OECD Economic Surveys: Israel 2020

Report

OECD Economic Surveys: Israel

23 September 2020

1. Key Policy Insights

The coronavirus pandemic is threatening to reverse some of the achievements made over the last decade in boosting standards of living (Figure 1.1). After the virus outbreak reached Israel, stringent confinement measures were swiftly introduced and helped limit the number of new infections during the first wave of the pandemic. This included an early closure of borders as well as strict mobility, gathering and workforce restrictions (Box 1.1). However, after the economy was largely reopened in June the pandemic resurged, requiring renewed tightening of some confinement measures and eventually a second nationwide lockdown in September. The government and financial authorities introduced a wide range of measures to cushion the shock for households and firms. Nevertheless, prospects are now less certain.

Figure 1.1. The COVID-19 crisis threatens to reverse progress made in boosting living standards

Box 1.1. Key policy responses to the COVID-19 pandemic

Israel reacted swiftly to the first wave of the coronavirus pandemic by adopting strict containment measures as well as a wide range of fiscal, monetary and financial measures to cushion income losses and provide liquidity to households and firms. However, the pandemic resurged after the economy was largely reopened, requiring some retightening of containment measures and the extension of government support in July. A second nationwide lockdown was announced in September.

Containment: Israel closed its borders to foreign visitors in early March. Schools were closed by mid-March. On 20 March the government adopted emergency regulations including the closure of non-essential shops, strict mobility, gathering and workforce restrictions that limited the number of workers in each workplace to 30% in the public and private sector, and were further tightened to 15% in the private sector in the first half of April. Containment measures were broadly lifted and the economy was largely reopened in May. Amid rapidly resurging infections some containment measures were tightened in July. In September, the government announced a second nationwide lockdown for 3 weeks, including movement restrictions, gathering limits and closures of schools and non-essential businesses that receive customers.
Testing and tracing: Israel expanded its testing capacity, including by setting up several 24/7 drive-through testing stations, with the number of tests in relation to its population among the highest in the OECD (OECD, 2020a). Mobile data was used to trace infected people, to inform those who may have been in contact with them, and to enforce quarantine orders.
Monetary and financial policy: the Bank of Israel launched a programme to purchase government and corporate bonds, lowered the policy rate from 0.25% to 0.1% and established a credit facility for SMEs via banks. It also injected liquidity and reduced the capital adequacy ratio for banks by 1 percentage point.
Support to individuals and households: Eligibility to unemployment benefits was broadened for example to workers on unpaid leave and extended until June 2021. The government also provided direct payments to vulnerable groups including the self-employed, older employees (over 67 years) who lost their employment during the crisis, and families with children. Banks were encouraged to allow a postponement of mortgage and other household credit repayments.
Support to firms: Small and medium sized firms hard-hit by the crisis can receive grants as well as reimbursements for property taxes until June 2021. Loan funds with state guarantees for small and large firms were established. Payments of VAT, social security and government fees were deferred for small businesses. Grants were made available to firms for every person they rehire.

Before the coronavirus pandemic, Israel’s economy enjoyed low unemployment and living standards had risen close to the OECD average (Figure 1.2), thanks to effective macroeconomic management and ongoing structural reforms (Box 1.2). It achieved remarkable employment gains, notably by Haredi and Arab-Israelis, owing to reforms that strengthened work incentives (Figure 1.2). In addition, Israelis enjoyed good health outcomes and remained on average more satisfied with their lives than most other OECD residents (Figure 1.3). However, Israel remains a two-speed economy, with its vibrant high-tech sector offset by lagging sheltered sectors, which employ most of the workforce. In addition, a large infrastructure deficit and a lack of domestic and external competition contribute to duality in productivity between sectors. As a result, aggregate productivity gains have been slow and income gaps have remained large (Figure 1.4). Poverty is widespread especially among Arab-Israelis and Haredim. This reflects a lack of the skills needed for them to get high-productivity and well-paid jobs. For the Haredim it also reflects an explicit choice to focus on non-material benefits and engage in life-long religious studies (Box 1.3; Machlica, 2020). At the same time, air pollution remained a major concern as well as housing supply and affordability (Figure 1.3).

Figure 1.2. The economy performed well prior to the COVID-19 crisis thanks to high rates of labour utilisation

Due to the COVID-19 pandemic the economy experienced an unprecedented downturn in the first half of 2020. At the height of the crisis, over a million employees have been temporarily laid off. As containment measures have been lifted, businesses have reopened and many workers have returned to work. However, the second lockdown will weigh on activity and employment in the near-term. In addition, with uncertainty still high, business failures expected to increase and sectoral shifts in output likely, economic activity is set to pick up only gradually and unemployment to remain above pre-crisis levels at the end of 2021.

Figure 1.3. Before the crisis, well-being outcomes were mixed, with wide regional disparities

Figure 1.4. Slow productivity gains and high poverty are Israel’s long-standing challenges

Box 1.2. Key recent reforms

Taxation: The statutory corporate income tax rate was cut in several steps from 26.5% in 2015 to 23% in 2018. In 2017 Israel introduced new preferential corporate income tax rates for IP-related activities in line with the nexus approach under BEPS Action 5. In 2017 the surtax for high-income earners was increased from 2% to 3%.

Welfare: In 2017 the government approved the “Net Family” programme, with the aim of supporting working families with children. As part of the programme, the earned income tax credit and tax credits for children under the age of 6 were increased.

Competition: Competition in the banking sector has been strengthened, notably by separating two credit card companies from banks in 2018, as well as by the establishment of a central credit registry and the granting of a new licence to an online bank in 2019. The electricity-sector reform approved in 2018 requires the state-owned Israel Electric Corporation inter alia to sell part of its electricity generation capacity, which is expected to bring down its market share form 80% in 2017 to 40% in 2025. In 2018 exposure to parallel imports via the Internet was increased and import tariffs reduced on several products, including foodstuffs.

Education: The government is strengthening its programmes to boost the number of students in tech-related studies to counteract increasing sectoral shortages. In 2018 engineering became the most widely studied major in Israel. The share of high school students studying mathematics and English at the highest level has almost doubled since 2012.

Financial Stability: In late 2018 a Financial Stability Committee, comprising the Bank of Israel, the Ministry of Finance, the Securities Authority and the Capital Markets Insurance and Saving Authority, was established to foster oversight and enhance supervisory co-ordination.

Box 1.3. The Ultra-Orthodox population in Israel

Integrating the Arab-Israeli and Haredim into the labour market remains one of the key challenges for the Israeli economy. This is particularly important in the case of Haredim due to demographic trends. While the fertility rate of Arab-Israelis has fallen and is now only slightly higher than that of the non-Haredi Jewish population (3.1 vs 2.5), Haredi families still have on average seven children. Their share in the population is expected to increase from today’s 12% to 32% in 2065.

Haredi men are encouraged by their communities to engage in life-long religious studies in yeshiva schools rather than work. Men enrolled in religious studies are exempt from military service, which is compulsory for other Jewish citizens. Those who seek jobs are often unprepared for the labour market, because Ultra-Orthodox boys’ study a very limited core curriculum of secular subjects. Consequently, almost half of all Haredi men are out of the labour force. Most of those that do work tend to earn close to the minimum wage and therefore pay no or very little income tax. Almost half of the Haredi population lives in material poverty. Ultra-Orthodox communities in the United States or in the United Kingdom have much more favourable employment outcomes.

Despite their low incomes and high officially measured poverty, few Haredi consider themselves poor: less than 8% in fact, which is comparable to non-Haredi Jews. Life satisfaction of the Haredim is also higher than in the rest of the population. This may be explained by the high level of community activity, including high rates of volunteerism and donations, mutual aid and other economic support frameworks (Kasir and Romanov, 2018). It is noteworthy that more than 90% of the Haredim donate to charities, compared to 60% of secular Israelis.

Against this background, the main messages of this Survey are:

Macroeconomic policy needs to remain supportive in the near term to support the recovery and should stand ready to expand support as needed. Further structural reforms and additional public investment to enhance training and education, improve infrastructure and foster product market competition are key to strengthening the recovery.
The government should reduce wide differences in resources between municipalities to promote equal opportunities for everyone.
Reforms to improve the efficiency and equity of the tax system can help strengthen an inclusive recovery from the crisis and improve health and environmental outcomes while durably generating additional revenues.

The economy experienced an unprecedented downturn

Israel’s first case of the coronavirus was detected in late February and the virus spread quickly thereafter. Strict confinement measures were introduced swiftly, the health capacity expanded, and Israel was among the first countries to close its borders to foreign visitors in early March. Confinement measures helped limit the number of new cases in the first phase of the outbreak. The daily number of new infections trended down in April and May, but there has been a surge in new infections since June (Figure 1.5). In response, the government tightened confinement measures again and eventually announced a second, somewhat milder, nationwide lockdown in September. Infection rates have been higher in several Ultra-Orthodox and Arab towns and neighbourhoods. The death toll in Israel has been lower than in the hardest-hit OECD countries. The immediate policy priority must be to continue with distancing, testing, tracking, and treatment programmes and maintaining adequate health capacity.

Figure 1.5. Israel is facing a second outbreak of the pandemic

2020

Lockdown measures and heightened uncertainty led to a sharp contraction of domestic supply and demand in the first half of 2020 (Figure 1.6). Entire sectors have been closed down or forced to operate at a fraction of their normal capacity. During the peak of the first lockdown from end-March to mid-April, around a third of the economy was shut down. At the same time consumer and business confidence plummeted (Figure 1.7).

Figure 1.6. Domestic demand contracted sharply

Economic activity picked up relatively rapidly as the economy reopened and government support cushioned income losses, but the pace of the recovery has slowed more recently. High-frequency data from credit card purchases and business revenues suggest a relatively quick rebound in activity in May and June in sectors where the restrictions were lifted early. However, in other sectors, especially tourism, expenditure remained depressed. More recent data suggest a slowdown of the recovery amid the renewed outbreak of the virus and the tightening of some containment measures and business closures such as bars and night clubs.

The labour market suffered severely. At the height of the first lockdown in April, more than a million persons were laid-off or put on unpaid leave. Many people have returned to work since the economy reopened, helped by government subsidies to firms to rehire workers. However, the unemployment rate, broadly defined to include temporarily absent workers (mainly due to unpaid leave) and employees, who have left the labour force or have been discouraged to enter the labour force due to the pandemic, remains high at around 12% (Figure 1.8). Job vacancies remain depressed. Moreover, the severity of the crisis is likely to increase firm bankruptcies, despite government support to firms, forcing worker to find new jobs. In addition, a reallocation of labour across sectors might be required during the recovery, as activities requiring face-to-face contact, such as hospitality and food services (accounting for 2.5% of GDP) may face extended low demand, while other sectors, such as health and digital services, will benefit from rising demand. Reallocation will take time and require retraining especially since about a third of employees who have been on furlough or laid-off in June have been low-skilled workers (MoF, 2020).

The decline of exports has been somewhat more moderate in the first half of 2020, thanks to the resilience of the high-tech sector and the start of gas exports to Jordan and Egypt (Box 1.4). Almost half of services exports emanates from the high-tech sector (Figure 1.9). In contrast, tourism exports have plummeted as visitor arrivals from abroad halted. The shekel depreciated strongly at the onset of the crisis but has quickly regained pre-crisis levels. As the manufacturing sector is more sensitive to shekel appreciation (BoI, 2017), a strong shekel will weigh on goods exports. Accordingly, the erosion of export profitability is still a main concern of manufacturing firms, together with the lack of export orders (Figure 1.7, Panel D).

