Israel: Selected Issues

International Monetary Fund. European Dept.

doi:10.5089/9781513594675.002.A001

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Israel: Selected Issues

Author: International Monetary Fund. European Dept.

Publication Date:: 16 Sep 2015

eISBN:: 9781513594675

Language:: English

Keywords:: ISCR; CR; Israel; price; pay; productivity; lower-productivity firm; productivity-enhancing public spending; productivity scale; productivity gain; capital stock; Commodity markets; Total factor productivity; Employment; capital-labor ratio

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Israel: Selected Issues

Abstract

Israel: Selected Issues

Labor Productivity in Israel—Why is it Low?¹

Israel’s GDP per capita is low relative to the US, despite high labor input, as labor productivity is low. Catch-up of labor productivity to the US stopped in the 1980s and relative labor productivity has since declined. Low labor productivity is the result of a low capital-to-labor ratio—kept low by high employment growth—and low total factor productivity growth. The latter may reflect lack of competition and product market restrictions, which are amongst the highest in advanced economies. Boosting competition, lowering product market restrictions, and improving the quality of education and infrastructure would help boost productivity.

A. Labor Productivity is Low

1. By advanced countries’ standards, Israel’s GDP per capita is relatively low. It is similar to Korea and New Zealand, but well below the level in richer Western European countries and the United States.²

2. There was rapid catch-up to the United States between 1950 and the mid-1970s, but since then Israel’s relative GDP per capita has stagnated at around 60 percent of US GDP per capita.³ This relative stagnation is of course not unique to Israel, as it has also happened in many Western European countries. However, in Israel, it has stagnated at a lower level.

3. Israel’s GDP per capita is relatively low despite high labor input. Labor input (hours worked) per capita is 19 percent higher than the United States. It increased sharply over the last two decades as a result of a sharp increase in the employment to population ratio.⁴

4. Low GDP per capita is the result of low labor productivity. Labor productivity is only 53 percent of the US level, down from 69 percent in the early 1990s. Labor productivity growth since 1990 has been lower than in other advanced countries despite the low initial level of labor productivity. Labor productivity growth has been similar to that in Italy and Switzerland, countries that were much richer.⁵

5. An analysis by industry shows that low labor productivity is not just limited to a small number of industries, but is a structural problem across the Israeli economy. Israel’s labor productivity is below the European Union average across all industries except agriculture, forestry and fishing. Ben-David (2013) finds similar evidence in an industry-level comparison of Israel to OECD countries.

6. This chapter discusses why labor productivity growth and levels have been low. Two factors are likely to have been important: the low capital labor ratio (Section B) and low TFP growth (Section C). Using a production function approach, the next sections discuss the role of the capital to labor ratio and total factor productivity.⁶

B. The Role of the Capital to Labor Ratio

7. Employment has increased very rapidly, the result of both rapid growth of the working age population, and a sharp increase in the labor force participation rate:

Israel’s working age population growth rate has been high, reflecting a high birth rate as well as several waves of immigration, including from the former Soviet Union. Since 1990 its working age population has grown on average by 2.5 percent annually, far higher than most other advanced countries (over the same period, the average annual growth rate in the OECD (except Israel) was 0.7 percent).
The labor force participation rate has increased sharply as well. With the unemployment rate dropping, the result has been that the employment to population ratio increased from 36 percent in 1990 to 48 percent in 2013. The increase in the participation rate is the result of an increase in the general level of education of the population, as well as government policy to encourage individuals to join the labor force.⁷

8. Rapid employment growth enabled the absorption of the expanding labor force. Since 1990, employment has grown on average by 3.4 percent annually, the highest of all advanced countries. Employment growth was particularly rapid in the 1990s after a large wave of immigration from the former Soviet Union—in 1995 employment grew rapidly by 8.2 percent. Labor market reforms that simplified and reduced the costs of employment contracts helped the economy absorb the inflow of immigrants.⁸

9. Rapid employment growth was encouraged by modest real wage growth, which substantially lagged GDP per capita growth. Between 1995 and 2014, real wages increased by 16 percent, while GDP per capita increased by 38 percent. This pattern—real wages lagging GDP per capita growth—has also been observed in other countries where the employment rate has increased sharply, such as the Netherlands and Germany.⁹

10. The flipside of high employment growth has been lower labor productivity growth. Several channels exist that may explain the negative link between employment growth and productivity growth: i) new jobs have on average lower pay and productivity than existing jobs; and ii) rapid employment growth keeps the capital to labor ratio subdued.¹⁰

11. The slow increase in capital per worker since 1990 has been the result of rapid employment growth—not a slow increase in the capital stock. In fact, the percentage increase in the net capital stock in Israel was relatively rapid.

