Contents include: Budget deficit - concepts, measurements, and developments; definition, accounting basis, scope, and coverage. Structural reform issues: privatization; capital market reform; exchange and trade liberalization; other government intervention - investment subsidies and price controls; labor market reform; and land reform. Current account sustainability in Israel: overview of the Israeli economy and its transformation in the 1990s; a model of the current account applied to Israel; and sustainability indicators. Statistical tables.


Contents include: Budget deficit - concepts, measurements, and developments; definition, accounting basis, scope, and coverage. Structural reform issues: privatization; capital market reform; exchange and trade liberalization; other government intervention - investment subsidies and price controls; labor market reform; and land reform. Current account sustainability in Israel: overview of the Israeli economy and its transformation in the 1990s; a model of the current account applied to Israel; and sustainability indicators. Statistical tables.


A. Introduction

Israel has been, by tradition, a highly regulated and institutionalized economy. Given the magnitude of the task of immigrant absorption at the outset of the creation of the State of Israel, the political leadership was reluctant to delegate the regulation of the economy to market forces. Thus, all natural resources were nationalized in 1949, and state-owned companies were established to exploit them. The new state developed into a “three-sector” economy, consisting of the public, private, and Histadrut27 sectors, with the Government and the Histadrut prominent in heavy and basic industries.

Following the 1985 stabilization program, Israel embarked on a process of structural reform that has contributed to enhancing the efficiency and market orientation of the economy. Progress has been particularly marked in areas of tax reform and financial market exchange and trade liberalization, and there has also been a striking improvement in the functioning of the labor market. More recently, there have also been marked achievements in the areas of antitrust and competition policy and land reform. Meanwhile, there has only been limited progress in the area of privatization and the Israeli economy is still characterized by a large degree of government intervention. Cartels and monopolies are prevalent (firms may operate together as cartels if deemed to be in the public’s interest); investment subsidies (and loan guarantees) are provided under the Encouragement of Capital Investments Law; and, a number of retail prices are still regulated or under government supervision.

This chapter reviews the structural reform process in several areas of major importance: privatization, including of the banks; the capital market, exchange and trade regulations; investment subsidies and price controls; labor market reforms; and land reform.

B. Privatization

In 1987, the Israeli Government commissioned the First Boston Corporation to help develop a strategic master plan for its privatization efforts. At that time, the Government owned at least a partial stake in some 160 companies whose output amounted to approximately 10 percent of GDP. The government-owned companies covered a large share of the economy, operating in the fields of natural resources, minerals, and chemicals; infrastructure, tourism, and agriculture; public utilities; transportation; energy and oil exploration; defense and defense-related products; and land development, construction, and housing. The master plan, which was adopted by the Government the following year, identified 75 profit generating companies that could be sold to the private sector, including 30 which could be sold within the next five years. The privatization program, however, got off to a slow start, and did not gain momentum until the beginning of the 1990s. However, after peaking at US$1.24 billion in 1993, total privatization proceeds declined back to a meager US$205 million in 1994 against the backdrop of a stock market crisis.

A combination of factors seem to have contributed to the limited progress achieved in the area of privatization, including a lack of political will; resistance from employees, managers, and labor unions; depressed conditions in the Israeli stock market starting in early 1994; as well as the difficult financial situation in many of the companies to be privatized. Furthermore, the notion of “strategic importance” attached to certain companies has complicated the process of finding suitable (and in particular much needed foreign) investors. Also, the authorities have emphasized the importance of enhancing the regulatory framework before the privatization of several current monopolies can take place, further contributing to the delays in the privatization process.

Recent developments

In 1995, as the effect of the decline in stock prices wore off, privatization proceeds picked up to US$533 million, primarily as a result of a 25 percent share sale of Israel Chemicals and the complete privatization of Israel Housing and Development (Table 1). However, with the approach of the May 1996 election, privatization slowed again and as of end-August this year, only US$198 million had been raised. Overall, Israel has only raised about US$2 billion of an expected $5 billion from sales of shares of state-owned companies since 1986, while bank share sales have generated just US$1.5 billion compared with a potential US$4.5 billion.