Figure 1.8. The labour market has weakened substantially

The recovery from the global pandemic will be slow (Table 1.1). The second nationwide lockdown will weigh on activity in the near-term. In addition, as long as there is no vaccine or effective treatment for the virus, uncertainty in the economy will remain high. This together with health and distancing regulations for businesses will weigh on consumer demand and investment. In contrast, the government’s aid programmes will support demand. Weakness of global demand will hold back export growth. Assuming a gradual reopening of the economy after the second lockdown, the economy is expected to decline by around 6% in 2020 and to grow by 2.9% in 2021. Unemployment will be significantly higher in 2020 compared to 2019 and fall only slowly in 2021.

The projections are subject to substantial uncertainty and risks as the world continues to grapple with the coronavirus pandemic. A further deterioration of the health situation requiring extending or renewing nationwide lockdowns would delay the recovery further with more severe and persistent effects on activity, due to a higher number of insolvencies and longer unemployment spells. Growth could also be weaker in case of heightened geopolitical tensions or renewed internal political uncertainty. If financial conditions were to tighten, businesses may find it more difficult to obtain the necessary liquidity. This could lead to a large number of insolvencies of otherwise viable firms. The effects of more extreme shocks are discussed briefly in Table 1.3. In this environment of high uncertainty, macroeconomic policy should remain supportive and flexible to adapt to changing health conditions.

Figure 1.9. Exports are fairly diversified

Annual percentage change, volume (2010 prices)
	2019	2020	2021
Gross domestic product (GDP)	3.4	-6.0	2.9
Private consumption	3.8	-11.6	6.0
Government consumption	2.8	6.0	3.4
Gross fixed capital formation	2.4	-11.8	-0.8
Final domestic demand	3.3	-7.7	3.9
Stockbuilding¹	0.2	0.6	-0.4
Total domestic demand	3.5	-7.2	3.4
Exports of goods and services	4.0	-4.3	3.2
Imports of goods and services	4.1	-9.0	6.1
Net exports¹	0.0	1.2	-0.6
Other indicators
Unemployment rate (narrowly defined according to the Labour Force Survey, annual average)	3.8	6.1	6.5
GDP deflator (annual average)	2.3	0.6	0.8
Consumer price index (annual average)	0.8	-0.7	0.2
Core consumer prices (annual average)	0.7	-0.2	0.2
Current account balance²	3.4	4.1	3.7
General government fiscal balance²	-3.9	-13.8	-10.3
General government gross debt²	60.0	77.0	84.7

1. Contribution to changes in real GDP.

2. As a percentage of GDP.

Source: OECD Economic Outlook: Statistics and Projections database.

Box 1.4. The economic impact of natural gas discoveries in Israel

Israel has discovered several major offshore natural gas reserves in the past decade. These include the two big fields of Tamar (305 billion m³) and Leviathan (605 billion m³) in 2009-10 as well as several smaller fields such as Tanin (23 billion m³) and Karish (32 billion m³). The Tamar field has been exploited since 2013 and almost fully meets local demand (around 11.5 billion m³ in 2019), mainly for electricity generation. This had a positive impact on GDP of about 1.4% thanks to lower energy imports. The start of production from the Leviathan field at the beginning of 2020 allowed Israel to export natural gas. Export deals have been signed with Jordan and Egypt. Gas exports to these two countries are estimated to amount to about 6.5 billion m³ in 2020 and are expected to grow to 8.7 billion m³ in 2023 (Table 1.2). Gas exports are estimated to boost GDP growth by around 0.3 percentage points in 2020 and by further 0.2 percentage points between 2021 and 2023. Preliminary discussions are also ongoing to export gas to the EU. However, this will require further investment in technologies to liquefy gas or pipeline connections and the resolution of topographic and geopolitical issues.

Year	2020	2021	2022	2023
Expected gas exports to Egypt (BCM)	3.3	4.0	4.5	5.5
Expected gas exports to Jordan (BCM)	3.2	3.2	3.2	3.2
Total expected gas exports (BCM(	6.5	7.2	7.7	8.7

Source: Ministry of Finance

Besides positive effects on GDP, the gas discoveries will also contribute slightly to government revenues from royalties and corporate income taxes. Royalties from Tamar exploitation have so far amounted to around NIS 4.4 billion since 2013 (less than 0.1% of GDP per year). The gas industry is also liable for a special levy of 20-50% on profits over normal returns on investment. First proceeds from this levy are expected in 2020-21 and will be placed in a dedicated sovereign wealth fund to share with future generations. By law, the sovereign wealth fund will begin operating once NIS 1 billion have been accumulated. The proceeds will be invested abroad to reduce the risks of Dutch disease.

Shock	Possible Impact
Major house price correction	A large fall in house prices would adversely affect residential investment and consumption through wealth effects with possible spillovers to the labour market creating feedback loops. This would expose vulnerabilities in the banking sector due to its strong exposure to the real estate market.
Heightened geopolitical tensions	Geopolitical instability in the region would increase uncertainty and weaken both domestic and external demand, with negative budgetary repercussions. A likely rise in military spending would crowd out more productive spending or force the government to hike taxes.
International debt crisis	Amid record-high levels of global corporate debt and declining debt quality, a substantial repricing would reverberate through the global financial markets and have significant ramifications on Israeli financial asset prices and reduce the willingness to take financial risks.
Increase in global protectionism	A new wave of isolationist foreign economic policies and protectionism would lower global trade and would be particularly harmful for countries without a large domestic market, such as Israel.

Monetary policy is appropriately accommodative

Amid plummeting energy prices and weak domestic demand, inflation has fallen into negative territory at the onset of the crisis (Figure 1.10). Even before the COVID-19 outbreak inflation was subdued and below the lower bound of the 1-3% inflation target range mainly due to sharply declining tradable goods prices owing to strong shekel appreciation in 2019, particularly energy prices, and volatile fruit and vegetable prices. Inflation is set to remain weak and below the target range in the near-term as demand recovers only slowly and a weakening labour market puts downward pressure on wages. However, there are upside risks. Longer lasting supply disruptions, cost pressure from new hygiene and distancing rules, and possibly weaker competitive pressures as firm bankruptcies increase could push up inflation in the medium term. Medium-to long-term inflation expectations remain within the target band (Panel C).

Figure 1.10. Inflation has fallen into negative territory

In reaction to the COVID-19 outbreak, the Bank of Israel used a range of instruments to increase the extent of monetary accommodation, provide liquidity and ensure an orderly functioning of financial markets. It launched a programme to buy government bonds of up to NIS 50 billion (3.5% of GDP), three times as large as during the global financial crisis. In addition, the Bank of Israel lowered the policy rate from 0.25% to 0.1% in April, established a credit facility for SMEs via banks and injected liquidity, including foreign exchange liquidity via swap transactions. In July, amid a deterioration of the health situation, the central bank announced a new programme to buy corporate bonds up to NIS 15 billion. These measures helped to restore calm in financial markets. The shekel recovered close to pre-crisis levels, after it depreciated sharply by around 10% against the dollar and euro in mid-March. Government and corporate bond markets also stabilised although corporate bond spreads remain elevated compared to pre-crisis levels. In the low inflation environment, monetary policy should remain accommodative to support the recovery. If the recovery proves more sluggish than expected or financial conditions tighten, the central bank could further expand its existing programmes, including its asset purchase programmes.

Ample foreign exchange reserves (around 34% of GDP in early 2020) allowed the central bank to swiftly provide foreign exchange liquidity to banks during a short bout of dollar liquidity distress at the onset of the crisis. Sharp declines in global equity prices led to margin calls and a temporary shortage of US dollar liquidity in the domestic financial sector. In response, the Bank of Israel provided shekel/US dollar swap lines of around USD 7.5 billion. As the shekel recovered, the central bank resumed foreign exchange purchases. This is consistent with the central bank’s pre-crisis practice of operating in the foreign exchange market if the shekel deviates substantially from values justified by fundamentals, or in cases of excessive exchange market volatility. Past foreign exchange purchases have been shown to be effective in moderating currency appreciation, at least in the short term (Caspi et al., 2018). As Israel’s economy is strongly affected by monetary policy decisions by major central banks and is exposed to volatile international financial markets, using targeted foreign exchange interventions as an additional monetary policy tool is appropriate.

Financial market regulation was eased

Financial market regulators have taken a suite of measures to ensure sufficient liquidity and avoid a credit crunch. The regulatory capital requirements for banks were lowered by 1 percentage point. At the same time banks were encouraged to suspend dividend payments to shareholders to maintain capital buffers. A number of regulatory leniencies were introduced, including an increase of the limit to banks’ loan portfolio for credits to the construction and real estate sector and of the loan-to-values limits of consumer credits backed by real estate. In addition, the Bank of Israel formulated a common framework, which was adopted by all banks, to enable the deferral of loan payments on mortgages, and consumer and SME business credits. By mid-August, banks approved payment deferrals on loans accounting for about 16% of the total credit portfolio of the banking sector. These measures together with monetary easing and loan guarantee programmes of the government helped to limit the initial impact of the crisis on liquidity and credit supply and should be continued as needed to avoid widespread bankruptcies. Once the recovery gains strength, the easing of prudential regulation will have to be gradually reversed to rebuild capital and liquidity buffers.

The banking sector appeared sound at the onset of the COVID-19 pandemic (BoI, 2020), but the crisis raises risks. Since the global financial crisis Israel’s banks have increased capital ratios, which comfortably surpass Basel III regulatory capital requirements (Figure 1.11). Bank funding relies mainly on deposits, and their liquidity is adequate. Moreover, banks have improved their efficiency, including by adopting new technologies and digitalisation. The share of non-performing loans, at around 1% in 2019, was low by international comparison (Panel C), and banks’ profitability was robust. However, this situation could deteriorate rapidly. A sluggish recovery could heighten credit repayment problems or firm insolvencies especially once some of the liquidity measures, such as payment deferrals, are withdrawn. Small and medium-sized enterprises and firms in sectors such as hospitality may be particularly vulnerable to financial stress. Banks should therefore build up sufficient loan loss provisions. In addition, risks remain from banks’ heavy exposure to the housing market. The share of credits for housing and the construction and real estate sectors rose from around one-third of total credits in 2008 to around one-half in 2019 (Panel D).

The crisis may put downward pressure on house prices, but measures taken in the past have reduced the risks to financial stability from the real estate sector. After strong increases between 2007 and 2017, house prices have stabilised since 2018. The steadying of house prices in 2018 reflected the expansion of supply in the preceding years and government policies to reduce investor demand, such as the increase in the purchase tax on second (or multiple) homes (BoI, 2019a). Housing sales and investment dropped significantly at the onset of the crisis. Since 2009, the authorities have taken extensive measures to reduce risks to financial stability from the real estate sector. This included higher capital provisions and risk weights for high-risk loans, limits to mortgage loan-to-value ratios (75%) and payment-to-income ratios (50%) and limits to the exposure to certain loans and sectors. The share of higher-risk mortgages with loan-to-value ratios from 60-75% edged up from around 30% to 37% of all new mortgages in 2019 but 67% of new mortgages had a payment-to-income ratio below 30%.

Sensitivity analysis carried out in mid-2020 suggest that in a scenario of medium severity the simulated credit losses would bring capital ratios of banks close to the regulatory minima but would not endanger the stability of the banking sector. The analysis also points to a particular sensitivity of banks’ capital ratios to credit losses in the household and small and mid-sized business segments (BoI, 2020). As recommended in previous Surveys, creating a deposit insurance system and a bank resolution framework would further enhance financial stability.