12. Indeed, with very high employment growth, high investment rates were needed just to keep the capital-labor ratio from falling. To see, this, consider the following example. Assume the capital-output ratio is 2—the capital stock is 200 percent of GDP. If employment grows by 4 percent annually, the capital stock needs to expand by 4 percent annually as well—which requires net investment of 8 percent of GDP just to keep the capital-labor ratio constant.

13. Aggregate low capital-labor ratios in part reflect the dual nature of Israel’s economy. Capital-labor ratios are particularly low in the low-tech industry, which has absorbed a lot of labor. In the high-tech industry, by contrast, capital-labor ratios do not seem low.

C. Why Has TFP Been So Low?

14. Israel’s total factor productivity since 1990 has been one of the lowest amongst advanced economies. There was in fact a slight decline of total factor productivity levels, the result of a sharp decline in the 1990s and a recovery since.

Low TFP growth and levels may in part have been inevitable and reflect Israel’s position as a small isolated economy with few direct trade links with immediate neighbors, high defense expenditure due to its geo-political situation that limits productivity-enhancing public spending, and compulsory military service that lowers private sector employment amongst young individuals.

But there have also been some factors that were not inevitable. These include product market restrictions, quality of education, and quality of infrastructure, which are discussed below.

The Role of Product Market Restrictions

15. Israel is the most restrictive amongst advanced economies in terms of product market regulations (PMR). State control, barriers to entrepreneurship, and barriers to trade and investment all rank amongst the highest across its peers.¹¹ In terms of sectors, Israel ranks amongst the highest in regulation of network sectors, retail trade and professional services (see Box 1 for a description of PMR indicators).

The Impact of Product Market Restrictions on TFP—What Does the Theoretical Literature Say?

16. Many papers have argued that lower product market restrictions will boost TFP. The theoretical literature suggests that lowering product market restrictions improves allocational efficiency, boosts managerial performance, and increases incentives to innovate and adopt new technology.

Improve the efficiency of allocation of factors of production across sectors. This results from increased competition and lower margins, inducing reallocation of resources to sectors with higher value-added, as well as increasing productivity and resource allocation within sectors by forcing the exit of less-productive firms. Blanchard and Giavazzi (2003) suggest that lower restrictions lead to lower mark-ups, increased employment and higher real wages.
Overcome principal-agent problems and therefore boost managerial performance. Lower PMRs incentivize higher effort from management to avoid bankruptcy, and allow market entry, thereby enabling better monitoring of performance through comparison with peers (for example, Hart, 1983, Meyer and Vickers, 1997).
Increase incentives to innovate and the speed of technology adaptation. Lower PMRs increase the threat of competition through market entry, and therefore stimulate innovative activity in order to escape competition (Aghion, et al., 1997, 1999, 2001). Schleifer and Vishny (1997) argue that incentives for innovation and cost efficiency are stronger in private firms because owners can fully appropriate the benefits, whereas in public enterprises these benefits ultimately accrue to tax-payers that do not exercise any direct control.

17. However, other papers point to possible side-effects of lower product market regulations, arguing that they:

Diminish incentives for innovative activity. Monopoly profits provide an incentive for innovation, and a reduction of rents due to regulatory changes lowers ex-ante incentives to innovate if firms are unable to recoup any investment required for research and development (Aghion and Howitt, 1992; Grossman and Helpman, 1991).
Potentially increase principal-agent problems. Although increased competition diminishes shirking incentives for managers, it also reduces firm profits in equilibrium, thereby lowering total payoffs available to incentivize effort from managers (Scharfstein, 1988).

Box 1.

OECD Product Market Regulation (PMR) Indicators

OECD Product Market Regulation (PMR) indicators have been collected since the end of the 1990s to turn qualitative information concerning laws and regulations that may affect competition into quantitative indicators. They include economy-wide indicators and sector-wide indicators. All product market regulations are ranked across countries on a common scale from 0 to 6, ranging from least to most restrictive. Indicators are consistent across time and countries.

Economy-wide PMR indicators relate to common restrictions across all industries. Collected data are classified into state control (public ownership and involvement in business operations), barriers to entrepreneurship (complexity of regulatory procedures, administrative burdens on start-ups and regulatory protection of incumbents), and barriers to trade and investment (explicit and other barriers).

Sector-wide PMR indicators focus on regulations that are specific to certain non-manufacturing sectors. The sectors covered include professional services (legal, accounting, engineering, and architecture), retail distribution, and network sectors (telecoms, electricity, gas, post, rail, and air passenger transport and road freight).

The Impact of Product Market Restrictions on TFP—What Does the Empirical Literature Say?

18. Empirical estimates on product market regulations broadly lend support to a positive impact of lower product market regulations on productivity.

