrastructure is particularly troubling, since it may have affected the overall level of investment – the share of private investment in GDP declining over the period from one-quarter to one-fifth. As will be shown, this decline in investment (both in human and in physical capital) had long-range implications for the growth of productivity and output during the period and will likely continue to influence these variables in years to come.
The changes in government expenditures were accompanied by changes in the government’s revenue and its composition: taxes, which constituted 35 percent of GDP in the year 2000, were cut to 31 percent in 2013. Israel, which ranked above average among the OECD countries in terms of its tax burden early in the period, was below average by its end. The cut in taxes was accompanied by a sharp change in their composition: while direct taxes were sharply reduced following the 2001–2003 crisis, indirect taxes increased over the period, their share in total taxation increasing from one-third in 2000 to 40 percent in 2015. The reduction in the progressiveness of taxation, accompanied by the cut in welfare allowances, had far-reaching implications for inequality in the net income of Israeli households.
The declared motive for the tax cut was speeding up economic growth. However, as the academic literature shows, the link between the tax burden and economic growth is quite tenuous. Strawczynski, in his chapter on taxation in this book, argues that, with the exception of corporate tax, the tax cut did not contribute to economic growth. If there was an effect, it was indirect. According to Strawczynski’s analysis, tax cuts preceded expenditure cuts throughout the period and, in this way, contributed (for good or ill) to the growth of the private sector.
The impact of the tax cut on public expenditures, following the 2001–2003 crisis, reflects the lesson learned by finance ministers that a large budget deficit impairs government credibility and may adversely affect Israel’s international credit rating. Maintaining a low budget deficit has become an almost permanent feature of the government’s economic policy since that crisis, and explains, at least in part, why the Israeli economy was barely affected by the 2008 global financial crisis.
The conservative budget policy had an immediate impact on the ratio between public debt and GDP and on its composition. In contrast to most developed economies, which saw an increase in their public debt following the global financial crisis, in Israel the debt/GDP ratio declined from 100 percent in 1995 to 60 percent in 2015 (Figure 1.3). The decline was the result of three factors: the contraction of the public sector, the increased budgetary discipline, and a series of redefinitions of the national accounts.Footnote 9
This achievement is even more noteworthy given the changes in the composition of debt: whereas early in the period, external debt constituted about a quarter of public debt, this share was cut to one-eighth in 2015. The changes in Israel’s balance of payments and public debt turned the country from a debtor into a creditor. Whereas in 1995 Israel’s foreign obligations exceeded its foreign assets by 17 percent of GDP, in 2015 foreign assets exceeded foreign obligations by 44 percent of GDP.
No less important for the preservation of Israel’s credibility in the world financial markets was the conduct of its monetary policy. Though the Stabilization Program brought hyperinflation to an abrupt stop, it did not bring price stability. The average annual rate of inflation in the years 1990–1995 was still almost 13 percent (Figure 1.4). This rate was cut by half over the next five years and inflation even seemed to have disappeared in the years 2000–2001. But then came an outburst of inflation in 2002, with prices rising at a rate of over 5 percent, showing that inflationary forces have not been vanquished. It required a sharp rise of the monetary interest rate, and a sharp decline in demand associated with the 2002 crisis, to break the inflationary inertia and establish price stability within the government’s boundaries of the inflation target. This stability has been preserved ever since.
Monetary policy faced new challenges following the global financial crisis. The economy’s resilience, and specifically the stability of its financial sector, minimized the economic damage of the crisis aftershocks. Monetary policy reacted to the crisis in the financial markets by a sharp reduction in the monetary interest rate from 4.25 percent in September 2008 to 0.5 percent in April of the following year. Since then monetary policy has tried to straddle the chasm between the expansive monetary policies adopted by the USA, the European Union, and Japan and the relatively stable growth of the Israeli economy. The Bank of Israel lowered its interest rate almost to zero, intervened aggressively in the foreign exchange market to prevent an excessive appreciation of the shekel, and, for the first time in its history, had to combat negative inflation in a period of full employment in the years 2015–2016.Footnote 10
1.4 Structural Reforms
1.4.1 Financial Reforms
The transformation from an economy based on government intervention to a market-based economy would not have been possible had it not been for a series of reforms in the input and goods markets that contributed to the competitiveness and the efficiency of the private sector.
In the first four decades of Israel’s existence, the government dominated the capital market using a wide array of tools to achieve its targets: administrative barriers, exceptionally high liquidity requirements, credit quotas, restrictions on international capital flows, and discriminatory tax and subsidy rates, in effect “nationalizing” the market. A long list of reforms was required to liberalize capital flows (Reference Ben-BassatBen-Bassat, 1990, Reference Ben-Bassat and Ben-Bassat2002b): the permission to issue corporate bonds, the suspension of the requirement imposed on the pension funds to invest in government bonds, the end of government-allocated directed credit, and the removal of all restrictions on international capital flows. As Table 1.1 shows, the reforms brought dramatic changes to almost every aspect of the capital market. Yet the financial system (banks, insurance companies, and long-term investment institutions) was still characterized by high concentration and little competition. Specifically, despite of the potential conflict of interest that existed between their various activities, the banks were involved in almost every aspect of the financial system. The government’s attempts to break this oligopolistic structure have continued throughout the last two decades but have met with only limited success.
