Source: Bank of Israel, Annual Report 1989 (Jerusalem: Bank of Israel, 1990), pp. 98, 99 [Hebrew].

A Case Study of the Application of the Law

Apart from the economic effects of the Law, it is badly administered. Every year the State Comptroller presents cases of maladministration.

One of the most controversial cases under the Law was that of Intel. The 1988 report describes the sequence of events leading to the probable misallocation of $51 million of public funds. (The State Comptroller does not publish the names of companies). 16

The Israeli subsidiary of the U.S. firm received approval from the Investment Center in the Ministry of Industry for a $58 million investment in a high technology plant in Jerusalem. It was offered 35 percent in grants and 50 percent in development loans, at subsidized rates of interest. In 1981 the overall investment was increased to $76 million, with a corresponding rise in grants and loans. An extra $2 million subsidy was added to cover the costs of training local staff at the parent company in the United States. As the equipment was being purchased the company decided to change the product and for this it needed a further investment of $47 million. A new total investment of $123 million was approved in 1983.

In March 1986, a $60 million expansion was announced, despite doubts, expressed by the State Comptroller, about the balance of payments, employment and tax benefits of grants now worth over $50 million.

The State Comptroller pointed out that the company was set up in Israel in order to sell exclusively to the parent company. The parent company would sell know-how and raw materials to the subsidiary and the pricing of these would be determined by the company in the light of taxation and other considerations. Market forces would not determine prices and would therefore not determine profits, output, employment or exports. Despite this, for more than six years the Ministry of Industry and Trade failed to investigate the company's proposals.

The decision to provide dollar linked loans at interest rates as low as 1/2 percent was severely criticized, and the loans were renegotiated. The 1986 decision regarding the $60 million expansion was taken by the Director of the Investment Center rather than by the body authorized to do so, the executive committee.

The State Comptroller levels two types of criticisms. The first is that the feasibility studies were not carried out properly. Sometimes uncritical use was made of data supplied by firms applying for grants. The second criticism is that procedures followed were not those specified in the Law.

Two conclusions can be drawn from these official reports. The first is that the Ministry did not have the capacity (either qualitatively or quantitatively) to carry out the analysis required. The second is that as a result of politico-bureaucratic procedures the right conclusions were not drawn. The State Comptroller is not authorized to conclude that perhaps the system is inherently wrong and therefore prone to faults.

It is very significant that there is no publicly available study, either from official or unofficial sources, that systematically analyzes the effects of the L.E.I.C. Schwartz has conducted the most comprehensive analysis of the effects on the development regions, 17 but no studies, either academic or official have been published comparing the health of subsidized versus unsubsidized companies.

Conclusions: Proposals for Reform

There are two categories of firms in Israel: those which receive government assistance (in the form of L.E.I.C. grants, allocated credits and tax concessions), and those which do not. In order to finance the former, taxes on the latter (and on the rest of the economy) are higher than they might otherwise be. Firms have to apply for special treatment, in itself a source of bureaucracy and a distraction for enterprises that should be getting on with other things.

* Excluding income tax on undistributed profits.

Source: State Revenue Authority, Annual Report for 1989 (Jerusalem: Ministry of Finance, 1990), p. 161 [Hebrew].

The best environment for business is a stable, predictable tax regime, one which does not discriminate between firms but subjects them all to the lowest tax rates possible. On this basis all subsidies and tax concessions should be cancelled and the revenues saved should be used to lower the general level of corporate tax. Although radical solutions are possible, there would be considerable opposition for a number of ostensible reasons:

1. The need to attract investment to Israel, given the concessions offered to investors by other countries;
2. The desire to spread investment throughout the country;
3. The perception that as Israel is at war, some investors (local and foreign) will not take risks here, or that the risks are higher than elsewhere and so compensation is needed. (In fact the risk is as much internal, having to do with bureaucratic factors and the capriciousness of government policy, as external.);
4. The need to encourage venture capital and high technology;
5. The need to promote investment at a time of unemployment and large scale immigration.

The following measures are therefore proposed:

1. Retain L.E.I.C. for the next three years and apply the subsidy to jobs created in the firm.
2. Re-define development areas very narrowly to a small number of towns and/or industrial parks in development regions. End tax breaks for firms not relocating in these regions and apply the funds to improving infrastructure in the new development regions.
3. At the end of three years terminate all grants and offer tax benefits only to newcomers.
4. Make the criteria for assistance clear and publicly available.

This plan has a number of advantages. It removes the distortion in favor of capital and will therefore encourage employment generation. The choice of how much capital equipment should be applied to each work place will be determined by economic/market considerations rather than by rent seeking.

Secondly, it will strengthen regional policy by concentrating its effects. The state will do more of what it is better placed to do (providing infrastructure) and less of what it cannot do (choosing capital/labor ratios in firms). By providing grants in the first three years there is a chance that a critical mass of firms will be attracted to a given development area, thereby encouraging other firms and services to move in. The later comers (after the first three years) will be compensated for any losses resulting from their location by tax concessions.

Firms receiving grants in the first three years will receive tax breaks for four years thereafter. Tax breaks are widely considered to be more effective than outright subsidies. This should be part of an overall move to simplify and increase the predictability of the tax system and to reduce the reliance of business on government.

The budget division of the Ministry of Finance has recommended that the Investment Center be closed and that private accountants be allowed to deal with applications for government assistance, as long as it lasts, in the same way as they are authorized to sign company balance sheets for tax and stock exchange reporting purposes. 18 This would also contribute to a reduction in bureaucracy.

Dr. Paul Rivlin is a Policy Analyst at the Institute for Advanced Strategic and Political Studies and also practises as an economic consultant.

NOTES

IASPS Policy Studies are published by the Institute for Advanced Strategic and Political Studies, Jerusalem. Nothing written here is to be taken as necessarily representing the views of IASPS or as an attempt to aid or hinder legislation in Israel or the U.S.
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