Results by Nicoletti and Scarpetta (2003) suggest that a one index point decrease in product market regulations increases multifactor productivity by 8 percent. They use a standard multifactor productivity growth equation extended to include product market regulation indicators, country and industry characteristics, and the state of knowledge in the technology leader country. Their data cover 23 industries in 18 OECD industries from 1984 to 1998. In an alternate model, they suggest that product market regulations have a negative effect on multifactor productivity by slowing down technological catch-up. The estimated impact on multifactor productivity is 2 percent (this model has the possibility of mis-specification bias as it excludes country dummies).¹²
Alesina et al. (2005) find that the investment rate increases by 0.9 percent in the long run for a one index point decrease in regulation. They use a dynamic model of investment to capital stock regressed against product market regulation data within network sectors¹³, country sector-specific fixed effects, and common (or sector-specific) year dummies. PMR data include overall regulation, barriers to entry and public ownership from 1975 to 1998 in 21 OECD countries.

Application to Israel

19. Applying estimated coefficients from empirical literature suggests that there may be labor productivity gains from lowering product market regulations in Israel.

Lowering overall economy-wide product market regulations from current levels to the best practice would increase multifactor productivity by 10 percent (a gradual change over 10 years would imply an annual boost to multifactor productivity growth by 1 percentage point).¹⁴ While these estimates are indicative, they suggest significant gains from product market reforms.
Decreasing product market regulations in Israel’s network sectors from current levels to those of the most liberal OECD country could increase long-run investment by 1.6 percentage points.¹⁵

20. Benefits of product market liberalization may take a significant period of time to be realized. On average, PMRs decreased by 0.77 of an index point in the OECD over the 15 years between 1998 and 2013. Compared to its peers, Israel’s current PMR levels rank in the middle of the distribution of peer PMR levels in 1998. While there is scope to lower PMR levels, the evidence also suggests that reforms may take time to implement.

The Role of Education

21. Data on the educational level of Israel’s labor force pose somewhat of a puzzle:

On the one hand, Israel has one of the highest shares of population with tertiary education.
On the other hand, it has one of the lowest PISA scores among OECD member countries.¹⁶

22. Low average PISA scores partly reflect a high share of poorly scoring students. Arab-Israelis score particularly low, which in part may reflect the lower quality of their schools compared with non-Haredi Jewish schools. Haredi schools do not participate in PISA examinations, although their inclusion would likely lower scores even further. The Haredi curriculum focuses on religious studies, and especially for boys, does not teach mathematics, science, or English to a level comparable with other schools.

23. But the share of students with high scores is also relatively low. The share of top performers in mathematics and science is below the average share within OECD countries, suggesting a gap in technical knowledge. However, the share of top performers in reading is higher than the OECD average.

24. While secondary education may be below average, tertiary education and military service may contribute towards closing any skills gaps. The fact that, in spite of low PISA scores, Israelis excel in some human-capital-intensive industies such as information technology may be explained by the outstanding quality of some of its institutions at the tertiary level, as well as skills gained during military service within some units of the Israeli Defense Forces.

25. The changing composition of Israeli students creates an important forward-looking issue for TFP growth. The share of ultra-Orthodox Jews and Arab-Israelis in the population is projected to increase by 18 percentage points to 50 percent in the next 45 years. The increasing share of ultra-Orthodox Jews and Arab-Israelis in the labor force is likely to have a negative impact on TFP growth if the skills gap is not closed.¹⁷

The Role of Infrastructure Quality

26. Geographical disparities in the quality of infrastructure hinder business. For example, while firms in central Israel do not report electricity or telecommunications as obstacles to their operations, over 17 percent of firms in Haifa and the North find access to electricity a major or severe obstacle to their operations. Over 30 percent of firms in Haifa and the north experienced power outages at least once in 2012, compared to 7 percent in the central region.

27. The overall quality of Israel’s transportation infrastructure is below that of other advanced economies. Rail networks are under-developed and congestion on Israel’s roads is high, in part because of the paucity of transportation alternatives.¹⁸ In part, the underdeveloped transport network may increase job search costs amongst lower income earners as transportation inefficiencies and fares to potential areas of employment are prohibitively high.

28. Lack of competition in network sectors is an impediment to productivity growth. Market power within Israel’s ports and commodity distribution networks (such as electricity and produce) are an impediment to productivity growth through inefficiency and high mark-ups that are passed on to other industries.

