State of Israel

Ministry of Economy and Planning

National and Economic Planning Authority

Multi – Year Plan for the Israeli Economy:

1995 – 2000

Summary

September 1994

TABLE OF CONTENTS

I. Introduction: The forces driving economic development
1. Developments in the years 1990-1994
2. Developments in the years 1995-2000

II. Economic targets for the year 2000 and guiding principles

III. External assumptions

IV. Macro-economic framework for the years 1995 – 2000
1. Principal trends
2. Population and employment
3. Investments
4. Private consumption and private savings
5. Public-sector consumption
6. Balance of payments

V. Alternative scenarios
1. Immigration scenario: limited extent of 40,000 immigrants per year
2. Defense scenario: 2.5% increase in domestic defense expenditure
3. Balance Scenario: Closing the gap in the balance of payments

VI. Policy recommendations
1. Stabilizing economic growth
2. Structural changes
3. Supporting foreign trade as the driving force of development
4. Integrating into the economy of the Middle East
5. Reducing government’s involvement in the economy
6. Regional development through capital formation, for economic and social purposes
7. Development of human capital, for both economic and social goals

LIST OF TABLES

Table 1: Resources and Use of Resources
Table 2: Balance of Payments 1992 – 2000
Table 3: The population, Labor forces and employment 22
Table 4: Comparison between the Basic and the Immigration scenarios, main indicators
Table 5: Comparison between the basic and the deface scenarios, main indicators
Table 6: Comparison between the basic and balancing the current account scenarios

I. Introduction: The forces driving economic development

1. Developments in the years 1990-1994

Economic developments have been greatly influenced, since the beginning of the 90’s, by the wave of immigration from the former Soviet block which began in 1989; by the peace process; and by the implementation of economic reforms begun at the end of the previous decade.

The immigration wave had brought to the country, by the end of 1993, about half a million immigrants. This immigration, along with the natural growth in population, increased demand, especially in private consumption and housing. Despite the burden imposed by immigration on public service expenditures, the government acted to restrain demand, and to lower public-sector deficit relative to GDP.

The extent of Israel’s integration into the world economy increased, as expressed in a considerable expansion of its business ties with the rest of the world.

On the supply side, these developments resulted in faster growth in capital stock and in employment, and also in the GDP. The multi-year average growth rate of the Israeli economy from the beginning of the 90’s has been approximately 5.5%, while the product of the business sector grew even faster: 6.5% per year. Nevertheless, the inflation rate stayed above 10% on average during this period.

Despite this impressive economic growth, some sectors of the Israeli public remain dissatisfied. This dissatisfaction may reflect the fact that economic growth, in itself, is not enough. True growth, as economists have increasingly realized, has to do not only with per capita growth rates, but also with a wide range of factors affecting social and economic well-being: unemployment rates; the purchasing power of wages; patterns of consumption; equality of income distribution; poverty; regional differences; public health; and education (considered both as a public service and as an index of the development of productivity).

Various indicators show that there is a gap between achievements in economic growth and the economic and social well-being of individuals.

As noted before, we can point to considerable achievements in the first years of this decade: increases in GDP and in GDP per capita, a huge increase in investments, and rapid growth in foreign trade. However, these statistical findings do not necessarily indicate the level of economic or social well-being of many individual citizens.

Some indicators of economic well-being point to more modest achievements than those of economic growth, and some even indicate a deterioration in the situation. Real wages remained stable, and at times even decreased. Unemployment dropped, but there are still many regions (especially development towns) where the number of unemployed is quite high. The percentage of the population under the "Poverty Line" has continually increased and the same applies to the inequality of income distribution

(Gini Coefficient index). However, consumption per capita has risen faster than economic growth per capita, due to some extent to the integration of immigrants into the consumption patterns of veteran Israelis. Thus, it is possible that most of the veteran population enjoyed only a relatively modest rise in their standard of living. To this must be added a certain anxiety among the public as a result of crises in the stock market, the health system, and in pension funds, as well as increasing inflation.

The gap between national growth and private dissatisfaction is explained, at least in part, by the nature of the forces driving economic growth in the first half of the decade.

a. Absorption of a huge number of immigrants during a very short period necessitates extensive investments, the fruits of which are felt by individuals only in the long-term.

b. The peace process brought down economic barriers at a pace, at times, more rapid than the political events themselves. Profound changes have already resulted, offering new opportunities in foreign trade and in investments. This kind of economic activity is of more benefit to the business elite and the wealthy, and thus raises the index of inequality

(at least in the short-term).

c. Reforms which have been introduced in recent years have brought drastic changes in the economic and social rules of the game. Easing foreign currency regulations, exposure to foreign trade, privatization of government companies – all are of undisputed economic benefit to the population as a whole in the long-term. In the short term, however, they may create unemployment or reduce income.

2. Developments in the years 1995-2000

In contrast to the drastic character of changes motivating the Israeli economy in the first half of the decade, the stimulating forces in the second half are expected to be of dynamic nature. As a result, this period may offer good conditions for the implementation of a more balanced policy, which would lead both to national economic growth and to an increase in the economic and social well-being of the population.

