The law has had three major effects, all of them negative. Firstly, it results in a misallocation of resources between labor and capital and as a result has largely failed as a tool of regional policy. Schwartz concluded that the L.E.I.C. improved the absolute position of the development areas being assisted but did not improve their relative position (vis-a-vis the developed regions). It encouraged traditional industries to locate in the Negev and the Galilee rather than modern ones. The former paid lower wages and their financial viability was often marginal. The law encouraged over-investment in capital, with the result that fewer jobs were created. 7

There is also increasing discontent with the fact that unemployment is highest in precisely those areas which the Law provides with maximum assistance. 8

Source: Bank of Israel, Annual Report 1989 (Jerusalem: Bank of Israel, 1990), p. 199 [Hebrew].

Secondly, the Law has been a burden on the state budget, particularly in the period when subsidized loans were issued on an almost open-ended basis. Meridor has described the way in which subsidized loans (available until 1985) increased the budget deficit. 9 These loans had fixed, nominal interest rates but as inflation accelerated in the late 1970s and early 1980s the rates became negative in real terms. What the borrowers gained, the lender (the government) lost. The budgetary cost could not be anticipated because it depended on the rising and highly unstable inflation rate. Between 1960-1966 and 1971-1976 total civilian government expenditure as a share of GNP rose from 23 percent to 44.5 percent. One third of this increase was accounted for by the increased cost of subsidized loans. The absolute cost of cheap credits is detailed in Table 8.

Finally, the L.E.I.C. forms part of a business environment in which the state continues to try to make decisions for the private sector and in which companies rely on the government excessively. This has important consequences in behavioral terms, and is looked at in greater detail in the section below on the soft budget constraint. The loans, at subsidized rates of interest, and the grants now being provided under the L.E.I.C., have played an extremely important role in the economy. According to one expert on the economics of industry in Israel:

The productivity slowdown [in industry since 1973] is explained by the combined effect of three factors: the rapid acceleration of inflation to 3 digits in the 1980s; the heavy capital subsidization which increases excess capacity; and [sic] structural change. 10

Little has changed since another expert wrote in 1971:

In summary, the combined effect of all government policies directed towards industry was to encourage the growth of those branches that could improve the balance of payments (although not necessarily in an efficient manner). Little systematic attention to the problem of labor absorption is evident. Indeed, the combined effects of excessively low interest rates, low tariffs on imported machinery, and accelerated depreciation allowances on new investment probably intensified the process of capitalization and reduced employment opportunities. 11

1. Investment
Law for Encouragement of Investment Capital	230	0	230
R&D	115	0	115
Industrial infrastructure	15	0	15
2. Production & Marketing
Foreign Exchange fund	0	600	600
Shipments fund	0	750	750
Marketing fund	6	100	106
Long Term fund	0	150	150
Exchange rate insurance	545	0	545
Foreign Trade Risks insurance	15	0	15
Other	30	0	30
3. Aid to firms in difficulty
Assistance fund	4	0	4
Assistance to firms in areas of high unemployment	8	0	8
TOTAL	968	1,600	2,568

*The banking sector

Source: Ministry of Finance, 1990 Budget for the Ministry of Industry and Trade (Jerusalem: Ministry of Finance, 1990), p. 55 [Hebrew].

Grants under the L.E.I.C. now account for $230 million, about 25 percent of total industrial subsidies. Tax concessions granted amount to $70 million, about 15 percent of total tax concessions. Their effect on the allocation of resources is much greater than these percentages imply. The Law was originally designed to promote employment in development areas. Since its inception in the 1950s, the emphasis has shifted toward exports. There is therefore a mix of objectives which sometimes creates contradictions: employment maximization is not synonymous with export maximization.

Two other issues are of importance here. The Law accords govern-ment officials and ministers wide discretion in handing out grants to those industries which they favor. They can also designate towns or regions as development areas. The State Comptroller's report testifies that grants are misallocated, that the Investment Authority at the Ministry of Industry does not always operate inside the Law, and that ministers intervene.

The Law also creates at least two classes of enterprises: those which receive assistance and those which do not. Within the favored group those with more foreign investment receive more privileges. This is an even more serious problem, which has been acknowledged by experts both within and outside of the government, but which has not been rigorously examined.

The Bank of Israel has criticized the loan guarantee scheme for not sufficiently involving the private banks (of which the government is at present the majority shareholder). 12 There have also been criticisms that the premiums are too low. Finally the government may have trouble checking all the applications that are anticipated.

Source: Ministry of Finance, Main Points of the Budget 1990 (Jerusalem: Ministry of Finance, 1990), pp. 150, 168 [Hebrew].

Rent Seeking

According to Ricardo, rent is paid for the use of the "original and indestructible powers of the soil". 13 The prime example of rental income today is the revenues of oil producing countries from sales of their finite natural resource.