Table 1.

Privatization and Raising of Capital from the Public by Issuance of Shares and Convertible Securities 1995-August 1996

(In millions of U.S. dollars)

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Source: Government Companies Authority.

Even though the number of government companies declined by 24 during the course of 1995 and the first five months of 1996, 116 active companies remain under government control or with a major government ownership share, so called “mixed” companies.28 These companies exclude the state-owned banks which were acquired pursuant to the Bank Shares Arrangement (see below). Approximately half of the government companies are commercially oriented businesses (such as public utilities), with sales accounting for about 16 percent of GDP, while the remainder are non-corporations (airports, ports, etc.) or other non-business companies (Table 2). Several of the commercially oriented companies are quite large, with responsibility for the greater part of activity in their respective areas (Table 3).

Table 2.

Distribution of Commercially and Non-Commercially Oriented Government Companies by Economic Sector

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Source: Government Companies Authority
Table 3.

The Largest Government Companies as of December 31,1995

(In millions of U.S. dollars)

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Source: Government Companies Authority.

The new Government has expressed its support for a continuation of the structural reform and privatization program. Prime Minister Netanyahu has emphasized the importance of deregulation as key to economic growth and the privatization authority has been relocated from the Ministry of Finance to the office of the Prime Minister. The Government’s privatization program, which is to be presented in the very near future, is likely to suggest an acceleration of the privatization process and, according to newspaper reports, to propose sales of up to 70 companies and banks within the next four years, yielding an estimated NIS 18 billion in revenues. The privatization program is likely to include Bezeq Telecommunications Company, Mekorot Water Company, Israel Chemicals, Israel Electric Corporation, Israel Aircraft Industries, as well as the major state-owned banks.

Privatizations have been realized through both direct sales to investor groups and public equity offerings on the Tel Aviv Stock Exchange (TASE). Since the beginning of 1995, most of the sales undertaken have been carried out through direct private placements but according to the authorities, the new Government is likely to make an increasing use of public stock market offerings in Israel and abroad for its privatization program, in part to help revitalizing the ailing Israeli stock market. Meanwhile, a plan by the previous government to distribute options to the public for the purchase of government shares in state-owned companies and banks has been shelved, and is unlikely to be included in the new Government’s privatization program.

Banking sector

In 1983, as a consequence of a crisis in the market for bank equities and the subsequent Bank Shares Arrangement, the Government became the owner of most of the shares in Israel’s major banks.29 Following the termination of the Shares Arrangement in 1993, a banking sector reform was undertaken, resulting in an amendment of the 1981 Banking Act aimed at increasing the degree of competitiveness and reducing conflicts of interest in the Israeli financial system through, inter alia, limits on banks’ nonfinancial holdings. In particular, while banks were allowed to invest up to 25 percent of their equity outside the financial sector, their shares in any one nonfinancial company now had to be limited to 25 percent by the end of 1996. The process of bank privatization was also initiated in the early 1990s, and since 1993, two small banks have been completely privatized. Meanwhile, the privatization of the major banks have only seen limited progress, and the Government still owns a majority stake in four of the six largest banks (Table 4).

Table 4.

Privatization of Banks and Raising of Capital from the Public by Issuance of Shares and Convertible Securities

(In millions of U.S. dollars)

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Source: Government Companies Authority.

The purchasers of the controlling interest of United Mizrahi Bank (26 percent of its capital) were granted an option to purchase a further 25 percent on the basis of the market value (100%) of the bank, amounting to $423 million, plus linkage to the CPI and interest at the rate of 3 percent. The proceeds due to arise upon the exercise of the warrant are not included here.

The immediate revenue amounts to $80 million. Another $80 million in revenue is expected upon the exercise of the purchase warrants in Israel Discount Bank.