|Reserve ratio on unindexed local currency deposits1||50||38||6||6||6|
|Provident funds’ compulsory investment in government bonds||92||78||50||40||0|
|Pension funds’ compulsory investment in government bonds||92||92||70||70||30|
|Share of government directed credit out of total bank credit to the public2||60||50||5.1||2.3||0.9|
|Share of government directed credit out of total mortgage credit||65||53||33||32.7||3.2|
|Share of private bonds in total credit to businesses3||4.24||7.44||6.2||4.3||31.5|
|Overdraft interest rate minus the Bank of Israel interest rate5||79.2||34.6||7.1||6.1||6.9|
|Interest rate differential between long-term credit to government and mortgages6||5.6||6.2||1.1||1.1||2.5|
|Investment abroad + investment from abroad (% of GDP)||0.4||0.6||3||15.8||13.6|
1 Current account and deposits of up to six days.
2 Excluding housing.
3 Credit to businesses from the banking system, institutional intermediaries, and households.
4 In these years the share relates only to marketable bonds.
5 In annual nominal terms.
6 Indexed loans, credit to government for nine years, mortgages for between five and ten years.
The government was more successful in reforming the main saving channel – the pension market.Footnote 11 The roots of this reform had already been planted in 1995, when the government blocked the entrance to the existing pension funds, which had operated on the basis of “defined benefits” and suffered from growing actuarial deficits. New entrants were referred to new funds that were required to operate on the basis of “defined contribution.” A similar arrangement was applied in 2001 to new government employees, who were not entitled, as their predecessors had been, to a budgetary pension plan but were referred, instead, to the new “defined-contribution” funds. Finally, in 2008, the government passed the Mandatory Pension Law, which required all employers to insure their employees in a comprehensive pension plan.Footnote 12
The various reforms significantly expanded pension coverage and increased the share of long-term savings in total savings and the share of pension assets in total financial assets. But the reforms changed not merely the size of the pension market, but also its structure. In 2003 the government, as part of a policy package aimed at pulling the economy out of the crisis, took over from the trade unions the running of the old defined-benefit funds and closed them to new membership. New members were referred to new funds that were based on the “defined-contribution” principle and were, eventually, sold to institutional investors (mostly insurance companies). The sale of the new pension funds and the sale of the provident funds by the banks (as part of the Bachar Reform in 2005) changed the shape of the industry.Footnote 13 The gradual reduction in government support of the pension funds, in the form of subsidized bonds, forced them to compete in the open market, both in terms of their annual return and in terms of their fees. Despite the reduction in government support and the fluctuations in the capital market, the funds were able to achieve an average annual real rate of return of over 5 percent over the period 2001–2015. It is too early to determine how successful were the reforms in preserving the standard of living of the retirees, but current household expenditure surveys do not indicate that households headed by old people (seventy and older) suffer from a lower standard of living than younger families.
The sale of the pension and provident funds to institutional investors increased competition in the saving market and, at the same time, made the credit market more competitive (Figure 1.5). However, it was only the large business entities (those that could issue bonds) that benefited from the better terms. The markets for credit for small businesses and households remained uncompetitive.Footnote 14 To address this problem, two policies where adopted. First, the Bank of Israel set up the Credit Rating Register (CRR), which forces banks and non-bank institutions to share the credit-record information of their clients.Footnote 15 Second, the government forced Israel’s two leading banks to sell the credit card companies they owned.Footnote 16
Finally, in 2008, after eight years of deliberations and partial solutions, the government imposed a 25 percent tax on real capital gains, interest and dividends. This equalized the tax rate on all capital income sources and facilitated a reduction in taxes on wage income.
The period following the 1985 Stabilization Program was characterized by major reforms in the markets for goods and services, a primary aim of which was to expose these markets to foreign competition. A cornerstone of this policy was agreements with the United States and the European Union which called for mutual tariff reductions. In the early 1990s, other steps were taken to liberalize foreign trade: discriminatory exchange rate and tax policies were eliminated and exposure to imports from new markets was increased. The liberalization resulted in an increase in the efficiency of the manufacturing industries and a shift of labor from industries in which Israel did not have comparative advantage (e.g., furniture, rubber, plastics) to industries in which it did (Reference Gabai, Rob and Ben-BassatGabay and Robb, 2002).
Liberalization of foreign trade did, however, have its limits: a host of nontariff barriers helped maintain the semi-monopolistic power of large importers and some markets continued to be protected, a notable example being the market for agricultural goods. During the last two decades, the agricultural lobby prevented any reduction in tariffs on agricultural products, and only the mass demonstrations in 2011, which protested the high cost of living, brought about some minor changes in policy. The effects of the differential rates of liberalization are evident in the data: during the period 1997–2015, whereas the price of clothing, furniture, and home equipment (the imports of which had been liberalized) declined 22 percent, the price of food increased by 76 percent, twice the rate of increase in the Food and Agriculture Organization of the United Nations (FAO) world food price index (36 percent).