The following domestic and international developments are expected to affect Israel’s economic course in coming years:

a. A steady immigration rate through the end of the decade. Current immigration is different from the very high rate of immigration at the beginning of the decade. Population growth due to immigration creates new demand for various consumer goods, and provides a highly skilled and professional supply of labor. At the same time, the continued integration of veteran immigrants into the economy is expected.

b. The political and economic conditions resulting form progress in the peace process. Effects of the peace process will be felt in at least four areas:

1) Improvement in the terms of international trade, owing to the opening of new markets for both export and import.

2) A reduction in the risk premium, which increases the profitability of investments in Israel.

3) Relatively lower weight of defense expenditures in the GDP, enabling the transfer of resources for other economic purposes.

4) Possibilities for joint economic projects with Arab countries in the Middle East, and with the Palestinians.

c. Changes in the world economy

The economic growth forecast for the West, and the rapid growth predicted for South-East Asian countries, open up new possibilities for Israel, based on export to new markets. These opportunities are complemented by the entry of East-European countries into the market economy, and by the expected changes in the dimensions of world trade. International agreements (especially G.A.T.T.), changes in political atmosphere, and technological progress lead to a forecast for considerable growth in world trade. Anticipated political changes will enable Israel to claim its share in this renaissance in world trade.

d. Continuing implementation of structural economic reforms

The policy measures adopted in recent years, especially with regard to economic reforms, have not realized their full potential. In addition, growing investments in infrastructure and other areas could help lay the foundation of long-term economic growth. We therefore conclude that the leading forces for economic development in the second half of the decade will be: foreign trade; the new political and economic realities; utilization of the human potential of immigrants, both those anticipated and those already here;and the continued improvement of basic economic structures. Under these circumstances, economic planning for the second half of the decade can and must relate both to the well-being of individuals and to national economic growth.

II. Economic targets for the year 2000 and guiding principles

The central goal of economic planning for the coming years is to achieve rapid, sustainable, export-driven economic growth; while insofar as possible improving income distribution and socio-economic well-being, decreasing inflation and lowering unemployment.

According to estimates which are detailed in the plan below, the attainable rate of GDP growth is an average 4.9% per year. In the year 2000 the GDP will be 40% higher than in 1993.

At the same time, the aim of the economic plan is to achieve stability in the balance of payments, and to assure long-term, sustainable economic growth.

The goal of lowering unemployment is especially important, in view of the fact that part of economic growth comes from immigration, and the number of job seekers, for whom employment has to be found, will rapidly increase. Thus, reaching this goal may prove one of the most difficult undertakings in economic planning in coming years.

The effort to achieve economic and social equality may sometimes conflict, in the short term, with the goal of maximizing economic growth. This plan tries to maintain a balance between economic growth and equality, by suggesting policy measures, which – at least in the long-term – support both goals. Such measures basically involve strengthening of physical and human infrastructure, especially among lower-income population groups.

The main policy outlines summarized hereunder form a comprehensive framework, and set guiding principles for its implementation. Stabilizing economic growth

If the first half of the decade was characterized by drastic changes, expectations for the second half are for the stable continuation of processes begun in the first half. In contrast to the first half of the decade, the Israeli economy in the second half of the decade should follow a systematic and stable path of development. This path would take advantage of Israel’s changed situation. A main guideline for the proposed economic development policy is, accordingly, to stabilize economic growth and to prevent, as much as possible, social and economic upheavals that might arise during a process of rapid growth (such as widening social and economic gaps, creation of pockets of unemployment, etc.)

Adjustment to global structural changes

The changes in global structures include the advent of new political regimes in the former Soviet bloc, which add a number of countries of significant weight to the world economic systems; the growing number of countries with whom Israel has or will have economic relations, especially as a result of ongoing political changes;, continuing changes in world economic frameworks, due to new trade agreements, and the expansion of world trade.

Integration into the Middle East economy

The peace process has created a new situation, with significant implications for certain basic guidelines of economic development. The main guideline will be to give priority to the countries of the Middle East, to relate to them differently than to other countries, both for political reasons, and because of regional economic considerations.

Economic reform: staying the course

Reforms strengthen the proper functioning of the economy in the long-term, even if they sometimes create dislocation and require adjustment in the short term. The pace of reform has been sped up in recent years, though there is more to be done, for example in monetary and capital liberalization.

The continued liberalization in foreign currency control and capital movements has made possible the adjustment of assets in the hands of the public to a variety of foreign currency investments. De-control of capital movements has improved access to foreign assets and to foreign-currency credit, exposing the economy to international capital rates, and thus reducing distortions in the allocation of resources. This process will also help prevent the diversion of capital through indirect channels, rather than direct ones, thus reducing costs. Privatization of government companies and increasing competition, cancellation of monopolies in communication, transport and banking, etc. will improve the functioning of the business sector.

Restoring the balance between economic and social goals

Israeli economic development policy has tried, in the long term, to maintain a delicate balance between economic goals (such as: growth, or narrowing the gap in the balance of payments) and goals of a more social character (such as: lowering unemployment, reducing poverty, providing health and educational services, narrowing the gap between the center and the periphery). In recent years the gap between these two groups of goals has widened, as evidenced by the high rate of long-term unemployment, the increasing inequality of income distribution, and the widening of the gap between regions. An important guiding principle for future economic planning is therefore that policy measures which are selected to achieve economic growth should be, as much as possible, consistent with the achievement of social goals.