As attempts at privatizing the Government’s stake in the major banks continued in 1995, the issue of banks’ nonfinancial holdings and the concentration of ownership in the Israeli economy re-emerged. In Israel, the banking system is highly concentrated and the three largest banks—Bank Leumi, Bank Hapoalim, and Israel Discount Bank—with subsidiaries account for approximately 80 percent of the total banking business. Given the significant holdings of the two major banks in nonfinancial enterprises, there were concerns that bank privatization would lead to a substantial increase in the concentration of ownership, with a potential buyer obtaining de facto control over a large part of the economy. In response to these concerns, the Government, invoking a clause in the 1993 legislation, appointed a committee in October last year, chaired by the Treasury Director-General, Mr. David Brodet, to examine the issue of the concentration of power in the banking sector. The recommendations of the Brodet Committee, which were presented to the Government in December last year, implied far-reaching changes in the ownership and management structure of the major conglomerates that dominate the Israeli economy.

Despite significant lobbying against the main proposals by the major banks, the Knesset this spring completed the legislative process whereby the main recommendations were passed into law. The amendment to the banking licensing law provide, inter alia, for the following: (a) each Israeli bank will be required to reduce its nonbank holdings to 20 percent of the capital of any nonfinancial corporation by the end of 1998 (25 percent by the end of 1996); (b) the total nonfinancial holdings of each bank will be restricted to 15 percent of the bank’s capital after 2001; (c) the percentage of such holdings can be augmented by 5 percent of the bank’s capital provided that the holding in each nonfinancial corporation is no more than 5 percent of the company’s equity; and (d) each bank is authorized to hold a controlling interest in only one nonbanking corporation in which its capital exceeds NIS 1.25 billion after 1997.

The major banks have started to implement the disinvestment program imposed by the Brodet Committee. Bank Hapoalim has sold large amounts of equity in Clal Israel, lowering its share in the company to 25 percent, as well as some of its excess holdings in Delek Fuel, while Bank Leumi’s most significant disinvestment has been its sale of the Migdal Insurance company.30 The importance of nonfinancial income to the banks—and hence their opposition to the Brodet Committee recommendations—was highlighted in the 1995 results: Bank Hapoalim’s shares in Koor Industries, Delek Fuel, and other companies contributed 25 percent to the group’s net profit, while Bank Leumi’s holding in Africa-Israel made a significant contribution to its earnings. Given the banks’ reliance on their nonbank activities, some have argued that the imposed disinvestment of their nonfinancial holdings will further hamper the already slow bank privatization process. Others have argued that this development may in fact benefit the privatization process as prospective buyers would face leaner, less diversified banks.

C. Capital Market Reform

The financial deregulation and reform program for the capital markets which started in 1987 has proceeded in a slow and gradual mode. The most notable achievements so far have been a decrease in the segmentation of the credit markets; a narrowing of interest rate spreads; a marked decrease in reserve requirements, and an enhanced functioning of the stock market. However, various regulations and restrictions concerning the portfolio allocations of institutional investors remain and the capital markets are still characterized by a large degree of government intervention and subsidization, including a complex system of tax benefits and the issuance of guaranteed-rate bonds. The Israeli capital market still does not offer the range of financial instruments found in other industrialized countries: corporate bond issues are rare and simple fixed-income money market instruments and certificates of deposit hardly exist. Also, despite a sharp increase in the number of firms listed on the TASE in the last five years as well as recent reforms to allow for continuous trading of shares, the TASE is still characterized by a small and illiquid market; a slow and cumbersome trading system; and an absence of market makers and large institutional investors.

Table 5, which presents the main players and instruments of the Israeli capital market in 1995, highlights the dominance of the major institutions as well as the degree of government intervention. The value of the capital market, including (mainly government) bonds, shares, and other investments of financial institutions, stood at NIS 326 billion at the end of 1995, up by 7 percent compared with 1994 reflecting an increased supply of government bonds (to finance the higher deficit) and Treasury bills sold by the Bank of Israel. The Israel capital markets are dominated by the provident, pension, and mutual funds and the insurance companies, whose total assets amount to approximately two thirds of the entire market. These institutions enjoy extensive tax benefits as well as different degrees of government subsidization. Contributions to pension, provident, and life insurance funds are tax deductible, accumulated profits are tax free, and withdrawals tend to be tax exempt. Subsidized government bonds are still issued to the pension funds, in contrast to the provident funds which can no longer invest in such earmarked bonds. Meanwhile, the insurance companies continue to receive subsidized bonds on accounts opened before 1991. In addition to the special tax benefits applied to these institutions, various instruments also enjoy certain tax breaks, e.g., short- and medium-term investments (which typically are nonlinked) such as Treasury bills and deposits and savings plans are tax exempt.

