ECONOMY: The Economic Picture
Israel Ministry of Foreign Affairs
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 ECONOMY: The Economic Picture

 
Photo: I. Sztulman

Although the economic recovery is still fragile, and it may be too early to declare victory over the world’s worst economic crisis since the Great Depression, enough time has elapsed to assess the factors which softened Israel’s ride during the crisis.

The first factor was the Israeli banking system’s conservative nature, which meant that it was not significantly exposed to the subprime market which brought down some of Wall Street's great firms, and also that reserves were adequate to assure investors of the safety of Israel’s financial sector.

Israel in 2008 had seen five consecutive years of strong growth - over 5 percent each year - which left it in a strong position to deal with the recession. Deficits had been reined in, reaching near zero in 2007, and the debt to GDP ratio had declined from over 100 percent to a record 77 percent, allowing the government greater leeway for expenditure during the lean period.

Inflation, once the bane of Israel’s economy, had been taken under control by aggressive policies since the disastrous crisis of the 1980’s, abetting investor confidence and giving the average Israeli economic stability and security.

Israel had developed a number of different export sectors, especially hitech manufacturing, allowing for a more balanced current account going into the crisis.

Israel copes with recession

Israel’s primary weapon in dealing with recession was an aggressive monetary policy, which, under Bank of Israel Governor Stanley Fischer’s direction, took interest rates to unheard of lows. Fischer’s wisdom in being one of the first central bankers to reduce interest rates - and, later, being one of the earliest to raise them as the crisis waned - had a critical role in allowing Israel to maintain steady GDP rates even as exports dipped. In fact, Israel was one of the few Western economies to show positive growth for 2009.

The aggressive monetary policy allowed the government to steer clear of heavy deficit spending. The extent of Israel’s emergency spending was low relative to other governments, and thus it does not face the debt pressures mounting in Europe and elsewhere.

The Bank of Israel’s monetary policy also led to the appreciation of the Israeli shekel, thus putting pressure on exporters. The bank succeeded somewhat in controlling the shekel’s rise by purchasing large amounts of foreign currency, especially US dollars.

Checking Inflation

From its inception and until 2000, Israel's economy suffered from rising prices - though a linkage mechanism helped individuals somewhat to live with the consequences. All financial commitments, salaries, rents, savings accounts, life insurance policies, income tax brackets, and the like were linked to a steadier value (such as foreign currency or the consumer price index), thereby taking the sting out of inflation. Thus, Israelis managed to raise their standard of living whether the annual inflation rate was one digit (from the mid-1950s to the end of the 1960s), two digits (1970s) or three digits (first half of the 1980s). Obviously, the economy suffered from the inflation (e.g., decline in the propensity to invest), much of which was fueled by these linkages, until the situation came to a head in the mid-1980s.

In the summer of 1985, after inflation had soared from 191 percent in 1983 to 445 percent in 1984 and threatened to reach four digits in 1985, the national unity government headed by Shimon Peres of Labor, with Yitzhak Moda'i of the Likud as minister of finance, implemented a radical emergency stabilization program in cooperation with the Histadrut, the umbrella organization of the unions, and with the Employers' Coordination Committee. The inflation rate fell to 185 percent in 1985 and to 21 percent in 1989. It has since fallen further, to 7 percent in 1997 and - for the first time ever - to zero in 2000. Another first ever was an actual fall of prices in 2003, with a negative inflation of -1.9 percent. During the recession, the inflation rate was allowed to rise as the Bank of Israel lowered interest rates to stimulate the economy, but the central bank has shown a willingness to resume combating inflation as the global economic situation changes, by being the first in the West to raise interest rates.

The Public Sector

The high level of public consumption, in particular the resulting large deficit in the government's budget, was always a primary cause of Israel's high inflation rate. All the resources the government could recruit to finance the budget (domestic and foreign sources, loans from the public, direct and indirect taxes) were not sufficient to cover the amount spent, and the government found itself repeatedly compelled to resort to inflationary financing. This heavy burden of the public sector was due mainly to the tremendous defense expenditure and the need to repay internal and external debts, two items which only in the last few years have come down from two thirds to less than a half of the government budget.

The pursuit of economic viability also called for checking inflation, reducing the balance of payments deficit, and maintaining rapid economic growth, all of which required curtailing the high public expenditure as Israel’s economy grew. The high ratio of public expenditure to the GDP has been halved compared to what it was 25 years ago, from 95 percent to 43 percent of the GDP between 1980 and 2009. In 2006 there was a surplus in the balance of payments and the budget deficit was reduced to 0.9 percent of the GDP. The aggressive belt-tightening was relaxed during the recession, with a deficit of 5 percent of GDP, still a great deal lower than what most Western governments spent.

Although the government still encourages private economic initiatives, its policy succeeded in reducing actual involvement in business concerns through their privatization which in 2005 yielded an income of almost $3 billion.

The Tax System

The financing of Israel's massive public expenditure required heavy taxation, which its citizens had to bear, for years. This was one of the highest tax burdens in the world. During the first decade of statehood, taxes equaled one eighth of the GNP; in the 1960s, they reached one quarter; they wavered between 30 and 40 percent in the 1970s and 1980s; in the 1990s they averaged less than 40 percent, and were 40.3% in the year 2000. By 2003 Israelis' total tax burden decreased to 39.3% of the GDP, going further down to 31.5 percent by 2009 - well below the level of the OECD countries' average, which was 35 percent.