Figure 1.11. The banking sector appeared healthy before the crisis, but its exposure to real estate raises risks

Household debt has been growing fast over the past decade, but it remains low by international standards at slightly above 40% of GDP. Household debt increased quickly in recent years on the back of rising house prices, low interest rates and the enhanced supply of credit resulting from new financial institutions (Shami, 2019). Non-banks now account for around 20% of consumer credit, up from around 13% in 2014. Poorer households tend to use non-bank credit more than higher-income households and the share of household debt held by those in the lowest income quintiles has increased (Shami, 2019; BoI, 2019c). For example, the share of new mortgages provided to the two lowest quintiles has increased from around 20% to 30% between 2010 and 2017 (BoI, 2019c). While this eases credit constraints facing low-income households, the positive social implications could be offset by increased vulnerabilities in the financial system if these households have a permanently lower repayment ability. Shami (2019) shows that in 2016 the median debt–to-gross-annual-income ratio for those in the lowest income decile was 2.8 compared to less than one on average. Debt-to-income ratios are highest among the Haredim. The authorities should continue to monitor debt developments of low-income households and risks in the non-bank sector closely and ensure that there are no gaps in financial system oversight. The late-2018 establishment of the new Financial Stability Committee, comprising the Bank of Israel, the Ministry of Finance, the Securities Authority and the Capital Markets Insurance and Saving Authority, is a welcome step to foster oversight and enhance supervisory co-ordination.

Promoting an inclusive recovery while addressing fiscal challenges

In response to the COVID-19 crisis, fiscal policies have aimed to cushion income losses for the most vulnerable people and firms, provide liquidity to the business sector, and support the recovery (Box 1.5). The government’s initial aid package included spending and revenue measures amounting to around 4.5% of GDP. In addition, liquidity measures, such as loan guarantees and tax payment deferrals, were adopted, amounting to around 2.5% of GDP. The main measures included broadened eligibility to unemployment benefits (for example for furloughed workers), grants to firms that rehire (temporarily) laid-off workers and to the self-employed, direct payments to vulnerable groups such as the elderly and families with children, as well as a temporary reduction in property taxes and grants to small- and medium-sized businesses to cover fixed costs. Amid resurging infection rates and tightened confinement measures, the government approved the extension of some support measures until June 2021 in July, including unemployment benefits and grants for the self-employed and small and medium sized businesses, and the expansion of loan guarantees (Box 1.5). These measures will help reduce uncertainty. Budgetary costs are estimated at around 3.5% in 2020-21, if the economic situation does not improve significantly. In addition, the government approved further one-time cash payments for adults and families with children, excluding high-income earners (0.5% of GDP).

As in other OECD countries, the measures taken to respond to the crisis together with substantially lower tax revenues will lead to a surge in the budget deficit in the short-term in Israel and may raise public debt by around 25% of GDP by 2021.

Fiscal policy should remain supportive in the near term. The relatively low level of public debt before the crisis provides some fiscal space. In particular, fiscal policy should allow the automatic stabilisers to operate freely.

However, as the recovery progresses it will be important to shift policy from broad income and liquidity support to more targeted measures that facilitate efficient reallocation of capital and labour from sectors facing extended lower demand (e.g. travel, hospitality and part of the retail sector) to expanding sectors. In this respect, Israel has scope to step up active labour market policies, such as retraining and job search support (see below). As some emergency measures are phased out, there is also an opportunity to channel funds into areas that help boost growth and productivity and narrow Israel’s large socio-economic gaps. In particular, social and infrastructure expenditures remain internationally low, despite recent increases. (Figure 1.12, and below).

Box 1.5. Fiscal policy response to the COVID-19 shock

On 8 April parliament approved an initial package worth NIS 80 billion (5.6% of GDP) to increase the health capacity and shield households and firms from the impact of the crisis. On 2 June parliament approved an expansion of the package to NIS 100 billion (7% of GDP). Around NIS 65 billion are spending and revenue measures and NIS 35 billion liquidity measures. Main measures include:

Health and civic capacity: Around NIS 10 billion were allocated to the immediate health response including for increasing isolation capacity in hospitals and hotels, testing capacity, ventilators, medicine and protective gear. An additional NIS 1 billion was earmarked for measures to reduce the exposure of high-risk populations.
Individual support: Broadened eligibility to unemployment benefits including for people on unpaid leave and employees after employment of at least 6 instead of 12 months (NIS 15.4 billion); grants for the self-employed up to NIS 10 500 (NIS 3.8 billion); one time payments of NIS 500 to families for each child up to the fourth child, people receiving pensions, disability and income support (NIS 2.3 billion); grants of NIS 4000 for elderly employees (over 67 years) who were laid-off during the crisis (NIS 1.6 billion).
Firm support: Grants up to NIS 400 000 to small- and medium-sized businesses most affected by the crisis to cover fixed expenses such as rent and utilities (NIS 5.2 billion); the deferral of VAT, social security and utility payments for SMEs (NIS 9 billion); a 25% discount in local property taxes for firms that were shut down during the lockdown (NIS 2.7 billion); a NIS 22 billion loan fund with state guarantees for SMEs and a NIS 6 billion loan fund with state guarantees for large firms .
Recovery support: A package of measures including the acceleration of infrastructure investment projects (NIS 1.1 billion), financing support for SMEs in the high-tech sector (NIS 1.5 billion) and acceleration of the digitalisation of government services and distant learning (NIS 0.3 billion). A grant of NIS 7500 to firms for each employee they rehire from 1 June, paid in four monthly instalments if the employee is on the payroll (NIS 6 billion).

On 29 July the parliament approved a second aid package to extend the economic safety net to mid-2021. The budgetary cost is estimated at around NIS 50 billion (3.5% of GDP) in 2020-21. Additional liquidity measures amount to around NIS 30 billion (2.1% of GDP). Main measures include:

Individual support: Extension of unemployment benefits, including for people on furlough, until June 2021 or until the unemployment rate falls below 10% (broadly defined to include employed persons temporarily absent from work due to the coronavirus crisis). Unemployment benefits are reduced if the unemployment rate falls between 7.5% and 10%. Extension of monthly grants up to NIS 4000 to for people aged 67 and above until June 2021.
Firm support: Grants to self-employed and SMEs that were particularly hard-hit during the crisis until June 2021. Grants to small new businesses until June 2021. Extension of property tax reimbursement for small businesses particularly hard-hit by the crisis until June 2021. Expansion of the loan fund with state guarantees for SMEs by NIS 28 billion to 50 billion.

On 29 July the parliament also approved one one-off cash payments for adults and families with children, excluding high earners (NIS 6.7 billion, 0.5% of GDP).

In the medium-term, a key challenge will be to reduce the structural budget deficit while enhancing spending aimed at addressing Israel’s large socio-economic disparities and supporting productivity growth. The fiscal position started to weaken prior to the crisis. Despite robust growth and near full employment, the general government budget deficit increased markedly from 0.9% of GDP in 2015 to around 4% of GDP in 2019. Abstracting from cyclical and one-off effects, the estimated structural general government budget deficit has been continuously deteriorating since 2015, cumulatively by 3.4 percentage points, as strong increases in expenditure coincided with the lowering of some tax rates (e.g. VAT and corporate income). The extra spending was largely allocated to boost civilian expenditure, especially welfare, education, health care and infrastructure investment. Extra spending in these areas is welcome, as it is likely to help narrow Israel’s large socio-economic gaps and help foster productivity growth. To enable continued spending in these areas while reducing the structural deficit will require sustainably increasing tax revenues and further efforts to improve spending efficiency.

Figure 1.12. Public spending in some areas is still low

Long-run debt sustainability will depend on the capacity to continue integrating Israel’s young and growing population into the labour market, especially the Haredim and Arab-Israelis whose combined share in the total working-age population will increase to a projected 50% by 2065. The increase in deficits incurred in response to the coronavirus response will add to the debt stock. In a baseline scenario that assumes some reduction in the primary deficit over the next decade due to the cyclical normalisation and the phasing out of temporary crisis measures as well as a continuation of pre-crisis trends of labour market integration of vulnerable groups, debt would stabilise at around 100% of GDP in the medium term (Figure 1.13, Baseline scenario). Such a debt level would make fiscal sustainability more vulnerable to interest rate shocks and significantly reduce fiscal space if another shock hits the economy. Implementing a reform programme as suggested in this Survey (Box 1.6) would boost growth, speed up labour market integration and help put the debt on downward path (Figure 1.13, Reform scenario). A halt in the progress of labour market integration of the Haredim and Arab-Israelis would seriously curb tax revenues and raise social spending (e.g. on unemployment benefits or welfare), and the debt trajectory would become unsustainable (Figure 1.13, Adverse scenario).

Figure 1.13. Illustrative debt paths

General government debt, as a percentage of GDP

Enhancing the fiscal framework

The government operates a solid fiscal framework including spending and multi-year budget-deficit targets, which has helped bring down debt in the past. Currently, the annual real spending-growth ceiling is set at 2.8%, and the central government deficit targets are 2.5% and 2.25% of GDP in 2020 and 2021. These targets should be lifted in the near-term to avoid an overly contractionary fiscal policy stance that may endanger the recovery. At the same time a clear medium-term fiscal strategy should be formulated to bring debt back on a declining path while ensuring adequate resources for infrastructure, education and poverty reduction.

The government has recently strengthened its medium-term fiscal framework. The so-called “numerator rule" came into effect in 2017; it restricts fiscal commitments outside of the budgetary process that are not in line with the fiscal rules. According to the rule, any new commitment with future budgetary implications must fall within the deficit and expenditure ceilings for the next three years or immediate adjustments must be made by cutting other expenditures or raising revenues. The government publishes this three-year budgetary plan twice a year. The new tool enhances transparency and improves medium-term fiscal planning.

However, the government has at times resorted to measures to circumvent fiscal rules (BoI, 2018). For instance, expenditure programmes with essentially long-term fiscal implications, such as the “Net Family” programme (see Box 1.2), have been classified as temporary, one-year measures so that the requirements of the “numerator” do not apply. In addition, accounting practices have been used to keep expenditures and their funding outside the budget framework, including land sales to fund housing projects. Finally, alongside the 2019 budget the government also committed to future across-the-board budget cuts to fund future expenditure obligations while deferring decisions on which projects to eliminate (BoI, 2018). Across-the-board cuts carry the risk that they focus on easier-to-cut but potentially productivity-enhancing discretionary spending such as infrastructure projects.

To strengthen compliance with the fiscal rules, the government could consider in the long term setting up an independent fiscal council. This would enhance the authorities’ commitment to sound fiscal policy. Empirical evidence from other OECD countries suggests that independent fiscal councils can buttress a government’s capacity to comply with numerical rules (Hagemann, 2011). The majority of OECD countries have established an independent fiscal council. Over the past decade, the number of fiscal councils in the OECD has more than tripled. It is also important that all tax policy reforms and legislation be carefully assessed in close cooperation between the Ministry of Finance’s Chief Economist department, which is responsible for shaping, initiating and evaluating tax policy, and the tax authority, which is in charge of tax collection, initiating and implementing tax policy, as well as proposing tax reforms. This is key to ensure that their impact is appraised both in terms of revenue, macroeconomic and social impacts and from an operational point of view, as is required for a sound and evidence-based decision-making process.

Tax reform to enhance equity and efficiency

The overall tax burden, at 31% of GDP, is somewhat below the OECD average (34%). Israel’s tax mix is reasonably growth- and employment-friendly, but there is ample room to simplify the tax system by removing inefficient tax expenditures and broadening tax bases (Chapter 3, Table 1.5).

In particular, differences in tax rates across saving vehicles are large and distort saving decisions. For example, tax benefits for medium-term savings in “advanced training funds” should be reduced, as these funds are generally not used for training purposes. Reducing these benefits should take into account effects on saving and work decisions of higher-income earners, who are the main beneficiaries of these tax exemptions. Moreover, tax and reporting exemptions for landlords’ rental income below NIS 5100 per month should be removed to help tackle tax evasion on such income, which seems particularly high. This should be combined with steps to minimise the administrative burden associated with paying and enforcing taxes. Extra revenues could be partially used to lower purchase taxes on residential property, which may hamper household mobility. Furthermore, the local property tax in Israel suffers from several deficiencies, which create distortions, and should be reformed as discussed below.