Table 5.

The Israeli Capital Market 1995

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Source: Bank of Israel.

Excluding double counting and government-owned quoted companies.

Excluding securities held by the Bank of Israel.

Adjusted for provident funds’ and nonresidents’ holdings in mutual funds.

This section reviews recent developments with the two largest institutional investors, the pension and provident funds, and the recommendations of the Brodet Committee on capital market reform.

Pension funds

Approximately 95 percent of all Israeli pension savings are held in pension funds owned and operated by the Histadrut, covering around 30 percent of the Israeli work force. Israel’s pension system has long been recognized to be substantially underfunded; including the subsidy implicit in the issuance of earmarked government bonds to the pension funds, the total actuarial deficit of the existing pension funds was officially estimated at NIS 120 billion as of December 1994, prior to last year’s pension reform.31 As a result of the 1995 reforms, the existing pension funds are barred to new members, and limits were imposed on the maximum rate of increase in the pensionable base wage. The introduction of these restrictions, together with proposed administrative reforms, were estimated to reduce the actuarial deficit of the existing funds by NIS 30 billion. However, the 1995 reforms did not require any increase in the level of contributions of existing members, and the accumulated rights of current members and pensioners were maintained. Moreover, the reforms entail the continued issuance to the pension funds of government bonds with a guaranteed real rate of return of 5.56 percent per annum.

While the old pension funds are closed to new members, the 1995 reforms required that new pension funds be set up in an actuarially balanced manner for all new members. Furthermore, ceilings of up to twice the national average wage were set on the maximum rights that a member can accrue in a pension fund, and stricter terms for withdrawals were imposed. However, the new funds are still able to invest up to 70 percent of their assets in earmarked government bonds with an effective guaranteed rate equal to approximately 5 percent per annum above the CPI. The remaining funds assets are to be invested in the Israeli capital markets but are implicitly guaranteed a 3 percent real rate of return. According to government estimates, the total cost of the reform plan will amount to some NIS 70 billion, consisting of approximately NIS 15 billion for pension payments that the pension funds will be unable to make and another NIS 55 billion covering the subsidy component of the special government bonds, over an 80-year period. Critics of the reform plan have noted that, apart from the explicit budgetary cost of the government subsidization of the pension system, by inducing the pension funds to invest the major share of their capital in government bonds and thereby directing the majority of the pension savings to the public sector, the development of the Israeli capital markets will be hampered and the availability of long-term funds for other purposes will be reduced.

As mentioned above, only about one third of the workers in Israel participate in the pension funds. Government employees are not covered by the regular pension funds but instead participate in an unfunded government pension plan mandated by law. The actuarial liabilities of these budgetary pension schemes were estimated at some NIS 105 billion as of December 31, 1994. In March 1996, an agreement between the Government and the Histadrut came into force that provides that new government employees will not participate in the existing budgetary pension schemes but will join the new funded pensions plans, to which the Government will make contributions on their behalf. According to the authorities, this agreement will subsequently be revised to also require employee contributions.

Provident funds

Provident funds are the largest single institutional investors in Israel, accounting for approximately 30-40 percent of overall household savings; as of end-1995, total fund assets amounted to some NIS 106 billion. The overwhelming majority of the funds are managed by the five largest banks, with the three largest banks—Bank Hapoalim, Bank Leumi, and Israel Discount Bank—running the three largest funds: Gadish, Otsma, and Tamar, respectively. Contributions to the provident funds, which are encouraged by major tax benefits, complement or substitute for pension fund savings. Once deposited, funds typically cannot be withdrawn until the end of the agreed holding period, usually 15 years from the creation of the account, without paying the usual 35 percent tax on earnings. Until the mid-1980s, the provident funds invested almost exclusively in earmarked government bonds. However, as a result of the capital market reform program of 1987, the Government no longer issues guaranteed-rate bonds to the provident funds, which instead are allowed to invest up to 50 percent of their holdings in financial assets other than government bonds, such as equities. In 1995, the provident funds held on average 11 percent of their assets in equities, down from 14 percent at the end of 1993.

