Karnit Flug: Where is society headed?
Main points of a speech by Dr Karnit Flug, Governor of the Bank of Israel, at the Central
Bureau of Statistics Conference, Jerusalem, 17 February 2014.
* * *
I will begin my remarks with data from the OECD, which compared GDP per capita in its
member countries with the US, broken down into factors which explain the gap between the
various countries and the US. In 2011, the gap between GDP per capita in Israel and the US
was close to 50 percent. The OECD also tried to project what the picture will look like in
2060, assuming that current policy trends in the various countries, and expected
demographic trends, continue. The gap between Israel and the US is expected to remain
more or less the same, as Israel is forecast to decline by four places in the country ranking.
This is clearly a troubling picture.
Economic policy is conducted under various trends and constraints, though we must
obviously remember that over the long term we can affect the overall framework of the
constraints as well. These trends and constraints include demographic trends, the
geopolitical situation, the level of governance and efficiency in the public sector, the scope of
public expenditures, taxes and the debt, and of course, the global environment in which we
work is very challenging.
Expected demographic trends point to two very dominant factors. A change is expected in
the composition of the population, by sector, with an increase in the share of the Arab sector,
and more so of the ultra-Orthodox sector, in the overall population. There is also a change
expected in the age distribution - Israel's population is relatively young, compared with
advanced economies, but there is an aging trend by us as well, and the share of those
65 years and older, currently around 10 percent, is expected to reach 17 percent.
In the labor market, the employment rates of ultra-Orthodox men and Arab women, as
known, are low. The productivity of the people from those population segments who do
participate in the labor market is low, on average. The good news is that there is
improvement, albeit slow, in the employment rate of these two segments of the population.
However, if we make a radical assumption, that the participation rates of those sectors will
remain at current levels, demographic trends on their own are expected to reduce the
employment rate by 7 percent in the long term. Thus, it is important that we continue to
invest in increasing the participation and productivity of the Arab and ultra-Orthodox sectors;
otherwise, not only will we not remain in place, but we will even widen the gap vis-à-vis the
advanced economies. For example, in educational achievements, already today there is
some gap between Israel and advanced economies, and it can be assumed that the Arab
and ultra-Orthodox sectors are themselves at some gap vis-à-vis the general population in
such achievements. The implication is that under current conditions, the increase in labor
force participation of these sectors will be reflected in the addition of employees whose
productivity is low to the workforce.
The data indicate that in recent decades, the gap between Israel and advanced economies in
output per hour has remained. Among the factors in this phenomenon are an unfriendly
business environment, as reflected in international indices such as the Doing Business index,
the problem of low competitiveness in specific industries, and a low rate of investment which
leads to insufficient capital stock. Looking at per capita GDP, as well, indicates that we have
not closed the gap in recent decades. Although we have seen more rapid growth of our per
capita GDP in recent years, in light of the relatively moderate negative impact of the crisis on
Israel's economy compared with other advanced economies, we clearly don't want to hope
for a continued contraction of the gap between Israel and other advanced economies based
on the this factor. The two demographic trends that I discussed - the decline in the share of
the working age population, and the increase in the share of sectors with relatively low
employment rates - are expected to deduct 1.3 percentage points from the annual growth
rate. In this regard, I of course noted the improvement, which is still slow, in the employment
trends in the Arab and ultra-Orthodox sectors.
The aging of the population is expected to lead to a sharp decline in the ratio of number
people of working age to the number of the elderly, from 5.5 today to 3 in 2050. The meaning
of this is that there will be a need to increase the allocations for old age allowances, on
healthcare expenditure, nursing care, and such, in order to maintain the current level of these
allowances and services. Poverty is another issue with which we will need to deal. In recent
years there has been a trend of increase in the poverty rate among families with workers,
while the stability in the general poverty rate is the result of an increase in the share of
families with one or both parents working, which is an outcome of the trend of increase in
labor force participation. The picture is essentially of workers whose earning power does not
allow them a respectable livelihood, and so there is an increase in the number of poor
families in which there are one or two wage-earners. In this context, expanding the earned
income tax credit (negative income tax) is an efficient policy tool to deal with the problem, as
it focuses on the working poor, and in contrast to a policy of allowances, it does not contain
negative incentives. In the long term, of course, the main key to solving the problem of
poverty is continued investment in education and increasing earning power.
The challenges I have presented here will require a significant increase of civilian
expenditure on services such as education, healthcare, welfare, and infrastructure, even if
only to maintain the current level of services, given the expected changes in composition of
the population. In order to ensure that maintaining the civilian expenditure level will not
negatively impact on the important effort to continue to reduce the debt burden, there will be
a need to continue to increase tax revenues. This can be achieved in 3 ways, each on its
own or in some combination of the three:
1. Increasing tax rates, which obviously increases the burden on activity and growth.
2. Reassessing the tax exemption system. In this regard, it should be remembered that
some of the estimates of the cost of existing exemptions are biased upward, since
they do not take into account the expected change in activity resulting from the
cancellation of the exemption.
3. Reducing the shadow economy and enhancing collection. It is clear that from the
perspective of statistics bureaus worldwide, estimating the extent of the unreported
economy poses a large challenge. A very rough estimate by the World Bank, which
apparently has a large margin of error, assesses that the unreported economy is
about 20 percent of GDP in Israel. In this regard, there are several processes which
are being discussed: definition, in legislation, of severe tax crimes as source crimes
under the Prohibition on Money Laundering Law, which would allow the transfer of
information between the Israel Money Laundering and Terror Financing Prohibition
Authority and the Israel Tax Authority, and making punishment for tax crimes more
severe; collaboration between all the enforcement entities and transfer of
professional and intelligence information which will make enforcement against tax
evaders more efficient; and a reduction in the use of cash and third-party checks,
which is currently being considered by the Locker Committee.
To the extent that we will be able to do more in increasing the efficiency of the tax exemption
system and enhancing tax collection, we will be able to increase overall tax revenues without
increasing tax rates.
To summarize, the economy faces the challenge of supporting inclusive growth, which
integrates population sectors with low participation rates, while increasing their human capital
and earning capacity and increasing productivity. To that end, we must formulate a focused
strategic plan, which will include integrating population sectors into employment
(ultraOrthodox, Arabs, older workers), dealing with increasing human capital, dealing with the
factors leading to slow growth of productivity (infrastructure, business environment,
competitiveness), preparing public services systems (healthcare, nursing, etc.), and reducing
the unreported economy by collaboration between all entities.
The data I presented in the beginning of my remarks showed that an "automatic pilot" policy
will not lead us to reducing the gaps with other advanced economies; however, there is some
room for optimism, as an effective and well thought-out policy can definitely improve our
situation over the long term.