Still, the most protected sector over the whole period was the government-owned business enterprises, most notably the infrastructure monopolies in the fields of electricity, communications, water supply, public transportation, ports and airports, and the refinery industry. The low efficiency of these companies affected the economy as a whole. Following the Stabilization Program, there were few attempts to open these industries to competition, but the title of the chapter which analyzed these attempts in the previous volume on the development of the Israeli economy – “Structural Changes in the Israeli Public Utilities: The Reform that Never Was” (Reference Gronau and Ben-BassatGronau, 2002) – captures the essence of the story. It sums up the failure of the attempts to break up the Israel Electric Corporation (the electricity monopoly); to make the two seaports (Haifa and Ashdod) compete with each other; to privatize the two oil refineries and sell them to separate owners; and to break the monopoly power of the two major bus companies, Egged and Dan. The only case where reform was successful was the communications market, where a series of determined government ministers have managed to bring about the passing of a law that forced the communications monopoly (Bezeq) to separate its activities in the various sub-markets (domestic, international, cellular, and the sale of equipment). Bezeq preserved its monopoly power in the wired domestic network, but new entrants were allowed into the other markets. The beneficiaries of the monopoly power of the public utilities were their employees, who enjoyed excessive wages. The companies’ low efficiency and the government’s policy of keeping prices low resulted in them being the only “monopolies” with low (and sometimes even negative) rate of return.Footnote 17
The employees’ unions took advantage of their political influence in the two major parties (Likud and Labor) and used the threat of shutting down essential services to block any attempt of reforms that would result in a reduction in the number of employees or a slowdown in the rate of increase of wages. On the other hand, the unions were unable to block the introduction of a new cost-based system of rate setting. The new rates reduced the cross-subsidization among the various services (e.g., international phone rates and local rates) and among various users, introduced an ‘efficiency factor’ in the rates of most services, and set up a multi-period rate adjustment system. Basing the rate systems on “normative” (i.e., objective) costs, the new regime resulted in some cases (e.g., the communications market) in the lowering of the relative price of the service and in other cases isolated consumers from the inefficiency of production. The last two decades saw little change in this pattern, with one modification: though the government has been unsuccessful in implementing reforms in its own monopolies, it was successful in industries that had been privatized. Thus, the reforms in electricity and the ports are still at the planning stage, but reforms have been introduced in bus transportation, air transport, and the communications industry. The bus duopoly lost half its market, the “Open Sky” agreement tripled the rate of growth of outgoing tourism, and the rates of mobile phones (the largest of the communication industry’s subsectors) were slashed by more than one-half, and following the introduction of wholesalers in the internet market, internet rates were reduced.
Bezeq was able, however, to block any reform in the fixed-line phone market. Preventing the introduction of a wholesale market and blocking the adjustment of retail rates since 2008 has made this segment of the market the most lucrative part of the monopoly’s business.Footnote 18 Thus, although in 2016 the number of its fixed-line subscribers was only one-quarter of the total number of subscribers of the mobile industry, Bezeq’s fixed lines’ profit exceeded the total profit of the mobile industry by 60 percent.
Because of its size and political situation, Israel is ultimately a small island economy. The production of public utility services is characterized by returns to scale and network economics. Given the market size, oligopoly becomes the natural form of competition. Containing oligopolistic market power calls for all the sophistication and political stamina the regulator can muster.
1.4.3 The Reform to Reduce Economy-Wide Concentration
The small island character of the Israeli economy makes concentration not merely an industry feature but an economy-wide characteristic. Conglomerates are not new to the Israeli scene. Throughout the first five decades of its existence, large conglomerates operated in the economy – the most notable one owned by the national trade union (the Histadrut). The phenomenon became a focus of public debate toward the end of the 2000s, when there was increased concern that economy-wide concentration undermines competition and efficiency. It was felt that the advantages of the economy-wide conglomerates in the dispersion of risk and in their access to low-cost capital are outweighed by the increased risk to the economy of having a small number of owners affecting macroeconomic developments and by their power to curtail competition (in particular if they also wield political power). These problems were amplified by the pyramid structure of the conglomerates’ ownership, which allowed “tycoons,” owning relatively little capital, to govern entire “empires” through their ownership of a relatively small company at the top of the pyramid. These problems become particularly severe when the conglomerate includes a financial institution. The ownership of a financial institution (e.g., a leading bank, or an insurance company) raises the fear of preferential treatment in the allocation of credit, the access to inside information on competitors, and discriminatory allocation of credit to block entry into industries in which the conglomerate has a stake.
