IASPS Op-Eds
Comments on the Decline of the Nation-State
February 10, 2000
A TALE OF TWO ECONOMIES
by Dr. Alvin Rabushka, Director of the Division for Economic Policy Research
The Bank Hapoalim Economic Report of October 21, 1999, included a special focus comparing “Ireland and Israel - A Tale of Two Economies.” The purpose of the comparison was to learn how the Irish experience could serve as an example of the opportunities facing Israel’s economy, and vice-versa. Israel indeed can learn from Ireland but, sadly, Israel has nothing to teach Ireland.
The Facts
Let’s begin with a few basic facts. Ireland’s per capita GDP in 1998 was $21,800, much higher than Israel’s $16,000. Moreover, the rate of Ireland’s GDP growth steadily increased every year during 1992-1998, now running at 9 percent, while Israel’s GDP growth has steadily fallen every year during 1995-1998, now running at 2 percent. Israel has been in a serious recession for several years and its per capita GDP has declined during 1996-1998. Ireland’s growth has been accompanied by low inflationary pressure, 1.7 percent in 1998, with strong trade and current account surpluses. Israel’s GDP slowdown has been accompanied by high inflationary pressure, 8.6 percent in 1998, with large trade and current account deficits. Ireland’s unemployment rate has fallen from 16 percent in 1993 to about 6 percent in 1999. Israel’s unemployment rate has risen from 6.5 percent to 8.9 percent during this same period. To make matters worse, Ireland’s labor force participation rate is 66 percent of the population, while Israel’s is a much lower 53.5 percent. This means that the Israel’s higher unemployment rate poses a greater burden on the population. Both Israel and Ireland emphasize the development of human capital, especially technological education. But Ireland has performed significantly better in the educational sphere, and is now the world’s second largest software exporter after the U.S.The volume of foreign trade in Ireland between 1980 and 1998 increased from 115 percent of GDP to 165 percent of GDP, reflecting the country’s success in exporting to competitive global markets. For Israel, the share dropped during this period from 110 percent of GDP to about 80 percent of GDP. In addition, Ireland exports more than it imports, whereas the reverse is true for Israel. An outward orientation has spurred higher growth in Ireland, while an increasingly inward orientation in Israel’s protected market has resulted in declining growth.
Both countries have received considerable outside assistance. Israel receives some $3 billion in annual U.S. aid and billions more in other forms of charitable contributions from overseas Jews and European governments, notably Germany. Ireland, for its part, has received transfers from the European Union in the form of structural funds to assist Ireland’s entry into the EU. Israel’s aid has gone partly into defense expenditures, but has mainly been used to expand and sustain a massive welfare state, as well as cover its massive trade deficit. Ireland’s aid has been directed at infrastructure, education and training, and investment in the private sector.
Ireland has enjoyed a steady flow of foreign investment, about two-thirds from the U.S., averaging about 2 percent of GDP a year during the last 15 years. Most of this investment has been in the form of new enterprises or an expansion of existing enterprises. Almost half of Ireland’s labor force is employed in firms under foreign ownership. Israel has only recently begun to attract significant foreign investment. It did not reach 2 percent of GDP until 1996, but most of this investment involves mergers and acquisitions, and thus does not add to the capital stock or new output.
It is argued that Israel’s slow growth is due to its relatively high defense burden. But this burden has fallen from historical highs of 30 percent of GDP in the mid-1970s, to 20 percent in the mid-1980s, to 7 percent in 1998. At the same time, transfers and welfare payments have grown from just over 10 percent in the early 1970s, before U.S. aid began in earnest, to well over 20 percent in the mid-1980s, and have continued to climb. It is important to note that Israel’s period of high growth coincided with its relatively high defense burden. Israel’s GDP grew at annual rates of 8-9 percent (about 5 percent per capita) during 1950-1973, but slowed to about 4 percent (about 2 percent per capita) during 1974-1998.
Ireland’s growth continues to lead the European Union. The country has gone from being the “sick man” of Europe 15 years ago to its “highest flyer.” Ireland’s per capita GDP now exceeds that of Great Britain and the gap is further widening.