Policies to Increase Total Factor Productivity Growth

29. The following policies have the potential to increase labor productivity growth:

Lowering product market restrictions. Lower economy-wide and sectoral product market restrictions have the potential to increase market entry and competition, thereby leading to efficiency gains and higher productivity.
Increasing international competition to low-and medium-technology industries. Low- and medium-technology industries have productivity levels below the OECD average. Increasing international competition to these industries may stimulate efficiency-gaining innovation. While international competition will also force the exit of lower-productivity firms, with a potential negative impact on employment, it will also improve labor productivity.
More active regulation by the anti-trust authority. A more active anti-trust authority will identify and address market failures due to anti-competitive behavior. The anti-trust authority has made significant recent progress in addressing competition concerns. Measures taken include establishing a market studies division to identify market failures, introducing administrative fines for anti-competitive behavior, and raising the level of fines for violations.
Practical on-the-job training. On-the-job training could prove effective in increasing the labor mobility of less productive workers by giving them the necessary training to move up the productivity scale.
Outsourcing labor-intensive processes within high-productivity sectors to lower-productivity regions. Potential cost savings from outsourcing labor-intensive tasks from higher productivity to lower-productivity and lower-wage industries should be explored. Outsourcing would prove effective in generating employment and growth in smaller towns situated in the periphery of cities.

D. Conclusion

Over the past few decades, labor productivity growth in Israel has been very modest, which has held back relative GDP per capita levels. This partly reflects rapid employment growth, which has kept the capital-labor ratio low. But it also reflects low TFP growth. As labor force and employment growth slow in the future, an increase in the capital-labor ratio, assuming sustained investment rates, would increase labor productivity growth. However, low total factor productivity growth could remain a drag on labor productivity growth.

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Prepared by Aaron Thegeya.

It should be acknowledged that differences in measured GDP per capita may in part reflect differences in the size of the shadow economy.

GDP per capita data are obtained from the Total Economy Database, and measured in 2013 US Dollars with 2005 EKS PPPs.

Hours worked per employee did not show a clear trend.

While the unconditional distribution of income per capita across countries has diverged rapidly since the early 1800s, Barro (1991) and Barro and Sala-i-Martin (1992, 2004) show conditional convergence amongst countries with similar initial characteristics. Amongst advanced economies, those with low initial real GDP per capita in 1960 show faster growth over the subsequent 25 years. Neoclassical models such as Solow (1956) and Cass (1965) attribute this convergence to diminishing returns to capital. Countries with lower ratios of capital to labor have higher marginal products of capital, and therefore tend to grow faster.

The production function models the relationship between a firm’s inputs and output. At the aggregate level, output growth in a simple model is attributed to three factors: capital, labor and total factor productivity, which is a residual term that encapsulates other factors contributing to growth apart from physical capital and labor. Assuming constant returns to scale in capital and labor, the production function can be expressed in intensive form to model labor productivity (see for example: Solow, 1956; Romer, 2001).

See Bank of Israel Annual Report (2012), Box 5.1; Friedman and Zussman (2008).

See Bank of Israel Annual Report (2013), p. 128. Wascher (2007), p. 73, shows that countries with less regulated labor markets tend to have smaller differentials between native and immigrant unemployment rates.

See Bakker, Bas. B. “Employment and the Great Recession: The Role of Real Wage”, IMF Working Paper, forthcoming.

Similarly, poor employment may lead to high productivity growth if many of the jobs that are lost have below-average productivity. In this context, high labor productivity growth in the United States may partly reflect its poor employment performance in the past two decades, with the employment to working age population dropping from 72 percent in 1995 to around 58 percent currently.

The World Bank’s Doing Business Indicators (2015), show that enforcement of contracts in Israel takes 890 days, with most time spent in trial and judgment, compared to 150 days in Singapore; construction permits take 209 days, compared to 26 days in Singapore.

Dabla-Norris et al. (2015) run a similar model where TFP growth is dependent on the global TFP frontier growth rate, the gap between the frontier and a country’s TFP level, and normalized PMR variables in addition to other variables. They find a significant coefficient of -0.537 for the impact of a decrease in PMR in the services sector on TFP growth.

Network sectors include electricity and gas supply, road freight, air passenger transport, rail transport, post and telecommunications (fixed and mobile).

See Nicoletti and Scarpetta (2003). Israel’s overall economy-wide regulations are 1.25 index points higher than the Netherlands, which has the lowest overall economy-wide product market regulations.

See Alesina et al. (2005). Israel’s network sector regulations as of 2013 are 0.79 points higher than United Kingdom, which has the most liberal network sector.

Program for International Student Assessment (PISA) is a cross-country, comparable assessment by the OECD of 15-year old pupils’ performance in mathematics, reading, and science.

As skilled labor and advanced technology are complementary, a larger share of unskilled labor in the workforce may have an effect on total factor productivity by discouraging businesses from adopting technology-intensive production processes. Lewis (2005) finds in the United States that plants in markets with a larger share of unskilled labor use less automation. Acemoglu (1998) and Beaudry and Green (2005) model innovation and endogenous choice of technique and demonstrate that technique may respond to skill mix.

See Ben-David (2012), p. 57–66.

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