Once the economy has fully recovered, the government should also strive to eliminate VAT exemptions to improve efficiency and generate extra revenues that can be used to finance the inclusive growth-enhancing reforms recommended in this Survey (Box 1.6). This includes the VAT exemption threshold on online purchases, and exemptions on tourism services (including in Eilat) and on fruits and vegetables. To offset potentially regressive effects, existing more targeted transfers could be increased. Removing still high tariffs on certain fruits and vegetables along with other tariffs on agricultural products would help offset price increases (see below). If necessary, the government could also consider raising the VAT rate to generate additional revenue. Taxes on consumption are generally less distortive (e.g. Arnold et al. 2011). Increasing the VAT rate by 1 percentage point to 18% could raise additional revenues of around NIS 5.5 billion (0.4% of GDP), similar to the revenue gain from abolishing VAT exemptions. However, raising VAT revenues through base broadening instead of rate increases tends to be more growth-friendly (Acosta-Ormaechea and Morozumi, 2019).

There is also room to adjust environmental taxes to improve environmental outcomes. Introducing congestion charges would help better reflect the external costs of car use such as congestion, air pollution, accidents, noise and infrastructure cost. Revenues from congestion charges could be used to enhance the public transport infrastructure. Their introduction should be accompanied by improvements in the quality of existing transport services and by allowing municipalities to set higher parking fees. In addition, coal and natural gas are taxed very lightly (Chapter 3). The excise tax on wholesale primary fuels (heavy oil, natural gas and coal) should be gradually increased or a carbon tax introduced to better reflect externalities. This would lower CO₂emissions in a cost-minimising way, make renewable energy generation more competitive and help to further reduce air pollution. Part of the extra revenues from higher carbon taxation could be used to avoid real income losses, in particular of low-income households. For example, in British Columbia in Canada part of the carbon tax revenues were used for lump-sum transfers to households and cuts in other taxes.

Box 1.6. Quantifying the impact of selected policy recommendations

Table 1.4 presents estimates of the fiscal effects of the suggested reform package. The quantification is merely indicative and does not allow for behavioural responses.

In the short run, the government should continue to provide adequate fiscal support. Once the recovery strengthens and uncertainty is reduced, the government should gradually reduce budget deficits by ensuring that temporary crisis schemes, such as liquidity support measures and expanded unemployment insurance, are phased out.

In the medium to long term, additional fiscal resources are needed to finance the recommended reform package while safeguarding fiscal sustainability. The reform package focuses on three main areas: (i) education and labour policies; (ii) business regulation; and (iii) infrastructure. This could be funded by additional increases in tax revenues and by savings in the pension system. In addition, the reform package generates extra public revenues associated with the estimated expansion of GDP and employment.

	2030, % of 2019 GDP
Costs of reforms	-1.6
Strengthening education, active labour market policies and in-work benefits	-1.1
Improving business regulation	0
Enhancing infrastructure	-0.6
Raising pension age of women to the level of men	0.1
Revenue measures	1.0
Reducing tax inefficiencies	0.6
Environmental taxation	0.4
Revenue gain from recommended reform package	0.6

Note: 1) Education and labour market policies: (i) increase in spending of pre-school education to the OECD average to close half of the gap vis-à-vis the OECD countries in spending per child under the age of 5 as a share of GDP per capita (0.4% of GDP); (ii) increase in spending in primary and secondary schools to close quarter of the gap vis-à-vis the OECD countries in spending per student as a share of GDP per capita (0.3% of GDP); (iii) increase spending on active labour market programmes to the OECD average in terms of spending per unemployed as a share of GDP per capita (0.2% of GDP); (iv) increase in spending on in-work benefits to the level of US (0.2% of GDP).

2) Improving business regulation: improvement of PMR indicator to the level of the five best performing countries.

3) Enhancing infrastructure: increase in public infrastructure investment needed to lift infrastructure capital stock relative to GDP to the average level in the OECD.

4) Reducing tax inefficiencies: (i) abolishing VAT exemptions (0.4% of GDP) (ii) reducing tax benefits on medium-term savings (Keren Hishtalmut) (0.2% of GDP)

5) Environmental taxation: (i) NIS100 per tonne tax on coal (0.1% of GDP); (ii) phasing out diesel tax rebates for selected users (0.2% of GDP), introducing congestion charges and higher parking fees (0.1% of GDP).

6) Impact of reforms: The reforms will increase GDP by 0.4 p.p. annually and employment rates by 1.2 percentage points by 2030. The change in employment rates would translate into a 0.6 percentage point improvement in the primary budget balance (a 1% change in employment rates is estimated to improve the primary balance by around 0.5 point (OECD, 2010)).

Figure 1.14 quantifies the impact on growth of the aforementioned reform package. Its main effects will materialise over the medium-term horizon. Introducing ambitious reforms can improve the standard of living of the average Israeli citizen by some 15% by 2050 (Panel A) and will help reduce the gap in living standards vis-à-vis the upper half of the OECD countries (Panel B).

Figure 1.14. Illustrative impact of structural reforms on GDP growth

Recommendations in previous *Survey*	Actions taken since March 2018
Raise the spending-growth ceiling to make room for higher expenditure on education, infrastructure and poverty reduction	The 2019 budget included an increase in the expenditure ceiling as well as higher social and infrastructure spending.
Abolish inefficient tax preferences on fresh fruits and vegetables, medium-term saving in so-called “advanced training funds” and services in Eilat.	No action taken.
Raise more revenue by taxing carbon in the form of fossil fuels. Shift car taxes substantially from ownership to vehicle use to reduce pollution.	A planned excise hike on coal from NIS 45 to NIS 102 (USD 30) in 2018 was postponed to 2021. A gradual phasing out of diesel rebates for trucks, taxis and buses over 8 years started in 2018. The effective vehicle purchase tax rate was increased in 2018 and 2019.
Further exploit available databases to improve tax collection. Pursue plans to reduce tax compliance costs for business by simplifying the tax code so as to reduce the number of payments required.	An electronic system for filing and paying value added tax and social security contributions was introduced, which helped reduce the number of tax payments.

Strengthening public sector efficiency

There is scope to raise public sector efficiency and achieve savings on the expenditure side. For instance, the government should better leverage its impressive technological capacity by promoting the digitalisation of the government and e-government services. Relatively few Israelis interact with public authorities online (Figure 1.15). Providing public services digitally can raise public-sector productivity and boost private-sector adoption of digital technologies (Andrews et al., 2018).

Figure 1.15. Online interaction with public authorities is low

Individuals who used the internet to interact with public authorities, as a percentage of population, 2018

In addition, savings can be achieved by raising the retirement age of women to that of men. The normal retirement age for women is 62 years compared to 67 years for men. Israel is one of only a few OECD countries that currently does not have legislation to close this gender gap in the future, implying one of the lowest retirement ages for women in the OECD in the future. In 2016 a public committee comprised of representatives from the government, employers, employees and civil society, recommended to gradually raise the retirement age of women. This recommendation has recently evolved into a legislative proposal. Raising women’s retirement age would strengthen incentives to stay in the labour force, boost women’s pension income and reduce budgetary pressures.

Better transparency and a lower level of corruption are key to boosting public-sector efficiency. Corruption is costly because it diverts public resources available to support productivity. Indeed, OECD research shows that high levels of perceived corruption are associated with lower spending on social services, including health and education (OECD, 2015a; OECD, 2018a). In addition, corruption can impose additional adverse effects on the income distribution.

The perception of corruption in Israel is slightly worse than in other OECD countries (Figure 1.16). Opinion surveys show that Israeli citizens are concerned about corruption and that about 40% of respondents have personally encountered it (Herman et al., 2018; SGI, 2018).

Israel’s anti-corruption policy framework is relatively effective (Figure 1.17). A legal and ethical framework to guide civil servants and the courts has already been established. Israel has also fully implemented a number of recommendations of the OECD Working Group on Bribery related to the detection, investigation and prosecution of foreign bribery (OECD, 2017a). For example, it has designated the Tel Aviv Taxation and Economic District to handle foreign bribery prosecutions. The authorities have also fostered better detection of allegations through media sources and the anti-money laundering authority (OECD, 2017a).

Figure 1.16. Perception of corruption is slightly higher than in other OECD countries

Despite progress, Israel should step up its efforts to prevent corruption, particularly in the area of public procurement. More competition in public tenders would promote efficiency, lower prices, improve quality and increase innovation. In 2013 Israel undertook procurement reforms to streamline and standardise tender procedures, introduce centralised e-procurement and encourage staff professionalisation. However, still only about one-fourth of total public procurement at the central government level is processed in accordance with the programme (IMF, 2017). There are also a relatively large number of exemptions for selective public tendering (IDA, 2015).

In order to enhance its anti-corruption framework, the government should limit exceptions to competitive tendering. At the same time it could create a register of companies with criminal records. This would help procurers to verify potential suppliers electronically. For example, Germany recently introduced such a competition register, which enables contracting authorities to obtain information online, helping them to prevent and fight economic crimes more efficiently (OECD, 2019a). In this regard, Israel has still not adopted an express policy permitting procurement authorities to deny contracts on the basis of foreign bribery convictions. Hence, companies found guilty of foreign bribery can still participate in future tenders (OECD, 2017a). The government should also allot a period of time to submit a bid that is proportionate to the size and complexity of the tender. This is particularly important in technically complex projects where it may take time to develop more accurate cost estimates. Other OECD countries adjust their bidding periods more flexibly than does Israel (OECD, 2018c). These efforts to strengthen the anticorruption framework should be accompanied by measures to streamline the regulatory burden and reduce bureaucracy (see below).

Figure 1.17. The policy framework to detect corruption is relatively effective

Boosting productivity to make growth work for all

Israel’s productivity convergence with the most advanced countries remains slow. As a result of the COVID-19 crisis weakened consumer demand and heightened uncertainty will depress business investment, which is likely to weaken productivity growth. Looking beneath the aggregate trend shows a stark heterogeneity across sectors (Figure 1.18). Productivity levels in high-tech sectors such as information and communication services, scientific research and development, and computer and electronics manufacturing are higher than on average in the OECD. In contrast, more traditional sectors, including wholesale trade, construction, transportation, accommodation and food, account for most of the productivity shortfall. The COVID-19 crisis may further exacerbate this disparity as the high-tech sectors were less affected and better able to cope with the crisis. In order to boost aggregate productivity barriers that hinder the high-tech sectors’ expansion, mainly skills shortages, need to be removed (Chapter 2). At the same time, it is equally important to lift the productivity of the long tail of poorly performing sectors, which employ the majority of the workforce.

The productivity gaps between sectors are closely intertwined with the broader social gaps in Israel. The Haredim and Arab-Israelis often work in low-productivity sectors with low wages. Therefore, policies that boost lagging sectors' productivity and help low skilled workers to move to higher productivity, high-tech jobs are win-win opportunities to tackle the twin challenges of low productivity and widespread poverty.

The slow productivity convergence reflects longstanding weaknesses in educational outcomes, a lack of infrastructure investment and barriers to competition but the crisis will bring new challenges related to the likely surge in business insolvencies. Effective insolvency procedures will be crucial to minimise barriers to corporate restructuring and spur productivity-enhancing capital reallocation (OECD, 2020; Adalet McGowan et al., 2017). Israel’s insolvency framework appears to work effectively (Adalet McGowan and Andrews, 2018; World Bank, 2019) and a recent reform may further improve the framework. In September 2019, a new insolvency law came into force, aiming to promote the debtor’s financial rehabilitation; maximise the return to creditors; increase the certainty and stability of the law, and shorten procedures and reduce the bureaucratic burden, including by strengthening out-of-court procedures.