Reducing government’s involvement in business activities

Government involvement in the economy could be reduced in the following areas:

a. Reducing public-sector consumption – both defense and civilian – as a percent of GDP.

b. Gradually reducing public-sector debt as a percent of GDP.

c. Changing the structure of public expenditure – by lowering consumption and increasing investment in physical infrastructure.

d. Lessening the burden of taxation.

Government involvement in establishing long- term economic bases

While reducing its overall role in the national economy, the government should maintain its involvement in directing the economy towards optimal future development, by establishing vital bases for the economy, something which private enterprise cannot be counted upon to do. Building physical infrastructure, investing in technological innovation, and especially developing Israel’s human capital are the foundation of economic growth.

III. External assumptions

Net immigration

a. The immigration forecast for the years 1995-2000 is a yearly average of 80,000 immigrants from all nations, of which about 65,000 will come from the C.I.S. Thus the number of immigrants from the C.I.S. will have reached reach one million by the end of the 90’s.

b. The extent of emigration is estimated at a yearly average of 20,000, i.e. net immigration will total 60,000 annually. This forecast is based on an analysis by the Central Bureau of Statistics which predicts relatively higher emigration after years of high immigration.

The political process

a. Agreement will be reached on autonomy with the Palestinians, and borders between Israel and the autonomous areas will be open to trade

(except for restrictions on vegetables, fowl, etc. – which will gradually be lifted).

b. The number of workers from Judea, Samaria and the Gaza strip allowed to work in Israel will reach a total of about 100,000.

c. The peace process with Jordan and Syria will continue.

d. The Arab boycott will considerably weaken during the period.

e. There will be no war with the countries which have not signed peace agreements with Israel (Iraq, Iran).

Developments in the world economy*

a. The G.A.T.T. agreements of 1994 will be implemented. Consequently world trade is expected to expand, and in coming years will grow at an average annual rate of 6.5% (2.5% in 1993). World trade volume will increase during the decade by $750 billion (in 1992 dollars).

b. Estimated global inflation in the years 1995-1999 will average from 0.7% (Japan) to 2.4% in the European Community, 3.1% in the O.E.C.D.countries, and as high as 7.7% in South-East Asia (Japan excluded).

c. International interest rates (the prime rate) will rise somewhat, stabilizing in the years 1995-1999 at an average of 7.25%. The interest rate on United States Government Bonds for 30 years will be an average of 7.25%.

* O.E.C.D, Economic outlook, June 1994.

National Westminster Bank, Economic and Financial Outlook, June 1994.

Aid from the United States Government and from World Jewry

a. The United States government will continue its aid for civilian and defense purposes at a nominal value of about 3 billion dollars, i.e. the real value will decrease by 3.5% on yearly average. Israel will be able to take advantage as needed of loan guarantees, as per the agreement between Israel and the U.S Government.

b. The real value of other unilateral transfers will be somewhat reduced, in contrast to the high level received in the last two years.

Trade

a. New markets will open up, as a result of peace agreements, weakening of the Arab boycott and Israel’s improved standing in the world; Israeli exports will penetrate into new East-European, Middle East, and Asian markets.

b. In parallel, the number of countries from which Israel will be able to import will grow considerably, making cheaper imports possible.

c. The terms of trade will improve during this period, due to lower import costs as a result of new markets and the elimination of indirect trade routes; on the other hand, Israeli exports will be concentrated in specific commodities whose prices rise faster than those of ordinary goods.

Defense expenditures

a. Domestic defense expenditure will maintained at their present level, except for additional redeployment costs in 1994 and 1995; thus, defense expenditures as a percent of GDP will decline.

b. Regular as well as reserve service in the army will be shorter, creating savings to be passed on for equipment and supplies.

IV. Macro-economic framework for the years 1995-2000

1. Principal trends

The trend of expansion which has characterized the Israeli economy in recent years will continue in the next few years. The GDP will grow, according to the plan, at a yearly average of about 4.9%; the GDP of the business sector will grow faster – about 5.8%. This rate of GDP growth implies a yearly average growth of 2.2% per capita in the years 1995-2000. At the same time, imports will grow at an annual rate of 7.2%.

The targeted growth rate will require an increase of about 8.5% per year in commodities and services exports. An increase of 5.3% per year is needed in fixed investments. Growth in exports and in investments is highly dependent on the peace process. It is still difficult to estimate the influence of this process on the Israeli economy. We have assumed that, at the first stage, it will stimulate economic activity in the region, based on expectations for growth. These expectations will be realized in relatively higher investment levels (domestic and foreign), and the penetration of Israeli exports into new markets. This expansion will also be reflected in an increase in employment and a consequent drop in unemployment rates, from about 10% in the year 1993 to about 7.5% in 2000, in spite of continuing growth in the civilian labor force (see tables 1,2,3).

2. Population and employment

Because immigration is expected to stabilize at 80,000 immigrants per year, a certain slowing of population growth is expected, yielding a multi-year average of about 2.6%.