Krueger adapted the Ricardian definition to cover legal and illegal competitive seeking of returns from commodities in short or fixed supply. 14 She put forward the idea that certain goods or services, which are not of their nature finite in supply, may in fact be unavailable, or in limited supply in some economies. As a result those who can sell or use them receive an income which contains a rental element because of the shortage.

Krueger's definition (which she developed in connection with quotas or import licensing in developing countries) can be adapted to include finance, or finance at a lower price than others pay. Firms which receive "approval" in Israel get subsidized finance and therefore start in a better competitive position than firms which do not. They benefit from what might be called the rent on a scarce resource: finance. This explains the demand for aid. New companies and those considering expanding will always seek ways to obtain government help, something which affects their planning and decision making and which occupies their time and that of their financial advisors.

Source: Ministry of Finance, 1990 Budget for the Ministry of Industry and Trade (Jerusalem: Ministry of Finance, 1990), p. 47 [Hebrew].

It is important to note that the resources obtained by one company through rental income are not free. They have to be paid for somewhere in the economy (assuming that they are not gifts from abroad directed specifically to the company in question.) In fact, they are paid for by everyone else through taxation or through the costs of government borrowing. This creates a double effect. Company A receives a $1 million grant. It is therefore $1 million better off than those who do not receive a similar grant. Others have to pay for it: they are therefore made worse off. If we assume, for the sake of simplicity, that there are one million agents (i.e., firms and individuals) in the economy then, assuming a very simple tax system indeed, each of them will have to pay $1 more tax.

The Soft Budget Constraint

The environment in which firms work is a very important determinant of their functioning and success. It is natural, though not necessarily desireable that the government seeks to assist companies, in which it has a stake, from failing. The government has two forms of interest: through ownership and through assistance. Public sector companies are also eligible for assistance under the L.E.I.C. Either because it owns them or because it has invested in them, the government is unwilling to see companies go bankrupt. It therefore continues to help those firms in difficulties, providing them with continued rental income, in light of Krueger's definition,

The best industrial example in the public sector is Beit Shemesh Aircraft Engines. This company, owned by the Ministry of Defense, has never made a profit. An example of the second type is Koor. This giant is too big to be allowed to collapse and like Chrysler in the United States, the government continues to assist it. The government also organized help for Elscint, a large high technology exporter, when it faced bankruptcy in the mid-1980s, and has a standing fund to assist other companies in difficulties.

The environment in which companies work has been examined by the Hungarian economist, Kornai. His analysis is relevant for Israel. He examined reforms in Hungarian companies in terms of what he called the budget "constraints". 15 A hard budget constraint on a company is one in which the following five conditions hold:

1. Prices are exogenously determined (i.e., the firm has no influence over prices in the market).
2. The tax system is "hard". Tax rates cannot be influenced by the firm. Taxes are linked to various objectively observable and measurable criteria. Firms cannot receive individual and exceptional exemptions. Taxes are imposed unconditionally.
3. There are no free state grants.
4. There is no credit.
5. There is no external financial investment.

The last two conditions are very "hard" and are unlikely to apply in any real market economy. Kornai gives a range of conditions which might more realistically apply. In an "almost hard budget constraint" there is some price making by companies (i.e., some are big or powerful enough to set their own prices and thus influence the market). There is also some credit on tough conditions and there is also some external investment on the same terms. In a soft budget constraint (what Kornai calls the "pure" case) the following apply:

1. Firms make their own prices.
2. The firm influences tax rules, obtains exemptions and post- ponements; taxes are not strictly collected.
3. There are subsidies and soft credits to firms.

Kornai uses these definitions to describe the environment in which business operates. The conditions applying will decide whether the difference between proceeds from production and the cost of production determines the firm's survival. Where the soft budget constraint applies, the generation of funds is not vital for growth. The firm will not have to adjust its prices to changing market conditions. It will share with the state the risks involved with its activities and the profits which it makes.

Commenting on the use of these definitions in market economies, Kornai makes the point that today's large corporations are price makers. They cannot be allowed to go bankrupt because they are so big that their collapse will result in mass unemployment. The nature of the budget constraint will, in all types of economic systems, influence the behavior of management.

Israel is a country in which many firms face a soft budget constraint. The high degree of protection through quotas and customs duties also means that local producers and distributors can often set their own prices within the context of a domestically monopolized or cartelized market.

All those who receive subsidies under the L.E.I.C. start in a privileged position. Not to apply means foregoing something that competitors and potential competitors receive or may receive. Among the first considerations for any business is whether to apply for a grant; this affects the psychological outlook of investors, owners and managers. It may affect the location of the plant. All of this distorts the process of analyzing the market and the many other factors which should be looked at when a business starts.

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