Economy-wide concentration was already of concern to policymakers twenty years ago. At the time, policymakers were worried about the excessive power of the two largest banks, who owned large amounts of the equity of firms. These fears led, in 1995, to the establishment of the Brodet Committee, which recommended that no banking firm will control a non-banking firm and that the largest bank had to divest its equity stakes in at least one of the two powerful industrial conglomerates which it controlled (Reference Blass, Yosha and Ben-BassatBlass and Yosha, 2002). When this recommendation turned into law a year later, the banks divested themselves of most of their equity holdings.Footnote 19 The sale of this equity, as well as the sale of the provident funds (following the Bachar Reform), may have solved the problem of the banks’ conflict of interest but, paradoxically, served as the stepping stone for the formation of the newly founded conglomerates. A second group of conglomerates was created by the dismantling of the national trade union’s conglomerate, and a third group resulted from a change in ownership of existing conglomerates.
The law was successful in reducing the level of economy-wide concentration, but this trend reversed as new business groups came into being. What made the establishment of the new conglomerates especially worrisome was the excessive leverage of their financial structure, and their increased political clout due to their ownership of leading media outlets (e.g., newspapers, TV stations).
According to a study by Reference Kosenko, Yafeh, Colpan, Hikino and LincolnKosenko and Yafeh (2010), the largest ten groups accounted for about one-third of the equity registered on the Israeli Stock Market, one of the highest rates among Western economies. According to Kosenko’s estimate (in Chapter 9, this volume), the twenty largest business groups in Israel constituted 70 percent of the market value of public corporations.
The 2011 mass demonstrations brought to the fore the issue of the large conglomerates and their effect on competition and the cost of living (especially food prices).Footnote 20 The demonstrations put pressure on the Concentration Committee, which was established a year earlier, to finish its deliberations. The committee recommended to restrict the number of levels in the pyramidal structure of business groups to two, to disallow the control of real (i.e., nonfinancial) companies by large financial institutions, and to include considerations of economy-wide concentration in the government’s privatization decisions. The Law for Promotion of Competition and Reduction of Concentration was passed in December 2013, but it is too early to tell what its effects will be.Footnote 21
The main beneficiaries of the shrinkage of the public sector and the growth of the private sector were private consumption and exports of goods and services. Both increased as a share of GDP, but the latter did so much faster: while the share of private consumption increased from 52 to 56 percent, the share of exports increased from 24 to 31 percent (Figure 1.6). Exports benefited from the continued trend of globalization and reduction in trade barriers, and its rate of growth was strongly tied to the rate of growth of world trade. It was 10 percent per year in the early part of the period, slowed down to 7 percent following the dot-com crisis, and went down to 2 percent after the global financial crisis. Unsurprisingly, the slowdown in exports was the main cause of the slowdown of Israel’s overall rate growth following the global crisis.
Exports changed not only in terms of volume but also in terms of composition. For the first time in its history, Israel took advantage of its abundant stock of human capital and its scientific infrastructure and turned it into an engine of growth. The share of high-tech in industrial exports increased from 37 percent in 1995 to 50 percent in 2015, while the share in industrial exports of traditional manufacturing industries declined from 39 to 19 percent (Figure 1.7). An even more dramatic shift occurred in the advanced services sectors (information and communications services and research and development services), whose share in total exports increased from zero in 1995, to almost half of exports in 2015.Footnote 22
The slowdown in investment resulted in a reduction in the share of imports in GDP. Partly as a result of this, since 2003 Israel consistently has a surplus in the current account of the balance of payments.Footnote 23 The reversal in the current account from a deficit to a surplus and the growing inflows of foreign capital (both foreign direct investment and investment in financial assets) has had a dramatic influence on the value of the Israeli currency. The shekel, which had weakened in nominal terms against other major currencies since Israel’s establishment, reversed its trend, and since 2005 the currency has been appreciating in nominal terms. The appreciation of the shekel has posed new challenges to monetary policymaking and was one of the main factors responsible for the low rates of inflation since 2013.Footnote 24
All in all, it seems that the last two decades have been a period of almost unprecedented economic prosperity: inflation has been tamed, the perennial deficit in the current account has disappeared, the debt to GDP ratio has been reduced, Israel has turned from being a debtor vis-à-vis the rest of the world to being a creditor, and growth has become export-oriented. Naturally, we would have expected that these developments would manifest themselves in growth figures. And, indeed, the growth rate of GDP during 1995–2015 puts Israel in eighth place among the thirty-six members of the OECD (Figure 1.8). Thanks to exports, the rate of economic growth over this period, 4.1 percent, was faster than the rate of growth of potential output (3–3.5 percent) and much faster than the average rate of growth among OECD countries (2.3 percent).Footnote 25 This achievement has been even more notable in 2005–2015, the decade of the great recession, in which the rate of growth of output in Israel (4.0 percent), had hardly an equal among OECD countries.Footnote 26
Nevertheless, and without belittling these accomplishments, the ultimate test of an economy and an economic regime is that of the growth of per capita income. After all, it is this measure, and the rate of growth of per capita income in terms of purchasing power parity (PPP), in particular, that reflects the improvement in households’ material well-being. Surprisingly, according to these criteria, the Israel’s achievements in the last two decades were less than spectacular: although the rate of growth of per capita income (1.67 percent) was faster than the corresponding rate during the “lost decade” of 1973–1984 (1.08 percent), it was much slower than the rate of growth in the post-Stabilization Program period of 1984–1995 (2.39 percent). The rate of growth of per capita income in the last two decades places Israel only close to the median of the OECD countries, and so does its rate of growth in PPP terms (Figure 1.9). Not only did its ranking among OECD countries in terms of income per capita not improve, but when it is measured in PPP terms, it even deteriorated.Footnote 27 Despite the global financial crisis, which affected almost all developed countries, and the improvement in most of Israel’s economic parameters (inflation, debt, balance of payment, etc.), the narrowing of the gap in standard of living between Israel and the United States and most of the European countries has been minuscule.
