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The government of Israel spends hundreds of millions of dollars a year in direct and indirect subsidies to industry. It has traditionally used subsidies as part of its policy of intervening in the economy in order to increase growth. The subsidization of industry had its origins in the 1950s, when the economy emerged from the War of Independence to face an enormous wave of immigration. Economic controls included rationing, quotas on imports and very strict foreign exchange restrictions.

During the 1950s some of these controls were lifted and were replaced with subsidies. As the government took upon itself the task of raising capital abroad, so it allocated funds at home, according to its preferences. The development of industry was given priority from the late 1950s and assistance was granted largely in the form of loans at subsidized rates of interest. With the acceleration of inflation in the 1970s and especially in the 1980s, the costs of this form of subsidy rose rapidly.

These payments reached a peak in the early 1980s when subsidies to the business sector alone equalled 14.6 percent of GDP (as shown in Table 1). They form part of a collection of measures to assist industry which can be viewed according to the framework given in Table 2.

Subsidies continue to play a large role in the Israeli economy, despite major cutbacks in 1985. The 1990 budget allocated approximately $350 million for consumer subsidies, $250 million for credit subsidies (see below) and a total of $968 million for industrial subsidies. There are also subsidies to other sectors, both explicit and implicit, and tax concessions for certain companies.

Definitions: The business sector's GDP is defined as that of the whole economy less housing services, government and of non-profit making organizations.

Subsidies are defined as all grants on current account by central and local government to private industry and public corporations, and the operational deficits of government enterprises. Also included are capital grants and loan subsidies.

Source: Central Bureau of Statistics, Monthly Bulletin of Statistics, Supplement, May 1988 (Jerusalem: Central Bureau of Statistics, 1988), pp. 158-159; and Central Bureau of Statistics, Monthly Bulletin of Statistics, Supplement, May 1990 (Jerusalem: Central Bureau of Statistics, 1991), pp.48-49 [Hebrew].

The policy of subsidizing investment through the Law for the Encouragement of Investment Capital (the L.E.I.C.) has been subject to criticism for many years. In 1957 the Bank of Israel, in its annual report, stated that as a result of the policies followed, the rate of industrial profit was determined by the investment policy of the government . 1 In 1990 the Bank said that the law discriminated between sectors, plants, products and geographical areas, thereby creating distortions in the economy. It consequently advocated replacing the law with other measures. 2

Israeli economists generally favor greater reliance on the market mechanism but often hesitate about when and how far to move. This was true twenty years ago and it is true today . 3 The current hesitations are due to uncertainty about the ability of the market to provide jobs for thousands of immigrants without government assistance.

Source: Jerusalem Institute of Management, Export Led Growth Strategy for Israel (Tel Aviv: Jerusalem Institute of Management, 1987), pp. 93-94.

This paper will show how government assistance to one firm is paid for by others in the economy: both companies and individuals. It will review the main types of subsidies paid to industry and will then examine in greater detail those paid under the Law for the Encouragement of Investment Capital in Industry (L.E.I.C.). It is my contention that the present system of subsidies paid out under the L.E.I.C. fails to achieve its stated objective. The paper will examine the effects of the subsidies paid and suggest reforms including the abolition of the law.

Main Types of Assistance to Industry

There are three main subsidies to industry. By far the largest is that of exchange rate compensation. This is paid to exporters in order to compensate them for the uncompetitive exchange rate and for taxes paid on imports (only some of which are refunded). The level of the subsidy does not vary with changes in any measure of export profitability; the implication being that exports are permanently affected by lack of competitive conditions.

The most important aspect of this lack of competitiveness is the fact that Israel has a higher rate of inflation for internationally traded goods and services than many of her trading partners. 4 The exchange rate of the shekel, in terms of a basket of the currencies of Israel's main trading partners, does not reflect this. The government has traditionally been afraid of the inflationary consequences of devaluation, given the extent of linkage in the economy.

The subsidy to exporters (known in Israel as "exchange rate insurance") can best be thought of as exchange rate compensation. It is in effect a separate exchange rate. The existence of a multiple exchange rate system imposes considerable bureaucratic costs on the economy: firms have to apply for the subsidy through their banks for each export deal and the latter then receive the funds from a government-owned company which insures against foreign trade risks. The exporter receives a payment through his bank, currently equal to six percent of the value added in exports.

The 1990 export subsidy budget was about $500 million. In September 1990 a two percent reduction in the subsidy was announced, part of a slow program to abolish it.

The second largest subsidy is the L.E.I.C., which is examined in detail below.