Why Ireland Grows and Israel Stagnates
What are the reasons for Ireland’s success compared with Israel’s dismal performance? They include low rates of tax and high incentives for encouraging investment, an inexpensive skilled labor force compared with other West European countries, access to the European market, and a high level of economic and physical infrastructure.Let’s begin with the most important item—low rates of tax. In 1987, the Irish government substantially decreased marginal tax rates. In particular, a 10 percent flat rate on corporate profits of overseas firms spurred a massive investment boom, making Ireland a major center of U.S. operations in Europe. Under pressure from other EU members to end the discriminatory treatment of its domestic firms, Ireland has now implemented a 12.5 percent flat rate for all corporations, domestic and foreign. Ireland has by far the lowest corporate tax rate in the European Union. This measure, more than any other, has attracted direct foreign investment, spurring high growth and job creation. High growth, in turn, has transformed budget deficits into surpluses. Public debt in Ireland has declined from 98 percent of GDP in 1990 to 56 percent of GDP in 1998, and has continued to fall. (In Israel, public debt fell from 135 percent of GDP in 1990 to 104 percent in 1997, but that percentage has turned up, reaching 106 percent in 1998.)
The second reason, an inexpensive skilled labor force, traces to the first of low tax rates. In marked contrast, high taxes in Israel result in high labor costs. These high taxes include high rates of income tax, value-added tax, social insurance tax, and health insurance tax, along with high taxes on automobiles, property, fuel, business inputs, and every other imaginable item. Indeed, at this very moment, a tax reform commission appointed by the finance minister is contemplating a new capital gains tax on the Tel Aviv Stock Exchange. In addition, Israel’s Histadrut labor union looks back to the nineteenth century for its inspiration, not forward to the twenty-first. Labor market rigidities and chronic strikes plague Israel, whereas Ireland’s labor force is flexible and opportunistic.
The third reason is political geography. Ireland is part of the European Union, thereby enjoying access to its large market. But access to the single market has not helped other EU member nations that have stagnated and whose labor force is mired in double-digit unemployment. France, Germany, Italy, Belgium, and Austria have lagged far behind Ireland’s sparkling growth. The factors afflicting Europe’s stagnant economies are the same as in Israel: high tax burdens, high marginal rates of tax, rigid labor markets, powerful unions, extensive regulation, substantial state-ownership of industry, and massive welfare states.
Finally, EU assistance in Ireland has been directly wholly at infrastructure and education, which yields a positive economic return. In marked contrast, the better part of unilateral grants and transfers to Israel, totaling some $8 billion a year, largely fuels consumption. Ireland has put its temporary aid into capital investment aimed at enhancing efficiency and the development of human capital. In sharp contrast, Israel spends its permanent stream of aid on salary increases to civil servants, subsidies to money-losing, state-owned enterprises, and consumer goods.
The Lessons?
There is nothing Ireland can learn from Israel, save to avoid mimicking any aspect of Israeli economic and fiscal policies. But there is a great deal that Israel can learn from Ireland: cut taxes, deregulate, privatize, invest in infrastructure, reduce state subsidies, shrink welfare, and make it attractive for real foreign direct investment, not just foreign purchase of Israeli assets.Will the message reach Israel’s policymakers or will it fall on deaf ears? There is nothing new in the reasons for Ireland’s sterling economic performance. They are the same factors that propelled the Asian tigers from poverty to middle-class status in one generation. They are the same factors that underpin the remarkable performance of the U.S. economy. But there is a big difference between Ireland, the Asian tigers, the U.S., and Israel. The difference is that Israel does not have to adopt sound economic policies to survive. Rather, it can depend upon U.S. taxpayers and overseas Jews to help pay its bills, a strategy it has followed for nearly three decades. This strategy has resulted in slowing growth, but the elements of the ruling class—big government, big business, big labor, and intellectuals—have retained their hold on power.
Give credit where credit is due. The economists who write “Bank Hapoalim Economic Report” should be praised for comparing Ireland with Israel to see how Israel might benefit from the Irish experience. It’s a bit disappointing, though, that these same economists can write, with a straight face, that “Ireland could also profit by learning from the performance of the Israel economy.” This is like the manufacturers of automobiles claiming a hundred years ago that they can learn from the makers of horse-drawn carriages. Only Israelis, who get much of their livelihood from outsiders, are capable of such chutzpah.