The change in the portfolio allocation initiated in the mid-1980s implied an increased exposure of the provident funds to market risk. While the yield on provident funds averaged about 5 percent in real terms in the early 1990s, yields turned negative in early 1994, primarily reflecting the downturn in the Israeli stock market; in that year, provident funds recorded an 8 percent loss in real terms. The poor performances of the funds, which continued in 1995 and the first half of 1996—in July this year, the three largest funds recorded negative returns ranging from 2.3 percent to 2.8 percent in real terms—have prompted large redemptions, especially from those deposits that had become “liquid”, i.e., that no longer suffered a tax penalty on redemption. While net deposits were almost always positive until 1994, withdrawals have consistently exceeded deposits since 1995, reaching a record NIS 3.5 billion in September this year for a total of some NIS 11 billion for the first nine months of 1996. As much as NIS 40 billion will become “liquid” and could potentially be withdrawn over the next year. According to official estimates, a large portion of the amounts redeemed from the provident funds have been invested in high-interest savings accounts, which were yielding close to 6 percent in real terms following the Bank of Israel’s 1.5 point June rate hike; in the first nine months of 1996, net deposits in savings plans amounted to NIS 5.2 billion.

In order to finance last years’ large and growing redemptions, provident funds were forced to liquidate part of their equity and long-term bond holdings, which in turn depressed equity and bond prices and further exacerbated the situation.32 This summer, the Government and Bank of Israel therefore announced that they would develop a “safety net,” with the Bank promising to buy up to NIS 15 billion worth of government bonds to support the market; in the event, the Bank only ended up buying some NIS 500 million worth of bonds in market support in July and another NIS 650 million in August. Meanwhile, the Knesset approved a Ministry of Finance proposal to increase the amount of short-term bills that the central bank can issue in order to absorb the liquidity resulting from the support interventions. The situation subsequently stabilized, with most funds reporting positive returns averaging 2 percent in real terms for September this year, and net redemptions declining to NIS 1.1 billion in October.

Committee on capital market reform

In the wake of last summer’s provident fund and bond market “crisis,” a committee, chaired by Mr. Brodet, was established to consider structural reforms of the Israeli capital markets. In particular, the Committee was to examine the desired structure of savings mechanisms; incentives for and taxation of savings; coordination of legislative, regulatory, and supervisory activities relating to the financial markets; and the functioning of policy tools in the credit, equity, and foreign exchange markets. The recommendations, which were presented in mid-September, listed five major structural problems of the Israeli capital markets: absence of long-term institutional investors; high degree of centralization; tax discrimination between investors and various savings instruments; lack of regulation of financial players; and a relative limited supply of stocks. The proposals centered around the goals of encouraging long-term (retirement) savings at the expense of more short-term investments; attracting more investments into the capital markets; and making more funds available for mortgage lending.

Tables 6a and 6b summarize the Committee’s main proposals, both regarding changes in the tax structure as well as more structural capital market reforms. In order to promote long-term savings, the Committee proposed to introduce tax exemptions for savings of at least 10-year maturity, while short- and medium-term savings would be taxed at rates ranging from 5 percent to 10 percent. The Committee also suggested a reduction in the tax on interest income from (tradable) bond investments and in the tax on dividend income, as well as a reduction in the tax on income from foreign securities. In order to stimulate the development of the Israeli long-term capital markets, the Committee proposed a reduction in the amount of bonds with a government-guaranteed (above market) rate of return that the pension funds can buy. According to the Ministry of Finance, this change alone would bring NIS 54 million into the capital markets by 1997 and almost NIS 10 billion by 2010, thereby increasing the availability of long-term capital. Another important proposal is to raise the wage ceiling for which deposits to pension funds, provident funds, and life insurance plans are eligible for tax benefits to twice the average monthly salary (this would presently amount to NIS 10,300) as a means to encourage retirement savings. New provident, pension, and life insurance plans would have to be created to comply with the new guidelines, while existing plans would not be asked to change their current provisions. Similarly, the proposed tax changes would have no impact on existing savings plans, but all changes would relate to new plans only.

