Israel - The Economy the Public Sector

Provision of Defense Services

Throughout its existence, Israel has been obliged to devote a considerable part of its resources to national defense. Since 1973, Israel's annual defense expenditure has equaled that of the Netherlands and exceeded that of Sweden. In per capita terms, Israel's expenditure has been two to three times as large as theirs. Defense expenditures in the Netherlands and Sweden each amounted to 3 to 4 percent of GNP in FY 1976; in Israel, they amounted to more than 25 percent of GNP. The persistence of a high defense expenditure over a very long period makes Israel's situation unique.

The simplest definition of the defense burden is the total budgeted resources diverted to defense and thus precluded from other uses by citizens. Other resource costs include the opportunity cost of labor working for the defense sector and therefore unavailable to other sectors, thus reducing civilian output. Finally, foreign currency spent on military imports is unavailable for civilian imports.

Although estimates of the defense burden suffer from inadequate data, the Central Bureau of Statistics publishes data on the noncivilian component of public consumption, which is used as a proxy for defense expenditures. Apart from the war years of 1967 and 1973, the annual fluctuations have been dominated by long-term changes in defense costs (commonly referred to as "ratchets" or step functions). By 1986 defense expenditure had declined to a range from 10 to 16 percent of GNP, depending on the measure used.

These official data do not include information on forfeited earnings of conscripted soldiers, forfeited earnings of persons on reserve duty, and costs of casualties, stockpiling, civil defense, land devoted for army training, and many other government and civilian expenditures ascribed to defense. Although it is impossible to assign a rough order of magnitude to the items mentioned, some economists have speculated that they are not insignificant components of the civilian public sector. This becomes clear when one considers that the length of time devoted to conscription, reserve duty, and regular army duty has been lengthened. Government defense functions involved in operations in the West Bank and the Gaza Strip add a further cost to the defense burden.

The cost of defense also includes direct defense imports and military aid from the United States. In FY 1986, Israel received United States military aid in the range of US$3 billion. A large share of these funds has regularly been spent in the United States.

On the other side of the defense-burden equation are the beneficial by-products associated with military activity. The most important benefits are education, absorption of immigrants, agricultural settlement, and the development and manufacture of weapons and equipment. An example of these beneficial by-products was the development of the Kfir interceptor, which created jobs for technicians and laborers. In short, when estimating Israel's defense burden it is important to consider the cost reductions implicit from these beneficial by-products.

Provision of Civilian Services

Civilian public services have employed a high proportion of the labor force and consequently have absorbed a high share of Israel's GNP. Spending on health, education, and welfare services rose from 17 percent of GNP in 1968 to 20 percent in the early 1970s. The level of spending on civilian public services remained constant at about 20 percent through 1986. The share of the total civilian labor force employed in civilian public services rose from 22 percent in 1968 to 30 percent in 1986.

The civilian services primarily responsible for these high outlays were education and health services, whose share increased from 50 percent of the total in 1969 to more than 60 percent in 1986. At the other end of the scale were economic and general services, whose expenditures declined from 33 percent of the total in 1969 to 23 percent in 1986. The share of other welfare services (including immigrant absorption services) remained constant. The decline of general and economic services reflected a transfer of some of these functions from the public sector to the business community and a decline in direct government intervention in the economy.

Unlike social welfare and economic services, which were directly funded by the government, until the early 1970s education and health services received substantial funding from foreign sources. In 1968, for example, the government financed only 70.5 percent of Israel's education services. By 1978 the government's share had increased to 84.5 percent. Whereas in 1968 the Jewish Agency financed about 20 percent of the total national expenditure on education from foreign aid funds, by 1978 only 7.6 percent came from foreign aid, and this percentage has decreased further since. The result was an added burden on the taxpayer, equal to approximately 22 percent of the national expenditure on education. Direct private financing of education expenditures contracted from 9.5 percent of the total in FY 1968 to 1.7 percent in FY 1978. The key element explaining this latter drop was the institution of free, compulsory secondary education in the late 1970s.

