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:

 

1. 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.

2. 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.