Table 6a.

Recommendations of the Brodet Committee on Capital Market Reform Proposed Tax Changes

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The Committee also proposed that subject to appropriate arrangements by the banks, non-linked savings would be divided into savings of up to three months, which would continue to be taxed on the nominal interest, and savings longer than three months, which would be taxed as linked savings at a rate of 10 percent on the interest, i.e., the acquisition cost would be adjusted according to the consumer price index. The real interest rate would be computed by the banks at the time of withdrawal.

Income from provident funds is, for example, tax exempt, if kept until the end of the agreed holding period.

In order to stimulate activity in tradable bonds, it was proposed that the 35 percent tax on interest income from nontradable bonds would be left unchanged.

Table 6b.

Recommendations of the Brodet Committee on Capital Market Reform

Other Proposals

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While the Committee’s recommendations generally were received as welcome first steps in the right direction, in particular as to proposals to promote retirement savings and stock market investments, some critics have opposed the proposition to tax short-term savings in a time when, they argue, Israel above all needs to promote domestic savings. Also the Histadrut has criticized the proposals to reduce the amounts available for pension funds to invest in guaranteed-rate bonds.

The recommendations were proposed to take effect at the start of 1997, taking into account that any changes dealing with the tax structure would require parliamentary legislation. However, in mid-October, the Government voted to adopt only part of the recommendations, while all decisions related to savings, including the politically sensitive tax on short-term savings as well as pension fund reform, were postponed for later. A new compromise proposal on these issues is to be presented to the Government before the end of the year, which may reduce the recommended tax on the nominal interest of nonlinked savings from 5 percent to 3.5 percent. Also, the new proposal may suggest that the tax on short-term savings only be levied on savings of up to five years instead often years as was originally proposed.

D. Exchange and Trade Liberalization

Since 1985, the Government’s extensive system of foreign exchange controls has been gradually eased and restrictions applying to the business sector have largely been eliminated. As part of its declared policy of attaining fiill currency convertibility, Israel accepted the obligations of the Fund’s Article VIII in 1993. In another important step toward fiill convertibility of the new Israeli shekel, the Bank of Israel in 1994 authorized banks to operate continuous bilateral currency trading at variable rates, and later that year, limits on direct investments abroad by Israeli companies were eliminated. In addition, regulations on portfolio investments abroad by Israeli companies and institutional investors have been eased.

As part of the liberalization of foreign exchange controls, reserve requirements on domestic foreign-currency deposits were reduced in January 1995 to 6 percent for current deposits, 3 percent for time deposits with a maturity of up to one year, and zero for time deposits with longer maturities. Furthermore, the reserve requirement on foreign currency deposits consisting of restitution payments received by Israeli residents have been gradually lowered from 90 percent in November 1991 to 18 percent on May 31, 1996. These reserve requirements are to continue to be lowered until they reach the level of domestic foreign-currency deposits.

Israel is a signatory to the 1947 and 1994 General Agreements on Tariffs and Trade, and is a founding member of the World Trade Organization. Israel has also concluded free trade area agreements with its major trading partners covering over two thirds of imports, and is the only nation to have concluded free trade agreements with both the United States and the European Union. Israel also has a free trade agreement with the European Free Trade Association, and similar agreements were recently concluded with the Czech and Slovak Republics. Meanwhile, negotiations of such agreements are currently under way with Hungary, Poland, and Slovenia, and Israel also recently expressed interest in discussing a free trade agreement with India.