Figure 1.18. Relative labour productivity varies widely across sectors

The government should continue to focus on closing the education gap

Improving the skills of the workforce is fundamental to boosting productivity and to enhancing opportunities in the labour market during the crisis recovery. As the COVID-19 pandemic has shown once again, the low-skilled are often the first to lose their job in a crisis. The skills of Israel’s adult population, as measured by PIAAC, are relatively weak in international comparison (OECD, 2018b). Moreover, there is a wide variation, as some Israelis have outstanding skills, while a large number are comparatively low-skilled (Figure 1.19, Panel A). This contributes to severe labour market duality, with high-wage jobs in the highly productive high-tech sector and low-quality, low-wage jobs in low-productivity, often non-tradable sectors. The share of high-tech employees in total employment has been hovering around 9% since the mid-2000s, because of significant skills shortages, as more than 15% of all job openings in high-tech sectors go unfilled. Empirical evidence suggests that fewer and fewer low-skilled people are finding jobs in high-tech industries (Brand and Regev, 2015). More worryingly, low-skilled adults are concentrated among the Haredi and Arab-Israeli populations (Panel B), which contributes significantly to Israel's socio-economic divide.

Improving educational outcomes of these groups, as highlighted in the 2018 Survey, is therefore crucial for the expansion of the high-tech sectors or productivity catch-up of lagging sectors in order to reduce significant income disparities. The government is aware of the problem and has been increasing education funding significantly in the last couple of years (Table 1.6). There are also some signs of improving participation among Arab-Israelis. For example, Arab-Israeli women have greatly boosted their average educational attainment, and many now study in science tracks (Blass, 2017). Nevertheless, international assessments of Israeli 15 year-olds’ outcomes (PISA) show significant differences among youth as low-performing students are clustered in certain schools to a greater extent than in other OECD countries (OECD, 2019b). The government should therefore continue with its efforts to upgrade education, focussing in particular on: (i) enhancing the quality of pre-school education; (ii) reducing the differences between different streams; and (iii) improving teacher quality.

Moreover the government should prepare for possible continuous disruptions of school and university attendance due to renewed outbreaks of the virus. Every week of school closure will imply a substantive loss in the development of human capital with significant long-term economic and social implications. Contingency plans should include training for teachers and school principals to work remotely, the deployment of online classes at scale and the setting and training of task forces of counsellors and teachers to support parents and students (OECD, 2020c).

Additional funding to build new childcare capacity and improving its quality, particularly in lagging regions, is needed. Empirical evidence suggests that participation in high-quality early childhood education and care can significantly improve children's development (OECD, 2018b). The number of children enrolled in public pre-schools and afternoon programmes has increased since 2012-13 when Israel introduced compulsory education from the age of 3-4. However, one-fifth of Arab-Israeli children in that age group still do not participate. In addition, the implementation of compulsory pre-school education for 3-4 year-olds has led to over-crowded classrooms and poor quality. Moreover, access to daycare centres for children aged 0-3 is still limited (Shavit et al., 2018). Although funding on new daycare centres has increased in recent years (Table 1.6), they are still lacking in the poorer municipalities. Pre-school funding per child is only around half the level of the average OECD country (Figure 1.20).

Figure 1.19. The dispersion in skills is the highest in the OECD

Recommendations in previous *Survey*	Actions taken since March 2018
Increase funding for disadvantaged schools. Increase salaries of young teachers, those teaching subjects where there are labour market shortages and those who teach in disadvantaged schools.	Education funding has significantly increased. In March 2018 an agreement was signed with the teachers' unions, and wages for the starting teachers increased, narrowing the large gap between starting and senior teachers.
Further expand Hebrew courses in the Arab stream.	No action taken.
Expand childcare and education for children under 3, and put it under the responsibility of the Ministry of Education.	Spending on new daycare centres increased in recent years from NIS 200 million in 2015 to almost NIS 350 million
Make funding to the Haredi stream conditional on an increase in core subjects in the curriculum, and strengthened monitoring and testing.	No action taken.
Introduce graduate tracking, and publish high-quality data and analysis about their labour market outcomes.	Financial aid has increased for tech-related studies whose graduates are in short supply in the labour market. Tertiary institutions receive on average NIS 45 000 ($13 000) for each student enrolled in an engineering or computer science programme.

Figure 1.20. Public spending on early childhood education and care per child is low

Expenditure per child aged 0-5, 2015¹

The government should also reduce the differences between individual educational streams as much as possible so as to raise quality and enhance social cohesion. Primary and secondary schools are divided into four systems: secular Jewish, religious Jewish, Haredi and the Arabic-speaking stream. Secular and religious Hebrew-speaking schools offer a state-education curriculum in Hebrew, which is set by the Ministry of Education. Haredi schools offer state-religious education in Hebrew, but greater attention is devoted to religion studies. As a result, many Haredi men often lack basic skills, notably in mathematics and English. Lastly, Arab schools offer the state curriculum in Arabic. As argued in the 2018 Survey this streaming exacerbates differences in outcomes (OECD, 2018b).

One way forward is to promote pathways between the Arabic- and Hebrew-speaking streams. Offering additional Hebrew courses in the Arab stream is important, since poor command of Hebrew prevents the Arab population from fully integrating into the Israeli labour market (Marom, 2015). Empirical evidence suggests that pilot programmes, which encouraged Jewish teachers to teach Hebrew and other subjects in Arab schools and vice versa, proved to be effective (Schneider, 2016; Chapter 2). Most importantly, the government should promote teaching English, maths, sciences and other secular subjects in Haredi schools to allow their graduates to more easily integrate into the labour market. As was stressed in previous Surveys (OECD, 2018b; OECD, 2016), the teaching of core subjects in Haredi schools should be strengthened.

The government should also strengthen efforts to enhance skills of adults who have already left the education system without proper skills. Work-based vocational programmes targeted at Haredi adult men could help alleviate skills shortages among this group. International experience suggests that for adults, diverse work-based learning measures, including apprenticeships, may help to integrate disadvantaged social groups into the labour market (Kuczera et al., 2018).

Today, there are relatively few options in Israel for those who do not obtain proper formal education to acquire relevant skills for the labour market. The existing vocational counselling centres for Ultra-Orthodox men and women tend to focus merely on finding jobs for their clients. This is welcome, but there is a need to expand post-secondary vocational programme centres for adults that enhance skills relevant for the labour market. Their organisers should closely cooperate with local employers who should be involved in the governance structures and the development of programme design and student assessment. These programmes should include work-based learning (e.g. apprenticeships) in companies. Apprenticeships in Germany and Switzerland have traditionally focused on young people, but in recent years both countries have begun to encourage adult learners to pursue apprenticeships, with financial incentives and other support measures such as tutoring (Kuczera et al., 2018).

The government should ensure high-quality teaching in disadvantaged schools. To attract good teachers to such schools some OECD countries supplement generous financial incentives with other measures such as smaller classes or more teaching assistants (OECD, 2014; OECD, 2012). Wage rises should be accompanied by measures that promote better teaching methods. The government should strengthen professional development programmes, where teachers receive relevant training together with regular feedback under the mentorship of a lead teacher. Empirical research confirms that these programmes can significantly improve teaching quality (OECD, 2009; Fryer, 2016).

The government should also seek to ensure that the education system aligns student qualifications with labour market needs, particularly today when digitalisation is transforming the way many jobs are carried out. High-level ICT skills are becoming increasingly important as more and more occupations are linked to new technologies. The coronavirus crisis may further accelerate this process. The government is strengthening its programmes to boost the number of students in tech-related studies with extra financial aid for tertiary institutions and students. Over the past decade the number of computer science students has soared by 84%, while those studying the social sciences and law has fallen some 20%. In 2018 engineering became the most widely studied major in Israel. In addition, the Ministry of Education has succeeded in recent years in increasing the share of high school students studying math and English at the highest level (from 12% to 19%).

These are steps in the right direction, allowing Israel to make significant progress in improving digital skills. To strengthen these efforts, Israel should also improve teachers’ digital skills and increase the use of ICT in schools (Figure 1.21). In addition, as was suggested in the 2018 Survey, the authorities should make available high-quality data and analysis about graduate labour market outcomes. Information on market returns from particular universities and colleges would help students to better respond to labour market signals. Collecting and publishing information about skills needs is considered good practice to align students’ choices with labour market needs (OECD, 2018b; OECD, 2016).

Fostering competition by improving business regulation

Lowering barriers that protect markets and promoting best-practice regulation are essential to foster investment and innovation, and spur the adoption of digital technologies (Sorbe et al., 2019; Andrews et al., 2018). In the wake of the coronavirus shock, fostering competition is likely to be important by supporting the entry of new firms and preventing the loss of existing viable firms, which may give rise to anti-competitive behaviour by the remaining incumbents. As highlighted in the 2016 Survey (OECD, 2016), low-productivity sectors in Israel are often sheltered from domestic and international competition (Brand, 2018a). Investment rates in these sectors lag behind those in the average OECD country (BoI, 2014; BoI, 2019d), hampering their ability to adopt new technologies.

Israel continues to make progress in improving the business environment, but regulations in a number of areas are more restrictive than in other OECD countries. An inter-ministerial committee was established to reduce the regulatory burden on businesses. For example, as part of these efforts, tax compliance costs for businesses were recently significantly reduced (Chapter 3). However, according to the latest OECD Product Market Regulation (PMR) indicators, Israel’s involvement in business operations, mainly due to still widespread price regulations and deficiencies in public procurement (see above), and its barriers to trade and investment remain high (Figure 1.22). Barriers to competition also persist in key sectors such as electricity, transport (see below) and e-communications. There is also at least one major state-owned enterprise in broadcasting, courier services, rail freight transport and logistics. The recently approved electricity market reform will reduce barriers and foster competition in electricity generation in the short to medium term.

Figure 1.21. There is substantial room to improve digital skills

There is room to reduce the regulatory burden and improve regulatory certainty for business. Two reforms in 2012 and 2018, which aimed at standardising regulatory requirements and simplifying procedures for licensing, have not been fully implemented. The bureaucratic costs of environmental licensing could also be cut if the currently fragmented approach were streamlined in an integrated procedure (OECD, 2016b; Eshet and Karni, 2016). More generally, Israel could introduce a “silence-is-consent” rule to business licensing when appropriate, as in Portugal. Since 2016, conducting Regulatory Impact Assessments is obligatory for all legislative proposals initiated by the executive, but not for the over 40% of laws initiated by members of the parliament (OECD, 2018d). Inter-ministerial coordination in the planning process of regulations should also be strengthened.

Figure 1.22. There is scope to improve product market regulations

Israel has made significant progress in boosting foreign competition (Table 1.7). The government has continued to open the economy including by further cutting tariffs and by signing new (with Ukraine) or expanding existing free trade agreements (with Canada, EFTA countries). It has also continued to reduce non-tariff barriers such as by aligning import standards with international norms, removing special import licenses for certain products and easing barriers for personal imports of goods over the Internet. Still, the country’s foreign trade exposure is relatively low compared to other small OECD economies, with the sum of exports and imports as a share of GDP at around 60%.

Recommendations in previous *Survey*	Actions taken since March 2018
Use high-quality regulatory impact assessments based on a whole-of-government approach to cut the regulatory burden.	A government committee to address this issue was set up and is expected to release its recommendations in 2020.
Further cut customs tariffs and non tariff barriers.	Tariff cuts have continued, including on textiles and electronic/electrical equipment. A committee is reviewing all import standards and reducing differences from international standards. The operation of private laboratories that test compliance with standards has been eased, special import licences for certain products (e.g. wireless communication equipment, cosmetics) removed and regulatory barriers for personal imports of goods over the Internet lowered.
Replace agricultural quotas and tariffs with direct transfers to farmers.	In October 2018 the government and the dairy farmers signed an agreement that includes a gradual reduction of tariffs on dairy products and direct transfers to the farmers. Legislation of the reform is pending.
Adopt EU or similar standards for sensitive agricultural goods.	The number of goods classified as sensitive has been reduced.