The mix of age groups in the total population will change. The 0-19 age group will drop from 40% of the total in 1993, to 36% in 2000. This drop will affect the expected demand for educational services. Three age groups will grow at a higher yearly rate than the 2.6% average, with significant planning implications:

a. The 20-29 age group is expected to grow at a yearly rate of 3.0%, and its share in the total population will grow from 15.7% to 16.1%. This relatively rapid growth of this age group will increase the demand for higher education, housing and employment.

b. The 65-plus age group is expected to grow at a yearly rate of 3.5%, and its weight in the population will grow from 9.5% to 10.0%. The rapid growth of this group, together with the 20-29 year-olds, points to an significant expected turnover in the labor force: a large number of workers will retire and a large number of newcomers will join the ranks of wage-earners. This fact will affect frictional unemployment. The rapid growth of the 65-plus age group also implies higher needs for services for the senior population. This phenomenon is similar to that in western countries.

c. The 45-59 age group will grow more rapidly than any other group: 5.5% per year, while their weight in the total population will grow from 12.3% to 12.7%. This growth implies a need to plan for professional retraining and adaptation. This group includes senior employees who will have to face transitions and will need professional retraining as a consequence of structural changes in the Israeli economy; as well as new immigrants who will have to adjust to Israeli employment realities. This group, then, represents human capital of high quality whose potential could be lost. Therefore, serious consideration has to be given to special training and to the maximum utilization of the potential latent in this group.

The working-age population will grow at an annual rate of 3%. Its share in the total population will therefore increase constantly between 1995 and 2000.

The civilian labor force will grow during this period by an average of 3.3% annually, a quite rapid rate of increase; this reflects women’s increasing participation in the labor force, as well as the high number of immigrants. Despite the growing labor force, an annual increase of 3.5% in the number employed is expected to slowly decrease unemployment rates. Altogether, during this period, about 500,000 newcomers will join the labor force. The rate of unemployed in the civilian labor force will drop from about 10% in 1993 to 7.5% in the year 2000.

3. Investments

Several factors will promote increased investment in the Israeli economy in coming years: a larger professional labor force; positive political developments; a slow-down in inflation and a lower economic risk level; reduction of deficit in the public sector, and lessened government involvement in capital markets; broader trade agreements and improved infrastructure, which will enable expanded production potential and attract private investments.

Investments in fixed assets (including infrastructure) will vary during the period. In the first years, such investments will increase rapidly, and in the last years at a more moderate rate. Altogether investments in fixed assets will grow at a multi-year average of about 5.3%.

investments in various economic sectors will grow, according to the plan, at a rate of about 5.2% per year, while in the business sector an annual increase of 5.5% is needed. These investments are intended to raise the capital stock,,and to replace amortized assets3.’

Investment in housing will grow by 5.8% per year in the period 1994-2000. Construction’s share in the total of investment in fixed assets will drop. In the years 1995-2000 housing construction will total 330,000 apartments, i.e. an average of 54,000 apartments per year. This assumes a reduction in housing density (persons per room) of new immigrants.

4. Private consumption and private savings

The stabilization of immigration rates will exercise a moderating influence on demand and consumption. However, there will still be a continuous growth in consumption, in line with the rapid growth of private consumption per capita in recent years, which has been reflected also in the continuous decline of the savings index. Private consumption in the period 1995-2000 will grow at an average of 5.1% per year, as compared with more than 7% in the past few years. This rate still exceeds by 2.5% the expected rate of population growth. This decline in the growth rate of consumption directly reflects the decline in immigration, and the completion of the adaptation process in which previous immigrants adjust to Israeli consumption patterns.

The household savings rate will stabilize, although its level will be lower than the multi-year average in the first half of the 90’s. The drop in savings rate is explained, in part, by changes in the population’s age-group composition: a drop in the relative weight of younger age groups

(up to 20), and a rise in the relative weight of age-groups over 45.

5. Public-sector consumption

The moderate growth rate characterizing domestic public-sector consumption in recent years will continue, according to the plan. Thus, the share of public-sector consumption in the national product will continue to decline.

Civilian public-sector consumption will grow, according to the plan, at an annual average rate of 5%. This increase is higher than the rate of population growth, by some 2.4% per year. The expected immigration will create demands for expanded public services of a higher quality. Structural changes in the population, the expected changes in the labor market and leisure-time activities imply a higher demand for social services, mainly in the fields of education and health.

The structure of civilian public-sector consumption is also expected to change. Purchasing costs will grow quite rapidly, but labor costs will grow at a much more moderate rate. In line with recent trends, employment in the public sector will grow more slowly than in the business sector. Consequently, the share of the public sector in total employment will continuously decrease.

Domestic defense consumption will maintain its real 1993 level, except for the years 1994-1995, when it will rise by 2%, as a result of agreements with the Palestinian Authority and the redeployment due to peace agreements. During 1996-2000, domestic defense consumption will remain fixed in real terms. The net result will be a lowering of the defense burden: the weight of domestic defense consumption in the national product will drop from 7.8% in 1993 to about 5.5% in 2000.

