Output Per Working Hour (2013, USD PPP)
The productivity gap between Israel and other economies increased during the recent years. According to Ministry of Finance research, the gap in labor productivity between Israel and the USA has increased by 10 percentage points in the last decade. This issue is of great importance, since labor productivity affects the average standard of living. Factors contributing to Israel's low labor productivity include low levels of physical capital stock, low competiveness of many sectors in the economy, lack of sufficient infrastructure, and an inefficient bureaucracy.
Israeli companies that export have higher labor productivity and pay higher wages than other companies, and supporters of the Encouragement of Capital Investments Law argue that the government should encourage them to expand. Some of the multi-national firms in Israel, such as Intel, would not have come to Israel if not for the law. There is global competition to attract large companies by offering tax benefits, and other productive firms would choose to expand their workforce abroad. The supporters of the law argue that the firms which benefit from the law have positive externalities due to knowledge spillovers, the international experience gained by Israeli workers in those companies and other effects. Another argument in favor of the law concerns the importance of exporters in Israel's economy: as a small country with small local market, the exporters are considered to be the main driver of economic growth for Israel, so the supporters of the law argue that they should be encouraged through the tax system.
Policy papers at the Roundtable
According to new policy paper by Professor Omer Moav and Dr Assaf Zimring, published by Aharon Institute for Economic Policy, those arguments are problematic. Moav and Zimring argue that laws that favor exporters do not ‘create’ jobs, but rather shift the allocation of employees to export-oriented activity, at the expense of employment in domestic-oriented production and importers. Similarly, opening the market to imports doesn’t harm employment levels, but simply shifts jobs to different industries. Encouraging exports and preventing imports – the Israeli government, in an attempt to support local employment, prevents imports of agricultural produce and industrial goods – are conflicting goals that waste valuable resources, because in the long run, as a result of adjustments in the exchange rate, imports and exports even out. This is borne out by the data. It is true that exporting Israeli firms are more productive, but correlation does not imply causality – it is not clear that the law or being an exporter made those firms more productive: it could be that they were more productive in the first place and because of that started exporting. To justify tax benefits for exporters, one must show a positive causal effect of exports on productivity among the firms that are exporting because of the law, and also that this increased productivity has positive externalities. Moav and Zimring found no evidence for these effects in the literature, and suggest instead that the law distorts the allocation of capital and results in lower average productivity.
A second policy paper presented during the round table, by Professor Zvi Hercowitz and Avihai Lifschitz, explored the law's implications through a quantitative simulation model adapted to the Israeli economy. They found that the existing tax discrimination leads to a distortion between the tradable sector (export-relevant industries) and the non-tradable sector, and also within the tradable sector. In response to the policy paper, Professor Zvi Eckstein argued that those distortions may be responsible for the low labor productivity of the non-tradable sectors in the Israeli economy. One of the distortionary effects of the law is that in order to reach an export rate of 25%, it incentivizes companies to reduce prices overseas while raising prices domestically.
Hercowitz and Lifschitz explored two alternative policies:
Repealing the existing law, making all Israeli companies pay the current statutory corporate tax rate of 26.5%, and increasing public expenditure to match the increase in revenue.
Repealing the existing law and distributing its benefits across all companies, while maintaining the same volume of corporate tax revenues. In this case, the uniform corporate tax will be set at 16.7%.
The simulation found that the first option would lead to a 5.5% drop in output and a rise in tax revenues; while the latter would yield a 1% increase in output without affecting tax revenues.
Many participants of the round table criticized the law. MK Professor Manuel Trajtenberg mentioned that today Israel has a positive trade balance, so the concerns regarding trade deficit and the need to encourage exporters are not relevant. Dr Michael Sarel argued that even if externalities exists, that does not mean that government intervention will have a positive effect. It is not easy to know what should be subsidized, or to calculate the correct sum of subsidies needed in order to mitigate this market failure. Sarel and other participants also argued that there are better ways to encourage employment in the periphery, such as investing in infrastructure.
Participants from industry, including Daphna Aviram-Nitzan of the Association of Manufacturers, Gilad Hacohen of Intel, and Doron Harman of Teva, did not agree with the criticism. They repeated the argument mentioned before about the importance of highly productive exporting firms to Israel's economy. While those arguments are reasonable, it seems that the consensus among the participants in the round table tends against the law, at least in its current form.