In September 1991, a process of trade liberalizing with “third countries”, i.e., countries with which Israel does not have free trade agreements, was initiated. The principal features of the Government’s trade liberalization policy included the elimination of certain compulsory licensing requirements designed to protect local producers (except for agriculture); the review by the Government of other licensing requirements with a view to eliminating those imposed for protection purposes; and the replacement of administrative and other non-tariff barriers to trade with tariffs, which are being reduced over time. As of September this year, the last stage of this five-year trade liberalization program came into effect, implying that tariffs on most industrial products have been lowered to 8 percent on raw materials and 12 percent on finished and intermediate goods, down from at least 25 percent at the time the trade liberalization program was introduced. However, the tariff reduction process for certain products which are considered to be more sensitive to competition, such as wood products, ceramics, footwear, cables, fertilizers, textiles and clothing, and some steel products will not be concluded until later.33 The trade liberalization program also provided for assistance to certain enterprises that would be particularly hurt by the implementation of the measures.

However, notwithstanding the recent trade liberalization, a number of trade restrictions remain, including restrictions on agricultural imports, quotas, licensing restrictions, as well as outright prohibitions against imports of certain goods.34 Israel also imposes two forms of protection for locally produced goods: one pre-duty fee applied to the c.i.f. value of the imported good to raise the value of the product to an “acceptable” level for customs valuation, and a post-duty fee which is applied after the imposition of an import duty but before any assessment of purchase taxes. Israel also maintains product standards which in certain instances favor local producers.35 The Ministry of Trade and Industry is currently in the process of revising the standards law to limit the Government’s authority to set compulsory standards for products sold in Israel for certain purposes, such as safety, public health, and environmental protection, and to prevent any potential use of this authority for protectionist purposes.

E. Other Government Intervention: Investment Subsidies and Price Controls

The Israeli Government spends large amounts on direct and indirect subsidies to industry under the Capital Investment Encouragement Law of 1953. The Law, which has been amended several times over the years, includes a number of “economic incentives” aimed at attracting local and foreign investment, including subsidized long-term loans, direct investment grants, research and development financing, and tax relief and rebates. The level of subsidies to the business sector peaked at around 15 percent of GDP in the early 1980s, but has subsequently been gradually reduced. In particular, the direct investment grants were reduced last year from 38 percent of the investment to 34 percent in class A development zones (which designate the most remote regions of the country), and from 20 percent to 17 percent in class B zones (which designate the peripheral regions). Pending approval of the Knesset, the new Government plans to amend the law and further reduce the rates of cash grants in Region A to 20 percent and in Region B to 10 percent.

A number of retail prices, constituting some 18 percent of the consumer price index, still remain under the control of the Government (Table 7). These prices are either set directly by the Government, such as education fees, municipal taxes, utilities, and communications and transportation fees, or are subject to government supervision, requiring approval before they can be increased, such as certain food stuffs, school books, and medicines.

Table 7.

Regulated Prices in the Consumer Price Index

(as of August 1996)

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Source: Bank of Israel.

F. Labor Market Reform

Structural changes in the wage bargaining process since the late 1980s have contributed to increased wage flexibility in the private sector and “de-linking” between private and public sector wage developments. Historically, private sector wage negotiations were performed on the national, branch, and workplace levels. Branch level negotiations started to diminish in importance in the late 1970s and since the late 1980s, national level negotiations have also become more limited in scope and now only define the common framework and rules by with each separate business subsequently negotiates its wage contract. National level negotiations now primarily focus on the cost-of-living adjustment (COLA), overtime compensation, and conflict resolution. The COLA has also been reduced, and now only partly compensates for inflation. The COLA negotiated in the private sector in turn becomes normative (binding) for the public sector. With a smaller share of the wage bill negotiated at the national level, firms have obtained more degrees of freedom in wage bargaining at the local level and, consequently, have become more able to negotiate wage settlements in accordance with their ability to pay. Furthermore, the increase in labor supply resulting from the massive immigration from the former Soviet Union since the early 1990s and the decision not to absorb immigrants through public sector employment have contributed to the greater degree of labor market flexibility.