6. Balance of payments

The modest size of Israel’s domestic market in effect limits the potential for economic growth, and the ability to fully achieve economies of scale. Accordingly, the possibility of realizing the full potential of production factors is limited. This explains why export has to play a leading role in the process of sustainable economic growth. Achieving economic growth will require expansion of exports at the rapid annual average rate of about 8.5% in the years 1995-2000.

This expansion is feasible, considering the anticipated developments in demand for Israeli exports, as well as in supply factors. On the one hand, the traditional export markets will gradually emerge from the recession. On the other, progress in the peace process and Israel’s improved international position, together with the weakening o the Arab boycott, will pave the way for Israeli export penetration into new markets, and expansion of its share in existing ones.

On the supply side, the increase in profitability which results from better export conditions will decrease relative costs per product. The high level of investments in the economy which has characterized the last few years, will thus bear fruit in the coming years. The growth of investments, in addition to the expected growth in the labor-force will create a high level of production potential. The continuation of improved terms for trade will reduce the import component of exports, and increase profitability.

Industrial export will continue to play a leading role in exports and will constitute about half of total exports. However, the export of services

(including tourism) is also expected to expand rapidly.

Civilian imports will grow, according to the plan, at an average multi-year rate of 7.2% during 1995-2000, in line with their accelerated growth in the last three years (12.2% annually). In addition to growth in consumption, this expansion of imports reflects a significant increase in the use of import-intensive goods. The relative drop in import prices is the result of the economy’s gradual exposure to imports, and to the abolition of administrative and other restrictions imposed on imports. The high protective tariffs which had been imposed to help the domestic market prepare for exposure, will be gradually reduced and will lower the price of imported goods. The elimination of trade distortions will also contribute to increasing the import component in goods.

With the signing of trade agreements with E.F.T.A., imports from countries which have free trade agreements with Israel constitute 75% of total imports. Imports from South-East Asian nations will rise, although their weight in total imports is still negligible. Accordingly their influence on domestic production is still small. We assume that their importance will gradually rise.

The result of these developments will be that civilian imports will exceed exports by some 7 billion dollars on multi-year average. In view of the expected stability in unilateral transfers, the current-account deficit will total 1.4 billion dollars annually during the period. The ratio of net foreign debt to GDP will drop from 24.0% in 1993 to about 20.3% in the year 2000.

                  Table 1: Resources and Use of Resources                           (Real Rate of Change)                               1986-       1990-                    1995-                              1989        1993        1994         2000                              Average     Average     Estimate     Average                                                                      In Annual Terms    Resources                   4.7         8.1        6.2          5.8   (Exc. defense imports)  G.D.P                       3.6         5.6        5.2          4.9  G.D.P, Business Sector      4.7         6.6        5.9          5.8  Civilian Import             6.5        12.2        8.9          7.2  Uses                        4.7         8.1        6.2          5.8   (Exc. defense imports)  Private Consumption         7.0         7.2        7.0          5.1  Domestic Public             1.4         2.5        3.2          3.4   Consumption  Investment in Fixed assets  4.3        16.3        9.3          5.3  Investments in branches     1.7        24.2       12.8          5.2   of economy  Investment in housing       2.9        43.1        0.0          5.8  Export of Goods & Services  4.7         6.2        8.6          8.5  Source: 1986 - 1993, The Central Bureau of Statistics.                   Table 2: Balance of Payments 1992-2000                         (in current US$, million)                                 1992      1993       1994       2000                                                   Estimate   Forecast                                Export of Goods & Services   20,780    22,242     24,070     39,800  Import of Goods & Services   25,999    28,158     30,650     46,900  Net Total Goods & Services   (5,219)   (6,016)    (6,580)    (7,100)  Defense Imports               1,448     2,106      1,500      1,500  Net Unilateral transfers      6,885     6,747      6,650      7,200  Current Account - net           218    (1,375)    (1,430)    (1,400)  External debt:   Gross                       34,127    35,970     38,820     54,850   Net                         14,741    15,695     17,120     23,700  Source: 1992, 1993, The Central Bureau of Statistics.              Table 3: The population, Labor forces and employment                1992     1993     1994     2000      1993   1994    2000                             Estimate Forecast             Esti-  Annual                                                           mate   average                     (In Thousands)               (Quantitative growth rate)                Mean         5,123.6  5,256.7  5,394.7  6,276.0     2.6    2.6    2.6  population Working-age  3,574.4  3,682.1  3,794.1  4,538.5     3.0    3.0    3.0  population Civilian     1,857.8  1,946.0  2,007.1  2,437.2     4.7    3.1    3.3  labor force Employed     1,650.2  1,751.2  1,836.2  2,254.7     6.1    4.9    3.5 Unemployed     207.6    194.8    178.9    182.5                       (In percents)                 Civilian        52.8     52.9     52.9     53.7  labor force  of population  aged 15+ Unemployed      11.2     10.0      8.5      7.5  of civilian  labor force  Source: 1992, 1993, The Central Bureau of Statistics. 

V. Alternative scenarios

The macro-economic framework introduced in the plan is based on a series of basic assumptions, detailed above. We now briefly analyze the possible effect of changes in some of these assumptions. One scenario alters the expected level of immigration; another, the level of security expenditures resulting from the peace process. A third scenario examines the anticipated effect of an alternative policy, which would assign highest priority to the objective of eliminating the deficit in the balance of payments.