The third major subsidy is that for industrial research and development, operated by the Chief Scientist's Department at the Ministry of Industry and Trade. This fund, of about $100 million, makes grants available to firms with research and development (R&D) projects which are considered to have export potential. While efforts have been made to increase the degree to which market considerations determine the allocations (there is a marketing advisor at the Department), one view holds that the fund should be run by a bank or by a commercial organization rather than by a government department. This paper will not deal in any further detail with this fund as there is extensive Israeli literature on the subject.

Source: Ministry of Finance, 1990 Budget for the Ministry of Industry and Trade (Jerusalem: Ministry of Finance, 1990), pp. 27-39 [Hebrew].

The Bank for Industrial Development is setting up a $40 million fund (from the government) to assist recently arrived immigrants in starting new businesses. Another proposal being discussed by the Ministries of Finance and Industry and Trade is to set up a new government company with $60 million in capital to finance joint public-private sector high technology ventures. As this contradicts the stated policy of reducing the number of publicly owned companies, no decision has yet been made.

*First 10 months

Source: Ministry of Finance, 1990 Budget for the Ministry of Industry and Trade (Jerusalem: Ministry of Finance, 1990), p. 98 [Hebrew].

In addition to subsidies, the government provides assistance to industry in two other very important ways. It protects the local market against imports and it permits (and often encourages) monopolies. Despite free trade agreements with the EC and the U.S., imports are discriminated against. The very protected nature of the economy is illustrated by the 80 per cent levy on imported carpets and the 170 percent levy on imported cosmetics. Another example was the ban, until recently, on importing canned tuna fish. This was enacted in order to protect a tiny local industry which was itself totally reliant on imports and in which the domestic value added was very small. Cheaper imports from Southeast Asia are subject to even greater discrimination (including the use of quotas and import bans). No trade agreements exist with these countries to prevent these restrictions.

The distorting effects of protection have been recognized by the Ministry of Industry and Trade (in recent months) and by the Ministry of Finance, especially by the State Revenue Authority. Tentative steps in the direction of free trade have included the recent withdrawal of some administrative import restrictions on goods from Southeast Asia and a reduction in the customs duty on Japanese cars. These represent the very beginnings of a policy of allowing Israeli consumers to enjoy the cheaper prices charged by South East Asian producers.

There remains a great deal more to be done in this field; until the reform is complete distortions will remain. It should be noted that no comprehensive studies have been made of the effects of these policies. The State Revenue Authority, of the Ministry of Finance, which advocates free trade, has stated that the distortion of trade away from cheap sources of supply in Southeast Asia costs the economy hundreds of millions of dollars a year.

The L.E.I.C.

The Law was promulgated in 1950 and at the same time the Investment Center at the Ministry of Trade and Industry was founded to administer it. An Investment Authority at the Ministry of Finance dealt with philanthropic donations to Israel, mainly by Jews abroad, but also took on responsibility for encouraging investment by foreigners. The Bank for Industrial Development is also involved in evaluating proposals under the law and in promoting investment.

A division of responsibilities has been retained to this day, with predictable bureaucratic impediments.

The Law grants "approved status" to investment programs, either to start new projects or expand existing ones. This status is available to both foreigners and Israelis, but not on the same terms. The project is examined by the Industrial Development Bank of Israel, the relevant sectoral department of the Ministry of Industry and Trade, and by the Investment Center in order to determine its economic viability. The latter is defined in terms of high local value added and "marketing capability in the local market and abroad". 5 Approved status means that the company or project will receive government assistance in the form of grants and/or tax concessions and/or loan guarantees.

The Terms and Conditions of the L.E.I.C.

According to the Law the contribution to exports has to be greater in the central areas of the country than in peripheral areas. In the latter the contribution to local employment is given a higher weighting:

Development Area A (Golan, East Galilee, Jerusalem, Central and Southern Negev): 35 percent export; Development Area B (Central Galilee, Jerusalem Corridor to Beersheba in South): 45 percent export; Development Area C (Coastal Plain): 65 percent export.

Every company which receives "approved enterprise" status must finance 30 percent of the investment program from paid-up share capital. Long term loans are available from the commercial banks to approved enterprises. Approved enterprises are entitled to grants for investments in fixed assets alone (i.e., in buildings and new equipment). The grant depends on the location of the project:

Source: Ministry of Industry and Trade, Investment Center, "Explanation Sheet for Investors," [pamphlet] (Jerusalem: Ministry of Industry and Trade, 1987), p. 1.

In addition to grants, approved enterprises are given tax concessions. In the central area no grants are available: approved enterprises are extended the tax benefits described below. The extent of these benefits is related to the extent of foreign ownership of the enterprise. The rationale for this is not clear. Presumably foreigners need greater incentives to invest and/or the gains to the economy from their investment are greater per dollar invested than that of local entrepreneurs.

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