G. Land Reform

National ownership of land has remained of significant importance ever since the creation of the State of Israel. Following an agreement between the State of Israel and the Jewish National Fund, the Israel Lands Administration (ILA) was established in 1961 to administer the usage of land, including planning and development activities. The ILA controls approximately 93 percent of the land of Israel (the remaining 7 percent is mostly located in urban areas). According to one of Israel’s basic (constitutional-type) laws, land is not to be sold and usage of land is instead granted through long-term leasing contracts, such as 49-year contracts (corresponding to up to two generations) for residential purposes; 10-15 year contracts for forested land; and 2-3 year contracts for agricultural land.36

Following the massive immigration from the former Soviet Union, residential demand for land rose sharply in the 1990s. While most of the land suitable for dwelling purposes was under the control of the Kibbutzim and the Moshavim by the early 1990s, by 1994 the majority of this land had been transferred to the ILA.37 The ILA subsequently initiated a process to deregulate and “privatize” its activities, and since 1994, the ILA has to an increasing extent begun to contract out many of its services. Contracts to lease, plan, and develop land for residential purposes are offered through public tenders, resulting in currently more than 400 projects being launched outside the Administration. The contractors are responsible for the entire dwelling process, including negotiations with the local authorities and obtaining statutory approval The ILA has also increased its efforts to file zoning plans and “intensify” the usage of land, resulting in a substantial increase in the supply of residential land in the last years. Up to one million dwelling units currently exist on ILA land, and another 500,000 units are expected to be “marketed” in the next ten years; in 1995 alone, 46,000 housing units became available.

While land cannot be owned, strictly speaking, the “property rights” of the leaseholders have been enhanced in recent years. Last year, a committee consisting of academics, lawyers, and public sector officials was appointed to examine the procedures and modes of operation of the ILA. Among the Committee’s recommendations was a proposal to, in the absence of a real land privatization, privatize the “usage of land” by offering residential leaseholders up to four consecutive spells of 49-year leasing contracts, i.e., land ownership for all practical purposes. The frequency of lease installments has also been revised. Traditionally, leaseholders could only pay their lease in annual installments; however, since 1991-92, the entire 49-year term must be paid in one single installment.38 By paying the entire lease at once, the leaseholder not only avoids the risk of a price increase over the term of the lease, but it has also implied an increased flexibility regarding decisions concerning house amendments and renovations.


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  • Murphy, Emma,Structural Inhibitions to Economic Liberalization in Israel,” Middle East Journal, vol. 48, 6588, 1994.

  • “The Report of the Committee to Examine Structural Changes in the Capital Market” summary (translated) 1996.

  • Salomon BrothersIsraeli Equities Road Map - Emerging Market Dynamism and European Affluence1996.

  • State of Israel prospectus presented to the U.S. Securities and Exchange Commission, 1996.

  • State of Israel, Government Companies AuthorityReport on the Government Companies 1995,” 1996.


Prepared by Ann-Margret Westin.


The General Federation of Hebrew Workers.


The majority of the companies privatized during this period were subsidiaries of government-controlled companies in the industry, trade, and chemicals sectors. In fact, while the number of government companies has declined from 147 since 1991 only eleven parent companies have been completely privatized during this period.


The managerial control of the banks did, however, remain with the original management.


The limits on banks’ nonfinancial holdings imposed by the Brodet Committee also apply to investments in insurance companies.


Approximately 95 percent of all pension funds are invested in guaranteed-rate government bonds, which between 1992 and 1994 paid an average annual above-market return of around 2.5 percent.


As only 10-20 percent of a typical company’s capitalization is available for trading at the TASE, with the remaining shares being held by the principals, interested parties, or long-term institutional investors, even limited transactions can have significant effects on stock prices.


Tariffs on most products, except for tariffs on certain remaining steel products (which will be lowered by September next year) and tariffs on textiles and clothing (which will be reduced by September 2000) will be lowered by September 1998.


This includes a ban on imports of non-kosher meat introduced at the end of 1994.


In addition, Israel charges importers 1.5 percent of the c.i.f value of imports for the use of Israeli ports and stevedores.


Land allocated to the Kibbutzim is, for example, leased on 3-year contracts within a 49-year framework.


The Kibbutzim and Moshavim were initially offered “generous” contracts to promote the planning and developing of residential land. However, due to a mixture of lack of interest and internal disputes, there was only limited progress, inducing the ILA to make use of its legal right to confiscate the land.


Mortgages are available for such lease installments.