The difference between Israel’s standing in terms of output growth and its standing in terms of the growth of per capita income lies, of course, in its population growth. Israel has been for years one of the leaders among developed countries in this parameter. Its average annual rate of population growth (2.1%) was 3.6 times higher than the OECD average. As a result, whereas the OECD population has increased over the last two decades by one-eighth, Israel’s population grew by more than one half.
Israel’s poor performance in terms of GDP per capita is particularly striking given its employment record. Whereas Israel’s male labor force participation was almost ten percentage points below that of the OECD average in the early 2000s, by the end of the period it equaled the OECD average (Figure 1.10). This increase encompassed all population groups, Jews and Arabs, ultra-Orthodox and non-orthodox, and affected especially the elderly and those with low levels of education. Similarly, women’s labor force participation rate, which already exceeded the OECD average at the beginning of the period, continued its rise.
The increased participation of men with little experience (and low levels of education and skills) in the labor force naturally had an adverse effect on productivity. However, the low level of productivity and its slow growth relative to other developing countries are not new phenomena. Until 1973 Israel was one of the fastest-growing countries, both in terms of per capita income and in terms of total GDP. The slowdown in growth after the Yom Kippur War was one of the main topics analyzed in Ben-Porath’s book, and it remained an important issue in Ben-Bassat’s book. In both volumes, it was found that a key factor behind the slowdown was the decline in productivity growth. The authors of the relevant chapters in the two books – Reference Metzer and Ben-PorathMetzer (1986) and Reference Hercowitz and Ben-BassatHercowitz (2002) – tried hard to uncover the causes of the productivity reversal. Metzer tied it to the underutilization of capital, because of inflation and the government’s wasteful credit policy. Hercowitz explained the slowdown in productivity in the early 1990s as the outcome of a lag following the adoption of new technologies and equipment as part of the absorption process of the Russian immigration wave. Unfortunately, productivity has not rebounded since 1995.
In Chapter 11 (this volume), Hazan and Tsur compare levels of output per worker in Israel and in six reference countries of similar size (Austria, Denmark, Finland, Ireland, the Netherlands, and Sweden). They find that productivity in the reference states is almost 50 percent higher than in Israel. Investigating the sources of this difference, they find that it cannot be attributed to differences in the industrial structure (i.e., Israel’s higher share of service industries) but rather that it is almost exclusively explained by differences in levels of physical capital inputs per employee, which are twice as high in the reference countries than in Israel. At first glance, this result is not surprising. After all, the many years of low investment (including low rates of government investment) in Israel should have resulted in low levels of physical capital inputs per employee. Nevertheless, one could have expected that the low levels of physical inputs should have been compensated by high levels of human capital inputs per employee. After all, Israel’s labor force is known to have the highest levels of formal education in the Western world!
The authors argue, however, that relying on data on formal education (i.e., the number of years of schooling) as a measure of human capital is misleading: surveys taken in the mid-2010s examining workers’ skills (the PIAAC – Programme for the International Assessment of Adult Competencies – survey) show that the skill level of Israeli workers is significantly lower than that of workers in the reference countries.Footnote 28 Adjusting for these findings, Israel’s “true” human-capital per-worker input is 8 to 25 percent lower than that of the reference group, reinforcing the effect of the low levels of physical capital inputs.
As mentioned above, the “productivity gap” between Israel and the OECD countries is certainly not new. Still, the investment in vocational training, job placement and on-the-job training is not only low, but even declining.Footnote 29 The Israeli government plays a major role in this trend. Its reduced involvement in these programs is only one manifestation of its declining role in the investment in human and physical infrastructure. According to Hazan and Tsur, raising the skills of the Israeli worker to the average level of skills in the reference states would narrow the output-per-worker gap from 30 to 18 percent, not counting its beneficial effect on the productivity of physical capital.