More room exists to reduce Israel’s restrictions on foreign suppliers of goods and services (Figure 1.23, Panels B and C). General and sector-specific restrictions act as a brake on the entry of foreign workers into Israel and discourage foreign services companies from opening operations there. Restrictions are particularly constraining in the construction, postal and courier, rail freight and telecoms sectors. Moreover, residence requirements still exist for the board of directors of Israeli corporations and for land acquisitions, and preferences are granted to local suppliers in procurement markets. Furthermore, Israel applies strict labour market tests for natural persons seeking to provide services in the country on a temporary basis (OECD, 2019c). The country has made some recent progress by easing foreign ownership of terrestrial broadcasting companies and by putting in place a temporary licensing procedure for foreign architects and engineers.

Figure 1.23. Barriers to foreign trade and investment are high

There is also still much scope to facilitate trade procedures at the border. For example, according to World Bank (2019) data, it takes importers 64 hours to comply with border procedures, compared to an average of only 8.5 hours in high-income OECD countries. Particular areas for improvement include cross-border agency co-operation and providing traders greater certainty about customs requirements by updating advance ruling systems, for instance by increasing the length of time for which such rulings are valid. In addition, further progress is desirable to streamline formalities by promoting the use of electronic signatures and allowing goods, in particular perishable goods, to be released prior to the final determination and payment of customs duties (OECD, 2018b). These trade facilitation measures will especially benefit smaller firms, as costs related to border procedures are particularly onerous for them (López-González and Sorescu, 2019). Israel’s new computerized customs system (“Global Gate System”), implemented in January 2018, should help improve efficiency of customs clearance.

Tariffs and regulations remain particularly distorting in the agricultural sector (OECD, 2019d). Despite reforms that began in 2014, Israel’s tariff profile for agricultural products remains highly uneven, with very high – sometimes prohibitive – tariffs for goods such as dairy products, eggs and certain fruits and vegetables. Israel’s average applied MFN tariff on agricultural goods (WTO definition) declined from 27.7% in 2012 to 19.1% in 2018 but remains much higher than the average for non-agricultural goods (WTO, 2018).

Onerous non-tariff barriers also persist for certain products, potentially limiting foreign supplies. Israel requires imports of beef, poultry and sheep meat to be certified as kosher, while other non-kosher agro-food products are rarely accepted by local marketing channels. The kosher certification system for businesses could be improved to reduce its restrictive impact on prices and competition. The system lacks transparency, the direct financial ties between supervisors and the firms they oversee generate conflicts of interest, and there is a need to better meet the various levels of certification required by consumers and businesses. The authorities have recognised a need to address these issues and to rationalise the government monopoly on kosher certification (Bennett, 2014). However, they could also consider reducing the role of the State in kosher certification and allow private systems organised by religious organisations, as is the case in the United States (Lytton and Talias, 2014), and regulating the system of supervisors (Philber, 2018).

The authorities signed a welcome agreement with farmers in October 2018 to undertake a comprehensive reform of the dairy sector. The outline of the reform includes a reduction of target prices, further cuts in customs tariffs, support for farmers leaving dairy production and subsidies for increasing production efficiency. The agricultural reform process should continue with the replacement of quotas, price guarantees and customs tariffs by direct payments to farmers to avoid distorting markets. The tariff system for agriculture should also be simplified by avoiding non-ad-valorem tariffs (OECD, 2019d). As recommended in the 2016 Survey, EU or similar health rules with ex post verification could be adopted for “sensitive” products, such as dairy, eggs and meat, which represent over half of all imported foodstuffs.

Improving infrastructure and its governance

Well-functioning infrastructure is crucial to increase productivity growth and can help facilitate the recovery by speeding up the transition to new and more productive jobs. The benefits of efficient spending on infrastructure go well beyond their contribution to capital accumulation. Good infrastructure facilitates trade, bolsters market integration and competition and fosters the dissemination of ideas and innovations. For Israel, the potential benefits of improving infrastructure have been estimated at about 6% of GDP by 2065 (Argov and Tsur, 2019). Moreover, connecting disadvantaged groups to job opportunities and public services can reduce income inequalities and foster inclusive growth (Chapter 2).

Israel's transportation infrastructure lags significantly behind most other OECD countries', as discussed in detail in the previous Survey (OECD, 2018b). Its current level has not been able to meet the demand from the expanding economy. Population and employment have been growing at a robust pace with sharp increases in the number of vehicles per population (by more than 50% since 1998). On the other hand, investment in roads and public transport as a share of GDP has remained relatively stable over the course of the past two decades, and the core infrastructure stock is well below the OECD average (Figure 1.24). As a result, road congestion is one of the worst in the OECD. Tel Aviv is now the fourth most congested city in the OECD (TomTom, 2019), with negative consequences for productivity and well-being. The commuting time required to travel to work outside one's residential locality has increased by one-third since 2005 (BoI, 2017).

Figure 1.24. Israel’s current core infrastructure stock lags significantly behind other countries’

Total core infrastructure stock, 2015 (per cent of GDP)

The government therefore needs to increase its investment in infrastructure, especially in public transport. Investment in public transit has increased in recent years due to large-scale infrastructure projects, such as the Tel Aviv–Jerusalem rail line and the red light rail line in Tel Aviv (Table 1.8). Yet, the infrastructure gap remains substantial.

The government should introduce congestion charges, which can help finance public transport, reduce congestion and improve air quality and public health. Road traffic intensity, measured by vehicle-kilometres driven per kilometre of road network, is much higher than in other OECD countries (Figure 1.25). Several other OECD countries have introduced congestion charges, while improving public transport at the same time. For example, in Milan and London revenues from congestion charges fund public transport improvements including higher bus frequency, long-term measures, such as extensions of the subway network, and measures to promote sustainable mobility services (OECD, 2019e). Israel should introduce congestion charges in Tel Aviv, where around 60% of the countrywide congestion costs are estimated to occur and adopt GPS-based monitoring technologies, which are likely to substantially increase efficiency by adding a large degree of pricing flexibility (OECD, 2019e).

Recommendations in previous *Survey*	Actions taken since March 2018
Raise budgetary resources for infrastructure. Use public-private partnership agreements, especially in public transport, following a careful and clear allocation of their risks.	Investment in public transit has increased in recent years due to large-scale infrastructure projects, such as the Tel Aviv–Jerusalem rail line and the red line of the Tel Aviv light rail. As part of the Ministry of Transportation’s “Hanetivim Hamehirim" project, private companies operate shuttles between central parking lots and central business districts, funded by toll roads and fees.
Promote road tolls and electricity smart meters to foster user funding of infrastructure	New major road and tunnel toll projects and 4 light rail train projects were launched in 2019.
Introduce systematic publication of cost-benefit analyses of projects with mandatory justification of policy-makers’ choices.	The Ministry of Energy publishes cost-benefit analyses and plans to publish a methodological guide for cost-benefit analyses in the energy sector next year.
Promote a more efficient use of infrastructure by enhancing its regulation. Introduce, in particular, competition in airport management.	No action taken.

Figure 1.25. Traffic intensity is significant in Israel

Road traffic intensity per network length, 1000 vehicle-km driven/km, 2014 or latest year available

Some infrastructure projects can be financed through public-private partnerships (PPPs), as was suggested in the previous Survey (OECD, 2018b). However, PPPs can entail risks for public finances, as they lead to contingent public liabilities. To limit these risks the management procedures for PPPs should be closely aligned with best practices based on international and domestic experience, for example by entrusting the supervision and management of these contracts to a single public agency (OECD, 2018b). The United Kingdom has a well-established system of PPPs. In order to keep the process transparent, the private sector is required to provide information on actual and expected equity returns. An additional step would be to publish quantitative assessments comparing the value for money offered by PPPs relative to alternative procurement mechanisms, in line with the OECD Principles for Public Governance of PPPs (Pisu et al, 2015; OECD, 2014). In general, improving infrastructure governance and regulation to the level of the best OECD performers could bring sizeable productivity gains (Figure 1.26).

In addition, coordination between central government and local authorities should be improved (Figure 1.27). Large projects require the consent of local authorities in the jurisdiction where the project takes place. This often leads to lengthy negotiations that slow project advancement, especially since the local authorities are focussed on their own needs. Empirical evidence suggests that a lack of coordination severely limits the gains from infrastructure investment (Demmou and Franco, 2020).

The government could establish metropolitan transit authorities, which can help promote transit solutions in line with national and local needs. Experience from other OECD countries shows that better coordination of transit management in metropolitan areas can contribute significantly to higher growth and well-being (OECD, 2015b). This would require transferring some of the responsibilities and funding assigned to lower levels of local government to the new metropolitan institutions, which have authority over strategic planning and responsibility for integrated land-use and transport planning (Chapter 2).

Figure 1.26. Israel can gain significantly from improvements in infrastructure governance

Productivity gains from raising infrastructure governance standards to those of the best performing country, in %

Figure 1.27. Coordination in infrastructure governance across levels of governments is weak

Infrastructure governance, coordination index (lower index = weaker coordination)

Fostering competition in public transport would lead to efficiency gains. Israel's product market regulation in transport is stricter than other countries’. Regulations in the rail sector are among the most restrictive in the OECD. The statutory state-owned monopoly in rail freight together with no significant transit rights for foreign suppliers closes the market for international trade and investment. Bus services, which were previously controlled by two monopolies, were gradually opened to wider market competition from 2000 to 2014. Stronger market competition has led to price reductions, higher passenger numbers and better service quality (Ida and Talit, 2017a). However, access is open in only half of the total market.

Levelling the playing field across sectors

Reducing distortions between sectors is essential to allow factors of production to move to their most productive uses. As discussed in Chapter 3, the government provides substantial support to internationally competitive and high-tech firms. Eligible firms benefit from sharply reduced corporate income tax rates (effectively in the range of 5–16%, compared to a statutory rate of 23%). Additional investment grants are available in peripheral areas. As a small open economy with a substantial high-tech sector, Israel is particularly exposed to capital mobility and the scheme may have helped attract FDI. However, evidence is limited that the preferential treatment leads to higher productivity in benefitting firms and productivity spillovers to the wider economy. On the contrary, it may distort the optimal allocation of factors of production across sectors (Hercowitz and Lifschitz, 2016; Zimring and Moav, 2016; BoI, 2019d) and make it more difficult for domestic-oriented sectors to attract investment and skills. Furthermore, sector- and location-specific tax incentives can create tax-planning opportunities and potential for policy capture and may raise the costs of tax administration. The government should therefore thoroughly evaluate the system of tax breaks with a view to better targeting the scheme in order to ensure net benefits to society. This could create room to broaden the tax base and allow for further cuts in the statutory corporate income tax rate or a lighter business property tax, which would benefit the economy more broadly.

There is also room to rebalance support for innovation (Chapter 3). Public R&D funding can reduce the costs of adopting new technologies and ideas and hence speed up technology diffusion (Berlingieri et al., 2018). Direct Israeli government R&D support (grants and procurement) is substantial, but mainly benefits a few sectors, with manufacturing of computer, electronic and optical products, computer programming and consultancy, and scientific R&D accounting for 80% of total government-funded business R&D. The government should continue expanding targeted grant programmes that support firms in lagging sectors or technology adoption and consider replacing the current system of preferential tax rates for intellectual property (IP)-based income with a broader system of tax credits for R&D expenditure. The benefits of IP boxes and similar income-based provisions are likely to accrue mainly to large MNEs, as they hold most intellectual property (Appelt et al., 2016). Expenditure-based measures directly support the financing of R&D and thus help overcome difficulties in obtaining external funds, which is particularly important for small and young firms. To avoid overly favouring incumbents, tax benefits should include carry-forward provisions or cash refunds. Tax incentives could also go beyond R&D and target innovation activity more broadly, and include, for example, training, ICT investment or IP acquisitions as eligible expenditure.