Over the past decades many countries reduced their export subsidies and trade protections. For many, this occurred as part of trade agreements such as the Trans-Pacific Partnership (TPP) agreement between the US and 11 other Pacific Rim countries. One of the factors contributing to this trend is the growing consensus between economists about the benefits of free trade and the harmful distortions in resource allocations that are induced by subsidies and tax benefits. While there has been an improvement during the past few years, according to latest OECD reports Israel is still less open to trade than other countries. The corporate tax rate in Israel, currently at 25%, is also relatively high, and several studies found that it may harm economic growth.
The second policy considered by Hercowitz and Lifschitz – repealing the existing Encouragement of Capital Investments Law and distributing its benefits across all companies – could eliminate the distortions to the resource allocation created by the law, while decreasing the corporate tax rate and contributing to future economic growth in the long run. However, as mentioned by MK Trajtenberg during the round table, it will be hard for Israeli politicians to choose this road, because of the political influence of large firms who benefit from the law and because of possible short-run effects on unemployment in the periphery.
Zvi Eckstein, Dean of the Arison School of Business and the Tiomkin School of Economics and Head of the Aaron Institute for Economic Policy at IDC Herzliya
Summary of Presentations of Research and Round Table Discussion at the Aaron institute for Economic Policy, IDC Herzliya
After achieving national independence in 1948, a new priority for the Israeli Government was to achieve economic independence. The young country, surrounded by enemies and flooded with newly arrived immigrants, needed to attract foreign investment and to establish local industries. In 1959 the Government introduced the Encouragement of Capital Investments Law, which gave tax breaks to foreign investors. The most notable early example of using the law occurred in 1968, when the Minister of Finance, Pinchas Sapir, changed the law to exempt the owners of Israel Corporation, Israel’s soon-to-be largest holding company, from taxes for 30 years, in addition to other benefits. In later years the benefits were directed specifically to investment in Israel’s periphery, which was less developed, and to exporters, to reduce Israel’s trade deficit. Today the law provides tax benefits to companies that export at least 25% of their output, and the benefits are greater for companies located in the periphery.
There is a lot of criticism and public discontent in Israel based on a perception that large companies do not pay enough taxes. There is also an academic view that the law distorts allocation of resources and fails to achieve its stated aims. The combination of political relevance and questionable economic benefit brought the topic to the attention of the Aharon Institute for Economic Policy. The Roundtable about this law took place on 1st November 2015: under discussion were two new policy papers about the law and its ramifications for the Israeli economy, and the current proposals for reform of the law. Participants included MK Manuel Trajtenberg, academic researchers, former and current public officials who advised on the law, and senior Teva and Intel executives, whose companies are among the largest beneficiaries of the law.
Background to the discussion
Several studies have found that the Encouragement of Capital Investments Law does not contribute to employment in the periphery. A study by the Bank of Israel, published in 2009, examined the effect of the law on manufacturing productivity, investment and employment in 1990-1999. The researchers found that while the grants provided by the law did not distort macro-level capital allocation, neither did they increase investment or employment. Previous studies found that the law mostly attracted low-tech industries to the periphery, which employed unskilled workers and were unstable due to globalization.
However, the arguments against the law are not limited to low-tech industries. One of the largest companies to benefit currently from the law is Intel, which employs about 10,000 workers in four development centers and two production plants in Israel. One of those high-tech plants is located in Kiryat Gat, a relatively poor town in southern Israel, but a study found that most of the skilled workers and managers who work in the plant live in more central Israeli cities. Therefore Intel's effect on the residents of Kiryat Gat is limited.
Another important issue is corruption. The incentives offered by the law led to several cases of corruption involving government officials and firm owners. In 2012 the Government was heavily criticized for an agreement that was reached with some of the largest companies in Israel, which concerns tax breaks on part of their profits distributed as dividends. The Government faced a budget deficit and wanted to encourage the companies to pay their taxes, but the law at the time incentivized the companies to not materialize their profits, so the government had to change the law and introduce a tax break on those profits. The Opposition blamed the Government for giving a 30 billion shekel gift to some of the richest companies in Israel, and many asked why those companies are paying lower taxes than small business in the first place.
The view from industry
Supporters of the Encouragement of Capital Investments Law often argue that it helps to mitigate one of Israel's main economic problems: low labor productivity. Output per working hour in Israel is lower than in other developed countries.
The Economic Effects of Tax Breaks for Exporters in Israel
"To justify tax benefits for exporters, one must show a positive causal effect of exports on productivity among the firms that are exporting because of the law, and also that this increased productivity has positive externalities."
"The second policy considered by Hercowitz and Lifschitz – repealing the existing Encouragement of Capital Investments Law and distributing its benefits across all companies – could eliminate the distortions to the resource allocation created by the law, while decreasing the corporate tax rate and contributing to future economic growth in the long run."