1. Immigration scenario: limited extent of 40,000 immigrants per year21. Immigration scenario: limited extent of 40,000 immigrants per year

The multi-year plan is based on the assumption of a gross immigration of 80,000 immigrants each year. In the present scenario we examine a more pessimistic option, according to which the gross number of immigrants per year comes to an average of 40,000. Thus, with the deduction of emigration, the increment of population from net immigration is 20,000. Table 4 shows the main implications:

a. A drastic decrease in the annual growth rate of investments in housing from 5.8% to 4%, as a result of lower demand for housing by immigrants.

b. A substantial decrease in the growth rate of private consumption as a result of slower population growth, on the theory that consumption growth is highly affected by the integration of new immigrants into Israeli consumption patterns.

c. A significant decrease in the unemployment rate, in view of the relatively large share of immigrants among the unemployed.

d. A moderate decrease in the economic growth rate, along with slower growth in the labor force, resulting from the limited extent of immigration.

2. Defense scenario: 2.5% increase in domestic defense expenditure

The military redeployment needed in order to implement peace agreements will raise defense expenditures in the years 1994 and 1995 by 2% in comparison with 1993 (in real terms). Furthermore, it has been assumed that defense expenses will remain at real 1993 levels after 1995. In the present scenario, another alternative is examined, which considers larger defense requirements in the middle term (even if their share of GDP continues to decrease). This alternative assumes a yearly increase of 2.5% in domestic defense expenditures through the period of the plan. As a result, defense needs will reach 6.6% of GDP by the end of the period, instead of 5.5% as originally outlined.

Table 5 shows two alternative approaches to this situation. In both cases, it is assumed that higher defense expenditures would not be covered by increasing the deficit in the budget.

The first approach is to cover additional security expenses through the tax system. In that case:

a. The tax burden would drop only to the level of 37-38% by the end of the period, and not to 36% as would be possible according to the basic scenario.

b. As a result, as can be seen in table 5, private consumption would grow at a lower rate, private savings would be lower, the economic growth rate would slow, and the ratio of the net foreign debt to GDP would be higher.

In the second case, the higher defense costs will be balanced by a decrease in the rate of growth of civilian public-sector consumption, from 4.9% to 3.8%.

3. Balance Scenario: Closing the gap in the balance of payments

The basic scenario assumes exports will grow by 8.5% a year, while imports would grow at a rate of 7.2% annually. This net growth in foreign trade would not, however, lead to narrowing the gap in the balance of payments. The trade deficit would even rise, as would the foreign debt. However, since the GDP is expected to grow at a relatively rapid rate, the ratio between foreign debt and the GDP would decrease from 24% to about 20%.

In the balance scenario, the option of eliminating the deficit in the current balance by the year 2000 is examined. Under the assumption that export possibilities are realized to their full extent, the various components of import would have to be decreased. In order to simplify the analysis, we assume no change in exports. The main implications are shown in Table 6, below.

The principal conclusion is that stabilizing the balance of payments by the end of the plan period implies a slow-down in economic growth from 4.9% as per the basic outline, to 4.4% per year. This results from the need to lower the growth of imports to a level of 6.6% per year (instead of 7.2% as per the basic scenario). This is accomplished by reducing the growth of two types of imports: private consumption and investments. In addition, the reduction of the economic growth rate will necessarily cause an increase in unemployment rates, or, if unemployment is to be kept at a relatively low level, a decrease in productivity. This may of course have negative repercussions for exports and growth in the long term.

     Table 4: Comparison between the Basic and the Immigration scenarios,                              main indicators                                   Basic                 Immigration                              Average number of               80,000                   40,000  immigrants per year                                  Annual growth rate (in percents)                                 Mean population                  2.6                      2.4  Labor force                      3.3                      3.2  Investment in housing            5.8                      4.0  Investment in fixed assets       5.3                      5.0  Private consumption              5.1                   4.8 - 5.4  Export                           8.5                      8.3  Import (exc. defense)            7.2                      7.0  G.D.P                            4.9                   4.7 - 4.8  Unemployment rate                7.5                      7.2        Table 5: Comparison between the basic and the deface scenarios,                       main indicators (in percents)                                  Basic                     Deface                                          End of period  Alternative I                   Weight of the domestic-defence   5.5                      6.6   consumption in the G.D.P  Taxation Burden                 36.0                    37 - 38  Debt-G.D.P ratio                20.2                 20.3 - 21.5                                         Multi-Year average  Alternative II                  Annual growth rate               5.1                  4.5 - 4.8   of private consumption  Rate of private savings         23.3                 22.3 - 22.8  Weight of the domestic           5.5                     6.6   defence consumption in   G.D.P, end of period  Annual growth rate of            4.9                     3.8   civilian public consumption        Table 6: Comparison between the basic and balancing the current                             account scenarios                                  Basic                 Balancing                                       Annual growth rates                                 G.D.P                            4.9                     4.4  Import (exc. defense             7.2                     6.6  Domestic public consumption      3.4                     3.4  Private consumption              5.1                     4.4  Investments                      5.3                     4.3  Export                           8.5                     8.5  Productivity                     2.1                     1.3 

VI. Policy recommendations

In view of the policy goals and economic plan outlined above, we now submit recommendations for policy measures needed to achieve development objectives.