Israel would benefit from stepped-up efforts to improve social cohesion

The COVID-19 crisis may reverse some of the recent labour market gains and aggravate inequality and poverty

Since the onset of the COVID-19 crisis the labour market has weakened substantially. To cushion income losses, the government acted swiftly and broadened eligibility to unemployment benefits, notably to workers on unpaid leave. At the height of the lockdown in April, unemployment claims surged to more than one million people, around a quarter of the labour force. Many people have returned to work since the economy reopened. This process has also been helped by a new government subsidy to firms that rehire laid-off workers. However, the severity of the crisis has translated part of the temporary lay-offs into permanent ones and unemployment remains high. Analyses by the Ministry of Finance (MoF, 2020) show that both low-skilled workers and workers with tertiary education have been affected by the current crisis. Youth, which represents one fifth of the new job seekers, is a particular concern because of scarring effects that may lead to persistent negative labour market outcomes (Bell and Blanchflower, 2011; Helbling and Sacchi, 2014).

The government should increase the role of active labour market policies to foster the efficient reallocation of labour from sectors facing extended weak demand and to reduce inequality and poverty. The crisis may accelerate a restructuring of the economy, forcing laid-off workers to find new jobs possibly in different sectors and requiring different skills. This calls for a strong focus on retraining efforts and job search assistance. Spending on active labour market policies remains low compared to other OECD countries (Figure 1.28). In most OECD countries, the public employment service (PES) has increased the possibility of online training as the provision of face-to-face training has been suspended shortly after the introduction of confinement measures. In Denmark, the law has been amended so that municipalities have the competence to offer new digital qualification courses. In France over 150 new training courses have become available online and Sweden has used part of the extra funding allocated to the PES to strengthen distance learning and internet-based education (OECD, 2020b).

Figure 1.28. Spending on active labour market policies is comparatively low

Per unemployed, as a % of GDP per capita, 2017

Israel has already implemented several pilot programmes to improve labour market options for the unemployed, focusing on enhancing the ability to find and keep a job, including job-search assistance and professional retraining. The evaluation of these pilots has shown an increase in employment and labour income and lower welfare payments (Larom and Lifshitz, 2018). These programmes should be scaled up at the national level. In addition, more focus should be placed on training programmes (Table 1.9). The focus of policy interventions has so far been on increasing employment and less on overall job quality and pay. Only a few public employment services (PES) in Israel offer the jobless basic skills and literacy training before seeking to place them in jobs (OECD, 2018b). Profiling of the unemployment can be used to determine needs and help provide training in high-demand fields. In Italy profiling is used to determine the amount of training vouchers. In Austria the PES covers course and related costs for job-seekers and low-income employees so that financial barriers do not deter them from taking up training.

In the longer-term, the evaluation of active labour market programmes should be strengthened. As was suggested in the previous Survey (OECD, 2018b), an agency should be set up to track and assess the net effect of programmes on the employment and income outcomes of participants, along the lines of the WhatWorks Centre for Local Economic Growth established by the UK government to promote evidence-based policy-making and evaluation (OECD, 2018b).

The government should also more vigorously address the needs of the most vulnerable groups and enhance its efforts to reduce poverty. In this regard government policy over the last decade has focused on promoting labour force participation to tackle poverty while cutting transfer payments that may harm work incentives, particularly among the Haredi, who value the time dedicated to religious studies, and the Arab-Israelis, who may face cultural barriers to female employment (OECD, 2018b; Yashiv and Kasir, 2013). However, even before the coronavirus pandemic, this policy has been partly reversed. Since 2015, the government stopped conditioning daycare discounts on both parents being in work, transfers were increased for families of religious students (yeshivat and kollels), and financial assistance was provided to needy yeshiva students (BoI, 2019a). Nevertheless, poverty remains among the highest in the OECD (Figure 1.29).

Figure 1.29. Poverty rates are high

Poverty rates with a poverty line of 50%, working-age population, 2017 or latest year available

Available evidence for Israel suggests that promoting employment while keeping transfers low has been successful, as employment among groups that have weak attachment to the labour market groups has expanded significantly (Figure 1.30; BoI, 2017). This, alongside minimum wage increases, has helped to reduce inequality. Inequality measured by the Gini coefficient has reached the lowest level since 1997. The employment rate for Arab-Israeli men and Haredi women has already reached the targets set for 2020, and the rate for Arab-Israeli women is very close. However, employment gains among Haredi men have stalled more recently, and rates remain considerably lower than those of the rest of the population.

Figure 1.30. Israel has made significant progress in increasing employment, but gaps remain for some groups

Per cent

Although higher labour force participation among groups with traditionally low labour market attachment has significantly reduced household employment differences, the income received from work was not enough to make a substantial dent in poverty, which remains comparatively high. The poverty rate has declined only slightly, as the number of working poor has risen considerably (Figure 1.31). A large share of workers remains stuck in low-quality jobs with fewer working hours, low wages and limited income from other sources (OECD, 2018b). These workers also differ in their perceptions of job security, as they fear more than others that they may lose their job and fail to find another with a similar salary (BoI, 2017). More worryingly, the working poor and people outside the labour market are concentrated in certain communities, in particular among Arab-Israelis and Haredim, whose poverty rates remain almost 50%. These households face geographic, socio-cultural, training and health-related barriers that impede their integration (see Chapter 2).

Figure 1.31. The number of working poor has increased significantly over the past 20 years

Per cent

As discussed in detail in Chapter 3, in order to tackle poverty while maintaining strong incentives to take up work, the government should further increase the negative income tax. Israel’s Earned Income Tax Credit (EITC) is an effective redistribution measure with significantly positive employment effects for low-skilled workers (BoI, 2015b; MoF, 2017c; Brender and Strawczynski, 2019). The EITC has been progressively expanded since its inception in 2008, most recently in 2017 as part of the “Net Family” programme (Box 1.3). Further expanding the EITC would not be overly expensive, since its overall budgetary cost including the latest measures is only around 0.16% of GDP (IMF, 2018). Spending on similar programmes in the United States and the United Kingdom is markedly higher (0.4-0.5% of GDP).

New simulations conducted for this Survey using the OECD Tax Benefit Model suggest that expanding the EITC could help reduce poverty, including among Arab-Israelis and the Haredim (Figure 1.32). Arab-Israeli and Haredim earn on average only 75% and about 90% of the median hourly wage, respectively, and Haredi households typically have many children and only one breadwinner. Simulations in the previous Survey suggested that even if two spouses in these families were working full-time, total family income would not be enough to escape from poverty, given the current tax-transfer system and the size of their families. New simulations show that doubling the maximum payout amount under the EITC could lift the average Arab-Israeli and Haredi households with two earners above the poverty line.

Figure 1.32. An expansion of the earned-income tax credit could reduce poverty

Estimates of a family income according to the numbers of earners and its community group¹

Recommendations in previous *Survey*	Actions taken since March 2018
Evaluate systematically the effectiveness of existing active labour market policies, raising funding for effective programmes, above all for training.	Pilot programmes for the unemployed have been introduced, focusing on enhancing the ability to find and keep a job, including job-search assistance and professional retraining.
Further expand the role of in-work benefits by providing higher transfers to large families where both parents are in low-paid work.	As part of the “Net Family” programme, the 2019 budget included several temporary measures to expand the earned-income tax credit: an increase of the tax credit for fathers by 50% to the level of mothers and the introduction of a 30% bonus for second-earners.

Improving access to affordable housing

Housing supply has been insufficient to meet increasing demand, causing shortages and high housing prices. Empirical research confirms that Israel’s housing supply response to prices is weaker than in other OECD countries (Figure 1.33). A weak housing supply response affects social inclusion as high house prices undermine access to affordable housing, particularly for the poor, who are the first to be crowded out in rigid markets (Grossmann et al., 2019).

Figure 1.33. Housing supply response to prices is weak

Estimated supply elasticities of housing supply to change in prices

Indeed, housing affordability is lower than in other countries, particularly for low-income households (Figure 1.34). More than two thirds of those who rent belong to the two lowest deciles of the income distribution, and in the bottom decile outlays on rent averaged 61% of net monthly income in 2015 (Swirski and Hoffmann-Dishon, 2017).

One of the reasons why the supply response is weak is because Israeli municipalities do not prioritise residential development, despite the nation's pressing need for more housing. The current property tax system creates incentives for municipalities to make greater efforts to achieve business rather than residential development, as the property tax charged for commercial and industrial parks is up to 11 times higher than that on residential properties (Chapter 2). At the same time having more residents means that the municipalities need to provide public services for them, increasing their expenditures. This creates incentives for municipalities to develop industrial parks and commercial centres instead of residential areas. As a result the supply of land available for commercial-industrial parks exceeds the market demand, and in many cases this land remains largely empty (OECD, 2017b).

The difference between residential and non-residential tax rates should therefore be reduced. To shrink this gap non-residential property tax rates could be lowered and residential rates raised. This should, however, be accompanied by exemptions for disadvantaged groups. In addition, the government should strengthen equalisation efforts within municipalities to support those with socio-economically weaker populations by higher compensation from the wealthier ones (see Chapter 2). The government could also promote mergers of municipalities. Economically strong municipalities created through mergers will have the potential to improve public services and be more efficient.

Another way to improve affordability is through a well-functioning rental market, both public and private. In 2017 Israel introduced a “fair rental law” clarifying tenants’ and landlords’ responsibilities in several respects in order to support a deeper market. This was a step in the right direction, but rents have continued to increase.

Figure 1.34. Housing costs are high for poor households

Rent-setting regulations require a delicate balance between security for the tenant and flexibility and possibilities for satisfactory yields for the landlord. One way forward is to collect information on the local reference rent, similar to the German system. Collecting and publishing local rents and making the price developments on the rental market more transparent can help reduce information asymmetries and support rental market competition, which can curb excessive rents. Other countries are following Germany’s example and setting up ways in which landlords and tenants can obtain comparable rental information (de Boer and Bitetti, 2014).

The government could also increase the effectiveness of housing-assistance policy to help reduce the segregation of poor population groups. Public housing in Israel is relatively scarce, although increasing (Figure 1.35). A large number of these housing units are being sold to the tenants at discounts in order to reduce poverty and support private home ownership. Public housing is often clustered in poor neighbourhoods, far from employment centres, with the risk of their developing into areas of distress (BoI, 2019a). At the same time living in public housing may impair geographical mobility, causing people to be locked into areas with limited employment opportunities. Evidence from other countries shows that these areas can result in significant disparities in employment outcomes and that children growing up in these poor-quality neighbourhoods perform less well in school and earn less as adults (Chetty et al., 2014; Galster, 2007; Gibbons, 2002; Andrews et al., 2011). Therefore, social housing needs to be located in areas close to employment opportunities and should be targeted at the most disadvantaged families, possible with additional social services to help their integration (Chapter 2). For example, some OECD countries are promoting mixed neighbourhoods by requiring new development projects to devote a small share of their flats to social housing to foster integration of disadvantaged groups. In England, at least 10% of the major residential development projects are required to take the form of social housing (HoC, 2019). The government should also consider abolishing its policy of selling public housing dwellings to tenants. Besides public housing, which should target the most disadvantaged families, housing assistance through rent subsidies should be strengthened.

Figure 1.35. The share of social housing is low in Israel

Per cent, 2015 or latest available year

In view of the long-lived nature of new housing, energy efficiency standards of new homes should be zero-carbon consistent (IEA, 2018). While such standards raise upfront housing investment spending, they avoid higher costs of retrofitting later and limit the investment needs in the context of the progressive decarbonisation of the economy. Improving energy efficiency can deliver substantial economic, environmental and social benefits, such as reduced air pollution and less land-use for energy infrastructure deployment (OECD, 2019f). The government should therefore consider making energy efficiency standards mandatory for new housing.

