Executive Summary
The coronavirus pandemic has had profound effects. Lockdown measures and high uncertainty have led to a sharp contraction in output. Large numbers of workers have been put on leave, unwinding some of the employment gains of the past. The downturn hit at a time when the economy was performing well, with GDP growth close to potential, record-low unemployment, and relatively low public debt. However, the crisis threatens to aggravate Israel’s underlying challenges of high poverty, large income gaps and wide productivity disparity between its vibrant high-tech sector and lagging sheltered sectors.
Confinement measures were introduced swiftly and, together with additional steps to strengthen the health care system capacity, helped limit the number of new infections during the first wave of the pandemic. However, a second outbreak, after the economy had largely reopened, has been more difficult to contain. The government and central bank put in place wide-ranging measures to protect people and firms from the economic consequences of the shutdowns.
The labour market has suffered a severe shock. As businesses were shut down, more than a million workers have been temporarily laid-off (Figure 1). Many have regained employment as the economy reopened, supported by government subsidies to rehire workers. However, the severity of the shock and possible restructuring of the economy will leave many looking for jobs. Government policies to retrain workers and support job search will be crucial.
1. Data not available before May 2020.
Source: Israel Central Bureau of Statistics.
The recovery will be slow (Table 1, Figure 2). The economy started to reopen in late-April. However, a second lockdown in September, high uncertainty, unemployment and new distancing regulations will weigh on the recovery of consumer demand and business investment. Weak global demand will hold back export growth.
Source: OECD Economic Outlook: Statistics and Projections database.
Monetary policy reacted decisively. Quantitative easing was started, the policy rate lowered from 0.25%-0.1%, liquidity provided, and a credit facility for SMEs via banks established. If financial conditions were to tighten, the existing programmes could be further expanded. Inflation will likely continue to undershoot the target range in the near-term.
The banking system entered the crisis in a robust state, and thanks to regulatory and monetary easing as well as government loan guarantees the initial impact on credit supply was limited. Nonetheless the quality of bank balance sheets may deteriorate quickly as liquidity support is withdrawn and firm failures increase. The banks’ heavy exposure to the real estate sector is another risk. Creating a deposit insurance system and a bank resolution framework could further enhance financial stability.
Fiscal policy responded forcefully to the crisis and provided welcome support to the most vulnerable people and struggling firms. Fiscal support should be maintained and targeted to strengthen the recovery. The resulting substantial budget deficits will add to the debt stock.
Additional social and infrastructure spending may be needed to enhance the authorities’ capacity to tackle large socio-economic disparities, boost productivity and support the recovery of aggregate demand. Allowing for this spending while maintaining budget control, will require improved spending efficiency and sustainable increases in tax revenues.
The tax mix is reasonably growth- and employment-friendly but there is scope to improve the efficiency and equity of the tax system. The tax burden on labour is relatively low, and the corporate income tax rate has been cut in recent years, while taxes on consumption, which are less distortive, are relied on more heavily. Nevertheless, ample room exists to simplify the tax system by abolishing inefficient tax expenditures and broadening tax bases.
The share of the working poor is high (Figure 3). Israel’s earned income tax credit is an effective redistribution measure with positive employment effects for low-skilled workers. Further expanding the programme would support the poor while maintaining strong incentives to work.
Note: Workers with income below the poverty line, living in households with a working-age head and at least one worker. 2018 data for Australia and Israel.
Source: OECD Income Distribution database.
The business tax system provides large benefits to internationally competitive and high-tech firms. This preferential treatment should be reviewed with a view to better targeting the scheme to ensure net benefits to society and reduced distortions. Better targeting could create room for broader business and innovation support that underpins the economy more widely.
Excise taxes should be adjusted in line with environmental goals. Introducing congestion charging would reduce traffic flows and pollution, and would prepare Israel for the planned phase-out of petrol- and diesel-fired cars starting in 2030. Gradually increasing taxes on gas and coal or introducing an economy-wide carbon tax would lower CO2 emissions in a cost-minimising way and protect the tax base as energy generation and use shift to natural gas.
Income inequalities between municipalities are among the highest in the OECD, despite Israel being one of the smallest OECD countries. Poverty rates vary significantly between different areas (Figure 4), as ethnic and religious groups with weak labour market outcomes are concentrated in separate cities or neighbourhoods.
1. Poverty threshold is 50 % of the national median equivalised disposable income.
Source: National Insurance Institute (2019).
The quality of schools and the attractiveness of the local labour market differ considerably between municipalities. Increasing the quality of education by moderating the differences between the various school streams would improve the employability of the labour force. The core subjects should be strengthened in the curriculum of the Haredi stream. Post-secondary vocational programmes should be expanded to target those adults who left school without proper skills.
Improving public transportation and coordination between central government and local authorities in infrastructure projects may help connect vulnerable groups to job opportunities. Establishing metropolitan transport authorities could promote integrated transport networks and pricing systems and ensure stable financial support for public transport.
Poorer municipalities do not have enough resources to finance adequate public services for their residents, which further widens the gaps between municipalities. This calls for changes in the local fiscal framework. Stronger equalisation through higher compensation from wealthier municipalities should be considered. The government could also merge municipalities and promote regional clusters to improve efficiency.
The property tax is the main source of municipal income but suffers from several major deficiencies. The current system is opaque, and large differences in rates between residential and non-residential properties and among non-residential properties contribute to revenue disparities between municipalities, housing shortages and locational distortions.
Stark differences in productivity exist between sectors. While productivity in high-tech sectors is already internationally high, the more traditional sectors lag significantly behind. Enhancing aggregate productivity will involve not only removing barriers that prevent resources from shifting into the high-tech sector, whose expansion has slowed, but also lifting the productivity of the long tail of lagging sectors. This will require developing human capital, improving infrastructure and fostering competition and regulatory reform in sheltered sectors.
Despite progress, regulations in a number of areas are more restrictive than in other OECD countries. For instance, price regulations are still widespread, and barriers to foreign trade and investment remain high, with Israel’s foreign trade exposure lower than in other small OECD nations. Further lowering tariff and non-tariff barriers as well as streamlining trade procedures will boost competition and productivity in sheltered sectors.
Tariffs and regulations remain particularly distorting in the agricultural sector. The authorities signed a welcome agreement with farmers in 2018 to undertake a comprehensive reform of the dairy sector, which would improve the functioning of this market if legislated and implemented. The agricultural reform process should continue in other areas, notably through the replacement of quotas, price guarantees and customs tariffs by non-distorting direct payments to farmers.
Poor air quality remains a concern for well-being. The transition to natural gas has the potential to reduce CO2 emissions and pollution in the near term. To achieve deeper cuts and take advantage of falling costs, the share of renewables in electricity generation must rise.
The electricity market reform of 2018 will increase competition in electricity generation, providing an opportunity to expand renewables. The reform also foresees the transfer of transmission system operations to a separate but also government-owned company. It will be important to avoid any discrimination in grid access through effective regulation and to further develop a wholesale electricity market and high-resolution electricity pricing. The government can also promote the expansion of large-scale solar plants through tenders integrating land-use rights and by making more public land available for tenders.