1. Stabilizing economic growth

The deficit should be reduced. The national budget deficit should gradually be reduced, from 3% at the beginning of the period to the level of 2% of the GDP by the end of the plan period (the year 2000).This is needed in order to maintain a high economic growth rate, while controlling inflation, lowering unemployment and reducing the relative weight of the public sector in the economy. At the same time, in accordance with the findings of the State Comptroller, the decision of the Ministerial Committee for Coordination and Administration to examine the definition of the deficit should be implemented. Special attention should be paid to the share of investments in the deficit. The higher their share, the lower the deficit’s negative effects, since investments create a foundation for rapid economic growth in the future. Therefore, a flexible evaluation of the deficit according to its components is recommended.

Investments in infrastructure should continue, within the framework of national priorities. Continued investment in infrastructure is needed to accumulate the necessary capital to make economic growth possible in the short and medium terms.

Housing infrastructure for 50-55,000 apartments per year should be prepared. This measure is needed in order to facilitate smooth economic growth. Housing infrastructure is needed to help in absorbing new immigrants; in their transfer from caravans; to decrease housing density (number of persons per room); to supply apartments to veteran residents, especially in view of the relatively rapid increase expected in the 25-29 age group, who will join the housing market. In case this measure is not sufficient and balance between demand and supply of housing is not achieved, public construction is to be considered. In addition, the introduction of new building technologies should be supported, in order to reduce dependence on foreign workers and to shorten construction time.

2. Structural changes

The tax burden should be reduced. The tax burden should be reduced from the present 40.5% of GDP to a 36.5% level, mainly by reducing indirect taxes (purchase tax) and by the restructuring of income tax levels. Such a reduction is still compatible with keeping the deficit at a reasonable level; it is also consistent with the accepted tax burden in other countries with a similar economic situation. Furthermore, it could encourage economic growth, by reducing wage costs and by increasing the labor supply. Top priority should be given to reducing indirect taxes, especially the purchase tax. This would decrease economic distortions and contribute to a more equal distribution of income, due to the regressive nature of indirect taxes.

Stock-market profits should be taxed, and income tax reduced. This measure is intended to equalize taxation of capital and labor, and to achieve a less distorted distribution of return on capital and labor. The measure might positively affect labor supply (by the reduction of income tax) and the equality of income distribution. It is recommended that the tax be imposed on stock-market turnover.

Agricultural lands should be redesignated, permitting other uses. Agricultural lands should be released for housing and other uses (while safeguarding the allocation of "Green Areas") in order to prevent economic dislocations resulting from a lack of land for building and other economic activities.

The labor market should be made more flexible. Easing the rigidity in the labor market would result in greater competitiveness and in higher economic efficiency. Increased flexibility of the labor market can be achieved by reducing the wage linkages between various sectors; and by reducing the importance of national wage agreements, which cause automatic wage increases without any relation to profitability or productivity. We do not recommend a decrease in real wages, but we do advocate maintaining a reasonable relationship between wages and productivity.

3. Supporting foreign trade as the driving force of development

The profitability of exports should be maintained. Our goal should be to raise the profitability of exports, especially in view of the increase in wage costs which may result from recent agreements; to prevent an increase in import consumption; and to avoid increasing foreign debt.

The "diagonal" system should be continued. The "diagonal" system for the determination of the exchange rate should be maintained, in order to ensure a correct relationship between price changes in Israel and abroad.

Liberalization of foreign trade and foreign currency markets should continue. The liberalization of foreign currency and capital movement controls will enable the public to hold a more appropriate combination of financial assets. Less control on capital movements will give the business sector better access to foreign assets and to foreign currency credits. This will expose the Israeli economy to international capital prices.

Industrial R&D should get increased support. Encouragement of industrial research and development is especially important in view of the slow-down in the defense industry, which has traditionally played a leading role in research and development. It is therefore imperative to identify and stimulate high- potential scientific industries in order to assure the continuation of technological development in Israel.

Commercial ties with new markets in Eastern Europe and Asia should be developed. Forecasts predict fast economic growth in countries such as China, India, Indonesia, and a rapid increase in their role in the world economy, – as opposed to the relative decrease in the role of countries where Israel’s foreign trade is now concentrated (Western Europe and the United States).

Trade barriers should be lowered on a reciprocity basis. The exposure in domestic markets of Israeli products to competition from foreign products in recent years has led to more moderate increases in the prices of imported goods, compared with domestic products. The exposure policy is intended to bring about a gradual reduction of all tariffs. A disadvantage of this exposure in the short term is its negative effect on employment, resulting from possible closure of enterprises unable to withstand competition. The advantage of lowering trade barriers, both in the short and long term, lies in the possibility of achieving both economic and social goals. It spurs Israeli enterprises to higher efficiency, reduces distortions in the allocation of production factors, and thus enables healthier economic growth. In addition, the lower prices that result from cutting indirect taxes increase public purchasing power and improve distribution, insofar as tariffs are lowered on commodities consumed by large segments of the population.