The key to raising the standard of living in Israel is, therefore, investment – in both physical and human capital. The government plays a major role in both. Israel has a much lower capital-output ratio than its reference group. This holds for the private sector capital-output ratio but is even more pronounced when it comes to the public one. The Israeli government did very little in the last two decades to close this gap. Government investment in infrastructure declined during the 2000s and recovered only in the last few years, placing Israel close to the bottom of the list of developed countries in terms of the public capital-output ratio (27 percent).Footnote 30
There is no better illustration of the adverse effects of low public investment on productivity than the investment in road infrastructure.Footnote 31 In the last two decades, investment in roads accounted, on average, for 0.7 percent of GDP. During this period, road area has increased by two-thirds (urban road area increasing by only a quarter). However, while early in the period the investment matched the growth in traffic, in the last decade it lagged behind (traffic per road surface increasing by 40 percent). Congestion, which was already a major problem in 1995 (Reference GronauGronau, 1997), turned into one of the economy’s most serious problems in the last decade. The cut in sales tax, the appreciation of the shekel, and the shift to more fuel-efficient car models reduced the costs associated with the use of private vehicles. Given the low initial rate of vehicle ownership, the rise in living standards and in labor force participation rates led to a 2.3- fold increase in private vehicle ownership and traffic.Footnote 32 According to the OECD report, congestion in Israel (defined as the number of vehicles per kilometer of road) is 3.5 times the OECD average. The Israeli Ministry of Finance has estimated that the annual economic costs of congestion are 35 billion shekels (about 3 percent of GDP). In spite of the millions of hours wasted daily, very little has been done to tackle this problem. The Ministry of Transport and Road Safety has for years blocked any attempt to deter the usage of private cars through congestion pricing or increased parking fees, and at the same time has done relatively little to advance public transport in the major urban centers.
The low level of investment in the last decade cannot be blamed on the level of savings. Though early in the period (1995–1999), negative public savings and the shortage of private savings necessitated foreign capital inflows to finance investment, things turned around in the early 2000s (Figure 1.11). The decline in investment and in the government budget deficit turned the deficit in the current account into a surplus, which has continued to grow in the last five years despite the recovery in investment.Footnote 33
Although there is no research evidence on this issue, it seems that one of the factors that contributed to the increase in household savings was the adoption of the mandatory pension law in 2008. And, indeed, since 2011 net deposits in pension savings have increased considerably, and as a result their share in overall net savings almost doubled (an increase from one-sixth to almost one-third) and so did their share in GDP (an increase from 2 to 4 percent). The liberalization of international capital flows and the foreign exchange market, and the equalization of the tax rates on foreign and domestic investment (introduced in 2003) contributed significantly to the diversification of the public’s portfolio, and to the increase in the share of foreign assets.
From the social perspective, more worrisome than the low investment in physical capital is the low investment in human capital. Though Israel ranks close to the top of the developed countries in terms of human capital per worker, in their chapter on education in this volume (Chapter 14) Ben-David and Kimhi argue that this position is threatened by the decline in the share of resources devoted to education. One manifestation of the cut in public expenditures was the decline in the share of government expenditures on education from 7.6 to 6.2 percent of GDP during 1995–2007, and though the government reversed this trend in 2008, the increase was only minuscule. National education expenditures reveal a similar pattern. Although Israel has managed to preserve its position in the center of the OECD distribution in terms of public expenditures per student in elementary education, it is placed along the lower spenders when it comes to public expenditures per student in secondary education. This trend is especially worrisome given the large differences in the quality of education across different population groups, gaps that are manifested not just in adult skills, but already during school years. Israeli students’ performance in international tests of knowledge (e.g., PISA – Programme of International Student Assessment) is poor, and although there has been some improvement in recent years, the Israeli average is still among the lowest among the developed countries.
The poor performance of Israeli students in these tests is partly explained by the gaps in performance between Jewish and Arab students. While the performance of Jewish students puts them in the middle of the distribution, the performance of Arab students puts them at its bottom.Footnote 34 This gap has not narrowed over time. The Jewish–Arab gap is just one manifestation of the large disparity of test results, whether it is tests of knowledge taken at school or tests of skills taken in later years. This disparity, which places Israel among the least equal in the developed world, is only partly explained by the between-group disparity and is as large when it comes to the within-group disparity (i.e., the disparity of skills within the Jewish population). Needless to say, this dispersion in skills translates into inequality of household income.Footnote 35
1.6 Lights and Shadows in a Market Economy
1.6.1 Economic Freedom
The reduction in the role of the government in economic activity increased the share of resources put at the disposal of the business sector. The market reforms were supposed to insure that these resources would be used efficiently. This policy, however, had its price. As noted by Brender in Chapter 2 on fiscal policy, choosing to have a “small government” means shifting more responsibility not only to the business sector but also to private households, with the government playing a regulatory role. Several such examples are discussed in the book: mandatory pension savings, private health insurance, and private education.
The increase in regulation was intended to ensure that the business sector would perform its duties properly. However, the reduction in public expenditures has resulted in many cases also in a reduction of enforcement, which was replaced by stricter licensing and more bureaucracy.
The structural reforms made a significant contribution to the efficient allocation of resources in the economy and to sustainable growth. Our discussion above of reform processes illustrates just how difficult is the reformers’ task, given the opposition of powerful economic actors whose excess profits are at stake.Footnote 36 As we noted, the share of the business sector in GDP has increased in the last three decades from 59 percent just before the Stabilization Program, to 69 percent a decade later, and to 74 percent by the end of the period.Footnote 37 But these figures may give an oversimplified picture of the change. To evaluate this change in more detail, and place it in international perspective, we employ the Fraser Institute’s Economic Freedom of the World Index.