Indirect taxes consist primarily of a 16% Value Added Tax (VAT). In addition, a purchase tax is levied on cars, fuel, and cigarettes. Imports from the European Union and the United States are duty free, whereas customs are applied on imports from other countries.

Direct taxes on income and property amounted to less than one quarter of all tax revenues until the late 1950s, climbed to around one third by the early 1970s, then to about one half in the early 1980s, and reached 45 percent in 1986. Since then the weight of direct taxes decreased to 39 percent in 1995 and fluctuated between that and 42 percent in 2006.

In recent years, further changes to the tax system were adopted to integrate Israel more firmly into the global economy. As part of this policy, custom duties and purchase taxes on imports continue to decline, the corporate tax rate fell gradually to 25 percent by the year 2010 and is to fall to 18 percent by 2016. The marginal rate of income tax is also being gradually reduced to 42 percent in 2012 and 39 percent in 2016.

 

Private Consumption and Savings

Private consumption has risen, almost without a break, since 1950. Its annual growth averaged 6 percent since 1960. Even during the recession year of 2009 consumption continued to expand, albeit at a reduced rate of 1.5 percent. Consumption was particularly robust in nondurable goods, which increased by 2.5 percent in 2009, one of the factors enabling Israel’s relatively smooth ride during the crisis.

Despite the ongoing rise in consumption, private savings have been consistently substantial. Until the late 1950s, the average ratio of private savings to private disposable income never fell below 29 percent; in the early 1960s, it dropped to 21 percent but rose again in 1972 to 38 percent, as it was in 1981. Since then it has fallen, almost steadily, to 26 percent in 2009.

Investment

The high rate of savings was never sufficient to support the immense investments made by a rapidly growing economy (generally 20-30 percent of all the resources available to the economy). As a result, a large proportion had to be financed by the transfer of public and private capital from abroad and directly by the public sector, mainly the government. During the past decade, overall investments grew from $17 billion to $22.8 billion between 1995 and 2000, and then declined for three consecutive years before rising again and reaching $24 billion by 2007. Indeed, Israel was seeing remarkable interest from parties totally new to the local economic scene. Although investment dropped off as a result of the financial crisis, the longterm trend is one of very strong investor confidence and excitement about investing in Israel, due to its dynamic, hi-tech business environment.

Many private investments, of both domestic and foreign origin, were also made as a result of government initiative and encouragement. This is reflected in the various versions, over the years, of the Law for the Encouragement of Capital Investment. Through this law, the government attracted investors with subsidized long-term loans (with reduced interest rates), direct grants as a percentage of the total investment, as well as R&D financing.

Tax relief and tax rebates were also offered for this purpose, allocated in accordance with the weight of the contribution by the specific investment to the implementation of economic policies, such as population dispersion, promotion of exports, and the like. This assistance may have accounted for the accumulation, during the 1980s, of capital stock (production capacity) at a rate exceeding the growth of the GDP. In some sectors, this surplus production capacity facilitated the rapid takeoff in the 1990s.

 

Wages and Working Conditions

Wages in Israel are determined mostly through negotiations conducted between three parties: the government (still the country's largest employer), whose wage scale has strong implications, influencing all segments of the economy, the Histadrut (General Federation of Labor), and the organization of private sector employers.

The agreements reached constitute a framework of wage scales for the different sectors of the economy and, with occasional changes, also provide for automatic payment of a cost-of-living allowance as compensation for inflation. Thus, the wage situation for many years had been rather inflexible - especially at the lower end. Waves of unemployment in Israel did not significantly reduce wages, although in times of labor shortages wages rise with greater elasticity where the demand for workers is more acute.

However, during the recent crisis the labor markets showed significant flexibility. Many workers agreed to reduce their hours or take cuts in pay rather than face the possibility of layoffs. This in turn helped stabilize the labor markets and abetted positive consumer sentiment, which in turn helped buoy the domestic consumption.

In June 2008 the average monthly wage was NIS 8,075 (about $2,250). Conditions for workers in the country's various economic sectors are set forth in work agreements negotiated between employers and employees. Minimum requirements, however, are anchored in law and include a maximum 47-hour work week (with the actual 2006 average in the business sector being under 40 hours a week), minimum wages (NIS 3,850 in 2008; approximately $1,000), compensation for overtime, severance payments, and paid vacation and sick leave.

The Histadrut - General Federation of Labor was established in 1920 as a federation of trade unions to represent the country's workers and to set up industries to provide jobs for its members. In time, it became one of Israel's largest employers and played an important role in the development of the country.

Today, the New Histadrut, with 700,000 members, unites 78 trade unions that are concerned with the local organization of labor, signing collective agreements, and seeing to their implementation. Most branches of employment in the Israeli economy are represented: food, textiles, hotels and tourism industries, government and public sectors workers, clerks, practical engineers, nurses, pensioners, and more. Some professions are represented by independent unions: engineers, medical doctors, academics, teachers, and journalists.

The Histadrut is not as strong as it used to be, as workers are increasingly being employed through sub-contractors or by personal contracts.

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