4. Integrating into the economy of the Middle East

Although the expected economic benefits are modest, trade between Israel and Arab nations should be supported. Development of trade in the Middle East will follow developments in the peace process. Trade serves as a means for supporting political relationships, and helps lay the economic foundations for the longer term. In the immediate period of the plan, the potential for foreign trade ties with Middle Eastern countries is very limited, because of major differences between their economies and the trade structures of the countries. In the longer term, the progress of the region’s economies might enable more significant trade ties, built on a more stable foundation.

Joint business ventures between Israeli and Arab businessmen, and economically-sound international co-operation projects should be encouraged. Business cooperation makes economic sense because of the potential complementarity of production factors in Israel and in the Arab countries. The Arab countries offer a more abundant and cheaper labor supply, and access to new markets; Israel can contribute scientific infrastructure, access to capital and access to Western markets. Certain joint national projects might be economically viable because of the advantages created by cooperation (such as common ports). Others have still to be studied (such as a Mediterranean-Dead Sea canal).

5. Reducing government’s involvement in the economy

The public sector’s share in economic activity should be reduced. This aim will be achieved by reducing the share of public expenditures from the prevailing 50% to 46% of GDP, and at the same time reducing the tax burden as suggested above. This would continue a process begun several years ago. Such measures are a natural consequence of the relative decrease in defense expenditures, of the process of privatization and the transition to a free economy.

The relative share of the public sector in employment should be reduced. Growth in public sector employment should be moderated, according to the plan. It will grow by 3.0% per year while employment in the business sector is expected to expand by 3.7% a year in 1995-2000.

Privatization of national companies should be speeded up. Privatization is vital for future economic growth, for increasing competition, for improving the capital market, for increasing labor market flexibility, and for opening-up access to international markets. Priority should be given to privatization of weaker firms, in spite of the temptation to privatize the successful ones; the competitive environment in which the company will function should be well defined before the beginning of the privatization process. It should be remembered that certain of the companies were not established for profit purposes (such as the defense industries).

6. Regional development through capital formation, for economic and social purposes

The Negev and the Galilee should get a greater relative share of funds for highways and industrial-park infrastructure. Distribution of funds to these regions will correct to some extent the distortion in allocations for infrastructure, which have traditionally favored the center of the country. It will improve the economic viability of business investments and of employing local labor in the periphery. This will create a basis for economic development, which in time may enable a partial or total elimination of the "reverse discrimination" provided by the Investment Incentives Law. Improvement of infrastructure will also lessen inequality between the population in various parts of the country. Infrastructure capital accumulation in the Negev and Galilee and the accompanying economic development can also reduce the problem of excess demand for housing in the center of the country.

More funds should be allocated for highways connecting the Negev and the Galilee with the center; public transportation by train and bus should be further developed. These measures would increase the mobility of the labor force and promote its more efficient utilization, and raise the productivity of capital in peripheral areas. In the first stage it is recommended to focus on the intercity transportation network, to those cities in the periphery that are closest to the center (such as Beersheva or Nazareth). This would enable daily commuting of the labor force between those cities and the center.

An economic development plan for the Arab sector should be prepared. This is needed in order to make efficient use of the economic potential of the physical infrastructure and labor force in the Arab sector. Such a plan should examine the supply of production factors in the Arab sector and make recommendations for building economic infrastructures in the Arab sector. This would lead to an increase in the productivity of the Arab labor force, as well as the rate of participation of Arab women in the labor force. This in turn would contribute to national economic growth, and help reduce the wide gap between populations (income per capita in the Arab sector is half that of the Jewish sector).

7. Development of human capital, for both economic and social goals

High priority should be given to expanded investment in education, including technological and scientific education, and in health and welfare. Human capital is the basis for economic development in the long term. Investments in education should be divided as equally as possible between various groups in the population, in order to enable a long-term reduction in economic and social gaps. The relatively low increase of population in the 0-14 age group (1.4% per year as against 2.6% of the whole population) may make it easier to increase per capita investment in education.

Funding for professional training and retraining, especially of new immigrants, should be increased. This measure would contribute to a more efficient use of the productive potential latent in the new immigrants’ professional skills, and would also encourage the integration of lower-income population groups in the Israeli economy. It should be pointed out that current unemployment includes what is defined as "natural" unemployment, but which actually reflects the lack of exploitation of segments of the labor force which could contribute to the Israeli economy, if helped through proper professional training. This is true both for new immigrants and for youth, whose unemployment rate is high.

The trend towards a wider regional distribution of higher education should be strengthened. This measure is needed for two reasons: first, that there is already a lack of higher educational institutions; second, the expected rapid growth of the 20-24 age group, which stands to benefit from higher education

(3.1% growth, compared to 2.6% per year in the total population).

More funds should be allocated for the retirement-age population. The needs of this age group are increasing, in view of its quantitatively rapid growth (3.5% per year for the 65-plus population, as against 2.6% for the total population), as

well as the growing demand for higher quality of services. The potential contribution of this group to economic growth should be re-examined, including such measures as a more flexible retirement age, and creating voluntary or semi-voluntary frameworks, which could help decrease the cost of labor to the economy.