The index is composed of both qualitative and quantitative indicators. It measures government involvement in several key areas: size of government, legal system and security of property rights, sound money, freedom of international trade, and regulation. Table 1.2 shows Israel’s progress over the years. Whereas in 1985 Israel’s index was one of the lowest among OECD countries, since then it has improved its relative ranking in all of the different areas, and by the end of the period Israel was able to boast an average almost equal to that of the OECD (in four out of the seven criteria it even surpassed the average).
|A. Size of government||Israel||2.74||3.72||3.1||4.65||5.84||6.17||6.23|
|B. Sound money (price stability)||Israel||1.25||3.95||7.43||8.09||9.34||8.96||9.49|
|C.1 Legal system and property rights||Israel||6.65||4.30||6.85||6.78||6.30||6.04||6.13|
|C.2 Freedom to trade internationally||Israel||6.22||6.86||6.89||8.66||8.46||8.23||8.11|
|C.3 Credit market regulations||Israel||1.14||3.81||5.38||6.06||7.67||9.27||9.57|
|C.4 Labor market regulations||Israel||–||3.35||3.84||3.81||4.87||5.28||5.38|
|C.5 Business regulations||Israel||–||–||6.60||8.13||7.20||7.12||7.20|
Notes: The figures for the OECD are simple averages for member countries. Countries that joined the OECD from 1985 to 2015 were included in the calculations only after the year in which they joined. The score for regulation (C) is a simple average of all the regulation subcategories (C.1 through C.5).
The table emphasizes the improvements in the measurable macroeconomic indicators (fiscal policy and price stability), but no less important were the reforms in the financial market and the regulation of credit. According to the Fraser Institute, Israel still lags behind the OECD average in terms of regulation of the labor market and of businesses, and in terms of the legal system and the security of property rights.Footnote 38 Even more worrisome is the slowdown in the pace of reforms. Israel’s progress was very fast in the decade following the 1985 Stabilization Program but slowed down as time passed. However, this phenomenon is not unique to Israel, and the authors of the Fraser report note that in many advanced countries there is growing skepticism about the claim that the “free market” is the solution to all economic and social problems.Footnote 39
One of Israel’s weak spots lies in the regulation of labor and businesses. Although the Fraser Institute ranks Israel close to the OECD average, the OECD experts themselves seem to disagree with this ranking. These experts regard the strictness of the regulation, the bureaucracy that characterizes government services, the lack of transparency of some of the rules, and barriers to trade and to entrepreneurship imposed by the government as some of the leading explanations for the low levels of productivity of Israeli workers.
Another manifestation of the retreat of the government from its traditional functions, and probably the largest concern associated with this process, is its effect on income distribution. The rise in inequality is not new. Dahan, who covered the topic in the Reference Dahan and Ben-BassatBen-Bassat (2002) volume, extends the analysis to the last two decades in this book (Chapter 12). The analysis highlights a unique pattern in Israel: while the inequality in net income (i.e., income after taxes and transfers) has been rising throughout most of the last two decades, the inequality in economic income (i.e., in gross income) had already started to decline in the early 2000s (Figure 1.12). Israel does not stand out in terms of inequality in economic income but still counts (in spite of a slight improvement recently) as one of the “leaders” among OECD countries in the inequality in net income.
There is wide agreement that the decline in economic inequality was driven in part by the increase in labor supply of those with low levels of education. The more than 50 percent increase in the number of those employed belonging to the lowest five deciles has significantly increased labor income at the bottom of the income distribution. Since the 2002 recession, labor income has increased by a factor of 2.5 in the lowest quintile, but by only a factor of 1.6 in the center of the wage distribution (i.e., the fourth to sixth deciles). Explaining the increase in labor supply, Dahan emphasizes the “pull” factors – the improvement in employment prospects and the decline in unemployment, which reached a historic low by the end of the period. On the other hand, Eckstein, Larom, and Lifshitz, in Chapter 13 on labor force participation and employment patterns, emphasize the “push” factors – the cut in government allowances and transfer payments undertaken as part of the reforms of the early 2000s.
The increase in labor supply contributed to the reduction in inequality at the bottom half of the wage and income distributions but did little to reduce inequality at the top. The integration of the wave of immigrants in the labor market led to an increase in the mean wage, but this process came to an end with the 2002 recession. The mean real wage has been stagnant since then, and it was only in 2015 that it returned to its pre-recession level. The integration of low-skilled workers in the labor market reduced the average wages of workers without an academic education, while the average wages of workers with an academic education increased only slightly. According to Danieli and Kornfeld (2017), the wage increase at the tails of the distribution has been significantly faster than the increase of the median wage. Hence, while intergroup disparity (among schooling or occupational groups) has declined, there has been a rise in intragroup disparity. As shown in the chapter on education, there are significant wage gaps between graduates of research universities and graduates of colleges, and even larger wage gaps between the graduates of different academic fields. While the growth of the high-tech and the business services sectors resulted in an increase in the relative wage of graduates in computer science, mathematics, engineering, and the exact sciences, excess supply of graduates in other fields led to the over-qualification of many employees, whose wage hardly changed.
