Consider the market-oriented reforms since the mid-1980s, for instance. Israel’s initial decades of economic management saw a corporatist approach, with widespread public ownership, strong trade unions and severe trade restrictions. Energy and telecommunications sectors were entirely operated by state-owned enterprises, and government had significant holdings and influence in many other sectors. Although trade-union power has diminished substantially since the mid-1980s, it is still considerable. In recent years the unions and employers’ representatives have increasingly presented a common front on policies.
Macroeconomic policy reached a turning point in 1985 with a radical stabilisation programme designed to tackle hyperinflation and put the debtto- GDP ratio on a downward path. The anti-inflation measures were particular successful and were followed up by the implementation of an inflation-targeting approach to monetary policy in the early 1990s. Indeed, inflation has typically been well below 5% annually since the late 1990s. The 1990s also saw extensive structural reform. As in many OECD countries, this included privatisation and regulatory reforms to encourage product market competition.
In addition to this dramatic switch in economic management, Israel’s economy has experienced rather more shocks (both positive and negative) than most, even during the relatively stable post-1980s era. Mass immigration from the former Soviet Union in the early 1990s, the dot.com bubble, the Second Intifada, which began in autumn 2000, and the recent global economic downturn have all generated considerable cyclical effects on output and employment.
The strong influence of the 1990s dot.com bubble on Israel’s economy highlights the prominent role high-tech activities have played in growth, attracting much interest from outside. Innovation policy has played a role in this, notably featuring a system of competitively awarded research grants and additional support for firms located in special business parks (business incubators). Other factors contributing to Israel’s impressive profile in high-tech and R&D activity include: a fairly large defence industry; training with sophisticated technologies during military service; a large pool of researchers in the Jewish diaspora; and engineering and science skills brought by the wave of immigrants in the early 1990s. Aside from defence industries, the main high-tech activities are computer component manufacturing, software engineering, medical technologies and pharmaceuticals. In fact, the world’s largest generic pharmaceutical company, Teva, is headquartered in Israel.
Outside the high-tech sectors, Israel plays an important role in the world diamond industry, though the sector accounts for only a small share of the economy. Agriculture now accounts for around 2% of GDP, though related experience in managing scarce water resources has developed into another area of high-tech expertise.
Policies have been favourable towards business for some time to draw investors in and anchor them down. Still, the country arguably has some outright disadvantages as far as some investors are concerned: it is further from major markets than many competing business locations and the politics of the region probably puts some off. Retaining a reputation for excellence in high-tech and research activities also presents challenges because of the global mobility of these sectors.
Substantial security costs
While the substantial resources devoted to the military and security services have some positive benefits for civilian economic development, this also incurs considerable costs. Government spending on defence equipment and personnel is now well below previous peaks, but it is nevertheless still comparatively high at around 8% of GDP. About 1.5 percentage points of that is accounted for by military aid from the United States. But even when this is taken on board, this spending still represents a fiscal burden and also has implications for human resources.
Compulsory military service (three years for men, two years for women, followed by reserve-service requirements) affects education and the labour market, and also contributes to divisions within society. Ultra-Orthodox Jews and Arab-Israelis are exempt, freeing them from the downsides of service but excluding them from a range of subsequent fringe benefits and other support; this exclusion contributes to lower labour market participation and income levels. In addition, there is little doubt that a greater share of resources is devoted to civilian security arrangements than in most OECD countries. Checks on entry to government offices are tight; transport networks, offices, shops, restaurants and bars are often manned by private security guards; and scanning devices similar to those used in airports are often found on larger premises.
Israel’s history and the geopolitics of the region have additional economic implications. The country is described by some as an “island economy”. Although trade and investment flows are substantial with the wider world, those with neighbouring economies in the Middle East are relatively small, while cross-border movement of labour is also limited. This has prompted a widening of channels to temporary foreign workers from further afield (such as the Philippines and Thailand), who now account for about three-quarters of the non-Israeli workforce. Meanwhile, economic ties, particularly with the United States and Europe, go beyond trade and investment. There is a large positive net balance of transfers comprising government-to-government transactions, not only from US military aid, but also transfers between private households (including remittances) and transfers to non-governmental organisations that support a wide range of groups and causes. Net private transfers come to about 2% of GDP, which is high by OECD standards. Land property rights are also somewhat unique: only 7% of land is privately owned, 12% is owned by the Jewish National Fund, and the remaining 81% either directly by the State of Israel or by the Development Authority.
These positive and negative influences have contributed to an average growth rate of nearly 4% per year since 1996, the sixth highest figure among OECD countries. However, growth has also been helped by relatively rapid population increase. Over the same period, per capita growth was only 1.7%. On a purchasing-power-parity basis, the level of GDP per capita, at $27,661 in 2009, is just over 80% of the OECD average (that average was about $33,023), and is far below that of topranking OECD countries. Furthermore, for a developed country, Israel suffers from high rates of poverty, particularly among Arab-Israelis and Ultra-Orthodox Jews. Building a good environment for stronger, more inclusive long-term economic performance must remain a core goal for both macroeconomic and microeconomic policies.
In several respects the economy is already on that path. The absence of critical failure in the domestic financial sector ensured that the recent downturn was mild and the recovery relatively speedy. Meanwhile, new finds of offshore natural gas will further reduce the need for imported energy and permit a cleaner fuel mix. The associated tax and royalty revenues will help fiscal balances, which are in better shape than many OECD countries but nevertheless need improving. The ratio of public debt to GDP was 75% in 2010, which is lower than many OECD countries but higher than is optimal.
However, there remain significant macroeconomic challenges. The monetary authorities are facing a difficult scenario in which rapidly rising house prices and overall economic performance have favoured an early start to normalising the policy interest rate. However, this has prompted exchange-rate appreciation, with potentially damaging effects on the profitability of the export sector. Fiscal policy also faces tough trade-offs. While there is a need for debt reduction, achieving policy goals in some areas, particularly on the social front, will require additional spending, and revenue growth is being restrained by ongoing cuts in income-tax rates, as part of a wider programme for encouraging business activity.
In structural policies, significant in-roads have yet to be made in reducing outcomes in poverty. However, measures are in train that ought to have impact in the future. In particular, education reforms are moving ahead quite rapidly on some fronts. For instance, in secondary education, teachers’ pay is being increased in exchange for increased hours devoted to teaching small groups of students.
For the business sector, ongoing cuts in income tax rates are being accompanied by efforts to lighten urban planning procedures and to cut other aspects of red tape for businesses. However, much work remains to be done, notably regarding competition. One study has estimated that the 20 largest family business holdings totalled 30% of the market value of Israeli company shares, a relatively high value compared with equivalent calculations for other countries. Public concern about the role of these groups in the economy has prompted the government to appoint a special committee, which is due to report in the coming months.
For more information on the economy contact Philip Hemmings at the OECD Economics Department
OECD (2010), Economic Surveys: Israel, January.
OECD (2011), OECD Economic Outlook, No 89, May.
©OECD Observer No 285, Q2 2011