Expanding renewables can boost environmental and economic outcomes

Policies to support the recovery should be designed with a view to continue progress on environmental performance and climate change mitigation. This is particularly important as plummeting fossil fuel energy prices at the onset of the COVID-19 crisis weaken incentives to invest in low carbon and energy efficiency technologies.

Most Israelis are still exposed to heavy small-particle pollution, well above the WHO-recommended limit of 10 micrograms per m³ (Figure 1.36, Panel A), causing almost 2500 premature deaths per year. It affects children’s health the most (WHO, 2018). Education outcomes for children exposed to higher air pollution are substantially and lastingly lower (Heissel et al., 2019); pollution also affects students’ subsequent labour market performance in Israel (Lavy et al., 2014). Applying recent EU evidence (Dechezleprêtre et al., 2019) to Israel suggests worker productivity could be at least 5% higher if average exposure was below the WHO threshold. In Haifa the energy sector contributes the most to pollution, while transport dominates in Tel Aviv and Jerusalem (Ministry of Health, 2017).

Israel’s CO₂ emissions have decoupled slowly from GDP, as is the case for the OECD at large (Figure 1.36, Panel B). In absolute terms CO₂ emissions have risen by 10% since 2000. In 2015 the Israeli government adopted a target of reducing per capita GHG emissions by 23% relative to 2015 by 2030. Since Israel's population is projected to be 25% larger by then, overall emissions may rise further. The government also aims to reach a renewables electricity share of 30% in 2030, up from 5% at the end of 2019. Worldwide, strong emissions reductions are needed by 2030 to meet the objectives of the Paris agreement, which requires signatories to limit global warming to well below 2 Centigrade degrees and make efforts towards limiting global warming to 1.5 degrees. Limiting warming to 1.5 degrees would result in substantially lower climate-related risks to human well-being than 2 degrees (IPCC, 2018). Droughts, heat waves and wildfires are expected to increase particularly strongly in the Mediterranean region, with significant and increasing risks for ecosystems, food, health and security in the coming decades (Cramer et al., 2018). Fresh-water availability may decrease by up to 15%, among the largest falls in the world. Israel is already the OECD member with the highest level of water stress. Israel plans to double its desalination capacity by 2030. This will strengthen Israel’s water stability but will add to energy consumption.

The Paris agreement invites signatories to present long-term emissions-reduction strategies by 2020. It is welcome that Israel plans to present its strategy in 2020. The strategy needs to cover a broad range of sectors, including electricity, buildings, transport, industry and agriculture (OECD, 2019f). If well designed, these policies can also reduce air pollution durably and generate well-being gains, which can materialise already in the near term. Taking early decisive action can harness these benefits and reduce costs, taking advantage of low-cost renewable energy and avoiding lock-in of investment inconsistent with decarbonisation (OECD, 2019f). Several high-income OECD countries have recently announced net zero GHG-emissions targets for 2050, including Switzerland, France and the United Kingdom.

In 2015 the energy sector contributed half of all GHG emissions in Israel, more than in the OECD area, where they account for about 30%. Transport accounts for about a further quarter. Many energy end uses need to be electrified to lower their emissions and pollution, including transport. It is therefore important to advance with the decarbonisation of electricity generation. This is discussed below. Improving energy efficiency is highly cost-effective in this context (IEA, 2018).

Israel has car purchase taxes that depend heavily on their environmental performance. It also plans to prohibit the sale of new petrol- and diesel-fired cars by 2030 and develop electric as well as natural-gas-based mobility. Recent research for the United Kingdom suggests phasing out petrol- and diesel-fired cars by 2030 is less costly than doing so at a later date (UK Committee on Climate Change, 2019). There is much scope to improve local policies in Israel’s cities to reduce transport-related pollution, CO₂ emissions and energy consumption, while reducing congestion and improving access to jobs and key facilities (OECD, 2019f). This requires metropolitan governance integrating urban planning, housing and transport policies, including better pricing of transport. Such policies can also boost productivity (OECD, 2015c).

Decarbonising transport can provide opportunities to develop innovative mobility and connectivity, implementing new technologies and pilots for transport solutions, such as digital-based ride sharing. This can include better batteries, grid technologies for cost-effective charging and technologies to decarbonise road freight, including alternative fuels such as hydrogen. Israel could benefit from further R&D investment in these areas as well as in areas discussed below, notably solar technologies, large-scale energy storage, dual use of land and smart grids.

Natural gas helps reduce emissions and pollution in the near term

In 2018 30% of total power generated in Israel was from coal, down from 59% in 2010. Use of natural gas has expanded on the back of the discovery of large gas fields off Israel’s coast. Natural gas accounted for 66% of total power generated, up from 39% in 2010. Recently, the Minister of Energy has announced plans to eliminate coal in electricity generation by 2026. Replacing coal with gas is reducing SO₂, small-particle pollution and GHG emissions, although gas combustion still produces NO_x emissions. At 3% at end-2018, the share of renewables was one of the smallest in the OECD (Figure 1.36, Panel C), but capacity is expanding quickly.

Relying predominantly on natural gas for electricity generation carries risks in the longer term. Electricity from ground-mounted solar panels is already cheaper to produce than from coal or gas, even without appropriate pricing of GHG emissions. The cost of solar is set to fall below that of gas in many regions across the world by 2023 (IEA, 2018). When accounting for emissions comprehensively, including fugitive emissions in extraction and transportation, gas-fired electricity emits about half of coal across the world (IPCC, 2014). The Israeli authorities are committed to minimising fugitive emissions, which is welcome. Equipping gas-fired electricity with carbon capture, use and storage (CCUS) may reduce emissions to a fifth of coal (IPCC, 2014) but would also raise costs. Relying predominantly on gas would therefore make the deeper emissions reductions that are needed in the longer term more difficult to achieve.

Gas-fired power plants would have value as a backup to produce dispatchable electricity to offset the intermittency of renewables and could eventually be used to fire zero-carbon hydrogen, provided they are equipped accordingly. Israel could export its natural gas to countries in the region where it could help reduce coal use. Gas exports to Jordan and Egypt have commenced at the beginning of 2020.

Gas production is supported by a purchase agreement at guaranteed prices between the state-owned electricity company and the operators of the gas fields. To provide incentives to phase out coal and reduce emissions cost-effectively it would be preferable to rely on carbon taxation instead, as argued in Chapter 3.

More can be done to boost renewables cost-effectively

These arguments suggest that Israel should expand renewable electricity substantially. The IEA has pointed to excellent potential and increasing economic attractiveness of solar electricity in Israel. Gas-fired power can ease this transition, in particular in view of Israel’s limited scope for international network connections in the current geopolitical context. Israel is giving solar energy policy support (IEA, 2018), including auctions for commercial rooftop projects and improved permitting and tax treatment for residential systems. It has required new buildings to be equipped with solar panels for heating for many years. Owners of new buildings now choose whether to install solar panels for heating or photovoltaic panels for electricity. However, restricted land availability, transmission grid constraints and permit procedures are holding back large-scale projects. These offer the lowest generation costs.

Israel deregulated solar installations and introduced an auctions system for solar investments. Well-designed and transparent auction schemes can attract investment in large-scale renewables (IRENA and CEM, 2015) and lower costs. In Israel, investors need to settle private land-development rights separately from the tender. Tendering pre-approved sites with secured land rights has reduced uncertainty, attracting investors and lowering costs, for example in the Netherlands (OECD, 2017), Jordan and India (Agora Energiewende, 2018). More public land should also be made available for tenders. One-stop shops (as in Denmark), standardisation of contracts and a legal time limit for permit procedures also help (OECD, 2017). Israel's weather and limited land availability make it an ideal location for solutions based on dual use of land. For example, solar photovoltaic installations that float on water reservoirs can reduce demand on land, prevent up to 80% of evaporating water (Taboada et al., 2017), improve efficiency and maintenance.

The potential to develop large-scale renewables generation is greatest in areas that are far from the centres of electricity consumption. However, infrastructure development has not taken into account renewables production (Gallo and Porath, 2017). In 2018 the Minister of Energy approved a five-year development plan to increase investment. The authorities have also become pro-active in identifying sites suitable for development. The economic benefits of doing such investments may include the development of regions heretofore poorly served with infrastructure, including job opportunities for the local population, although this may require upskilling (Agora Energiewende, 2018). Pre-approved sites for renewables generation can be combined with land rights for the needed transmission lines. Tenders also lower the cost of executing transmission network projects (IEA, 2016).

Israel’s solar tenders are based on a uniform price system, which guarantees a feed-in- tariff to all successful bidders. Remuneration of solar electricity should combine auction-determined minimum fixed prices with some market responsiveness. Minimum fixed prices reduce uncertainty to investors, while market signals provide incentives to choose installations that maximise market value, for example by supplying more at peak demand. For such incentives to materialise a well-developed wholesale electricity market is necessary. Israel has established the rules for a competitive wholesale market. However, the bids of most of the power plants are regulated. With the development of competition in the natural gas sector, regulated prices are expected to decline. Nevertheless wholesale competition should be further developed. Integration of increasing renewables generation can be achieved through high-resolution prices (including prices closer to real-time and locational prices that reflect grid constraints) and appropriate allocation of transmission and distribution network costs, as well as the use of smart grids and storage (IEA, 2016).

The government-owned Israel Electric Corporation (IEC) owned 80% of generation capacity in 2017. Privatisation is expected to bring that share down to 40% by 2025. According to approved legislation, all new power generation will be privately owned. The IEC also owns the transmission infrastructure. While state-owned enterprises can support policies to encourage investment in renewables, market concentration tends to discourage it (Prag et al., 2018). The major electricity market reform of 2018 aimed to facilitate entry, which is welcome. It foresees a transfer of transmission system operations management to a separate but also government-owned company. According to the government’s assessment, implementing this transfer as planned will ensure that the system operator will be fully independent of the incumbent. This is important to prevent discrimination against market entrants (Fuentes, 2009). The electricity market regulator will also need to have appropriate tools and resources, including effective ex ante regulation.

Rooftop solar electricity generation provides an additional option for expanding solar energy use when land is scarce. However, producing electricity with rooftop panels costs more than twice as much as with ground-mounted ones. Owners of residential rooftop photovoltaic systems benefit from a net metering scheme. It credits households for surplus electricity they feed into the grid. These households also contribute to grid costs. Overall the value of surplus electricity to households slightly exceeds the energy bill they save from consuming their own production (PUA, 2014). As solar energy has become cheaper to produce, Israel has replaced net metering with a lower feed-in price for surplus electricity in new installations. This creates incentives for households to shift demand in real time cost-effectively, taking advantage of periods when cheap solar energy is abundant, for example through the installation of heat pumps, plug-in electric vehicles or battery-based storage. Grid costs can then be lowered and recovered more easily without putting a charge on self-consumption (IEA-PVPS, 2016), thereby also preserving incentives to invest in rooftop solar. However, the new feed-in tariffs are only slightly lower than the retail price. Moreover, setting feed-in prices administratively is inherently difficult. Basing rooftop feed-in tariffs on wholesale prices would be an attractive alternative (IEA-PVPS, 2016).

Israel may also consider a large expansion of capacity when upgrading low-voltage distribution networks, as the cost of upgrading is relatively insensitive to the size of the capacity increase (Imperial College London & Vivid Economics, 2019). Time-varying pricing would reinforce incentives to consume electricity at times when variable renewable energy is abundant, while maintaining incentives for energy efficiency (IRENA, IEA, REN, 2018). In this way renewable energy generation as well as energy end-use costs can be minimised. Developing smart technologies to manage flexible demand response can also strengthen Israel’s technological leadership.

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