Furthermore, not only has wage inequality increased, but there has also been a decline in the share of labor income in output (Figure 1.13). The stagnation in real wages since 2002, on the one hand, and the fast growth in output following that crisis, on the other, resulted in the last two decades (1995–2015) in a sharp decline in the labor share in business sector output (from 73 to 57 percent) and an increase in the share of capital income (from 8 to 25 percent). The decline in the size of the labor-intensive public sector amplified this trend. The rise in the share of capital income in output contributed to the increase of inequality in total income, especially in the higher deciles of the distribution.
The rise in the share of capital in output is manifested in the growth of the public’s financial portfolio. The increase in this portfolio was almost twice as large as the increase in output, and significantly faster than the increase in labor income. These trends have immediate implications for the inequality in the resource distribution in the economy: while the share of the top decile in national income in 2013 was 27 percent, its share in total wealth (physical and financial) was 50 percent (Reference Milgrom and Bar-LevavMilgrom and Bar-Levav, 2015).
The increase in wage inequality and the decline in the share of labor income in total output are associated with the decline in the economic and political power of the trade unions (the Histadrut). The decline of manufacturing and the public sector resulted in a shrinkage of employment in the unionized sectors. The collapse of the Histadrut’s business “empire,” the takeover of its pension funds by the government, and finally the implementation of universal health insurance resulted in “mass desertion” of the unionized employees (particularly, those in mid-income scales of pay). As a result, the share of unionized labor dropped from 80 percent in the 1980s, to 45 percent in 2000, just over 30 percent in 2006, and 25 percent in 2012. The sharp decline had its bright side, the increased flexibility of the labor market, but at the same time it cast a heavy shadow on the economy as far as inequality in the distribution of income is concerned.
Tax policy has a major role in reducing inequality. The gap between the changes in Israel’s gross income inequality and net income inequality is explained to a large extent by the tax and welfare payment cuts undertaken during the 2002 crisis. As mentioned, the 2002 policy may have been successful in reversing the trend in the males’ labor force participation, thus reducing the gross income inequality, but it increased net inequality and deprived the government of its main weapon to combat the problem. The shift from direct taxation to indirect taxes made things even worse.
Even more serious in its long-run implications was the effect of the 2002 cut in government expenditures on human capital services, which made it harder for households to combat inequality on their own. Topping this list are the cuts in government expenditures on health and education.
The government’s involvement in the market for health in the last two decades is characterized by a move in two opposite directions: starting with the “nationalization” of health services, followed by a retreat. The inequality in access to healthcare, and the financial collapse of Israel’s largest health service organization (owned by the trade unions) led in 1995 to the adoption of the National Health Insurance Law. The law shifted the responsibility for funding health service organizations from the insured households (and their employers) to the government. The additional costs were financed through an increase in the social security tax (the imposition of a “health tax”) and from the government’s general funds.
Though the share of health services in GDP over the last two decades has not changed, the reduction in the government’s share put an ever-increasing burden on households: whereas the share of public funds declined from 66 to 62 percent, the share of private funding increased from 31.5 to 36 percent.Footnote 40
As noted by Bin Nun and Ofer on the health sector (Chapter 15, this volume), the partial adjustment of the “medical services basket,” and the freeze in the healthcare system’s infrastructure investment – specifically in the expansion of hospitals and their staff – have resulted in a deterioration in the quality of healthcare services (e.g., the availability of interns and hospitalization services) and increasingly forced households to rely on private health insurance plans. As a result, the share of healthcare services supplied by private providers increased from 22 to 30 percent. Though the partial privatization of the system has not affected standard indices of health outcomes (e.g., life expectancy and infant mortality), it did increase the gap in the availability of services between the center and the periphery, and given the decline in public investment in the training of medical staff, this trend may become even more severe in the future.
Expenditures on education account for the largest share, other than defense expenditures, in the government budget. As noted, the education budget was among the first to go through the 2002 cut. Noting the damage to education quality, it took the government half a decade to reverse its steps, but though the growth in its expenditures on education exceeded that of GDP, government expenditures as a share of GDP are still below the 2002 level. The government tried to overcome the wide dispersion in the education system’s outcomes by adopting differential funding: schools with students from relatively weak socioeconomic background receive more generous funding than other schools. However, this attempt has been only partly successful. Gaps in funding still remain between the Jewish and the Arab school systems, and between the different school systems within the Jewish sector.Footnote 41 These gaps are broadened by the schooling expenditures of local authorities and those of households.Footnote 42
When adding to these factors the intergenerational transmission of human capital, i.e., the contribution of parents’ education (and in particular, mother’s education) to the success of their children in the schooling system, one realizes the enormous challenge facing Israeli society in its attempt to close the gaps in skills between different groups within the country, and between Israel and the rest of the developed world. Given demographic trends – and in particular the accelerated growth of the ultra-orthodox population and (to a lesser degree) that of the Arab population – it will take an extreme effort by the government to prevent a deterioration in Israel’s relative standard of living in years to come.