Health services' funding followed a similar pattern. The government's share rose from 53 percent in 1968 to 62 percent in 1980. Here, however, the Jewish Agency's participation decreased even more sharply, from 20 percent of the total national expenditure on health in 1968 to nearly zero in 1980. The added burden of government financing from internal sources over the decade was almost 30 percent.

In both health and education, the trend illustrated a transition from foreign financing to internal resources and a switch from direct private financing (and independent fundraising by nonprofit institutions) to the imposition of a greater burden on the central fiscal system. In the past, when these services were expanded, the cost often was carried by aid from abroad. As this source began to dwindle, the cost increasingly shifted to the government, which for political reasons could not reduce these public civil expenditures.

Government Budget

By 1988 the government had been operating under a deficit for more than a decade. Between 1982 and 1984, the deficit equaled between 12 and 15 percent of GNP. After the implementation of the July 1985 Economic Stabilization Program, the government succeeded in balancing its budget. This balance was achieved not only because the government raised taxes and reduced spending, but also because the reduced inflation increased the real value of tax revenues. During FY 1986, the expansion of the economy compensated for the reduction in direct and indirect taxes. The government also initiated plans to reduce further its public debt.

Before the July 1985 reforms, the tax system was considered to be very progressive on individual income but barely touched corporate income. After the reforms, which included a new corporate tax law, large sums of taxes were collected from business sectors that previously had been untaxed. Personal income tax ranged from a base rate of 20 percent (payable on incomes equivalent to about US$500 per month) to a top rate of 60 percent on a monthly income of about US$2,100. Corporate income tax generally was 45 percent. Few corporations, however, actually paid this rate once various government subsidies were included in the calculation.

The public sector

The two most important tools of economic policy in Israel have been the budget and foreign exchange control. Through the budget, the government can deal with all financial activities of the public sector. Defined in its broadest terms, the public sector includes the central government, local authorities, and national institutions (where the central government clearly dominates). In 1986 government and private nonprofit institutions represented about 20 percent of GDP, which was about a 20 percent increase over the public sector's importance in 1968. Similarly, the provision of government-owned housing and rental services increased by 28 percent, rising from 8.4 percent of GDP in 1968 to 11 percent in 1986. Overall, in 1986 the business sector represented 69 percent of GDP, whereas the public sector, in all of its dimensions, represented 31 percent of GDP.

Taxation

From 1961 to 1983, government expenditures grew far more rapidly than Israel's GNP, primarily because of the sharp increase in defense outlays from the latter half of the 1960s through the 1970s. Taxation was insufficient to finance the increase in government spending. Although gross taxes increased, net taxes declined continuously during the period. To meet the deficit, the government resorted to domestic and foreign borrowing.

By the mid-1970s, the government increasingly relied on foreign sources to finance the domestic deficit. These growing debts were equivalent to almost 14 percent of each year's GNP, during a time when GNP was growing at less than 2 percent a year.

In the second half of the 1970s, the tax system collected approximately 47 percent of GNP, compared with 35 percent in the 1960s and 41 percent in the first half of the 1970s. This rise occurred mainly in direct taxes and taxation of domestically produced goods, while taxes on imports declined by a small margin. During FY 1981, direct taxes represented 25.7 percent of GNP; they were 14.3 percent of GNP in FY 1961. Taxes on domestic production represented 12 percent of GNP in FY 1981, a decline from the FY 1961 high of 13.9 percent. The introduction of the value-added tax on both domestic and foreign goods added a tax base of 8.7 percent of GNP in FY 1981.

In FY 1986, income taxes collected represented 33 percent of GNP. Value-added taxes represented 20 percent of GNP and customs duties represented 4 percent of GNP. In late 1987, the government announced plans to revamp the tax structure in the light of the 1985 Economic Stabilization Program.

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