Governor’s Remarks at the Eli Hurvitz Conference on Economy and Society 2019
Over the course of the past year, the Bank of Israel put a spotlight on the two main economic challenges we face, and that the next government will not be able to ignore—the fiscal challenge, which is a short-term and medium-term challenge, and the need to increase labor productivity in Israel—a medium-term and long-term challenge. In my remarks, I will give a short reminder and an update about the status of each of these challenges. I will then try to answer the question of whether there is a reason at all to discuss them given the political and fiscal situation in which we find ourselves.
The fiscal challenge
We all know that the responsible fiscal conduct of Israeli governments led up to the past year to a decline in the debt to GDP ratio from over 90 percent in the beginning of the 2000s to 60 percent last year. We are already reaping the benefits of this decline in the debt to GDP ratio, in the form of a marked decline in the government’s interest payments burden, due to the quantitative decline in the debt to GDP ratio as well as the decline in interest rates that derived from it, among other things. However, as you know, in the past year this trend halted, and the increase in the deficit led to an increase, even if small for now, in the debt to GDP ratio for the first time in 10 years. The steps taken in the past created credibility, which is an important strategic asset. Therefore, despite the political uncertainty, the financial markets believe that when a government is formed, it will know to deal with the budget gaps. As such, it is very important that the issue is in fact dealt with when a government is formed.
The Bank of Israel Research Department’s updated assessments, which I present here for the first time, show that in the “business as usual” scenario—if the government continues to carry out all the plans and undertakings that it has taken on itself, and does not raise taxes, the deficit is expected to stabilize at a dangerous level of over 4.5 percent of GDP, and the debt to GDP ratio is expected to diverge and in 2025 reach approximately 75 percent of GDP. These are significant levels, and they do not include a supplement that the government will possibly decide on regarding the defense budget. In addition, these results are reached under the assumption that the economy will continue to grow at the potential rate and with full employment. In the “slowdown” scenario, which unfortunately is not implausible, the growth in the deficit and debt will be even more notable. Thus, it is clear to us that a very great effort will be required by the government to converge the fiscal aggregates. Even meeting a deficit of 3 percent of GDP, which will require considerable effort, will not prevent a continued rise in the debt to GDP ratio. Therefore, the government ultimately will have to make a greater effort to stabilize the debt to GDP ratio.
Where can the efforts be concentrated? In the beginning of the 2000s, when Israel was at the threshold of a fiscal crisis, the government carried out a relatively sharp cut in civilian budgets. Today, primary civilian expenditure is very low in international comparison, and lower than what it was at that time. Moreover, the increase that we saw in civilian expenditure in recent years is the result of the government having to provide a response to the public’s budget demands. Therefore, there is a low probability that it will be possible to cut expenses substantially without very painful cuts in services supplied by the government. With that, I emphasize that this does not mean an increase in efficiency is not needed—I am of the opinion that every budget needs to be screened to see where and how efficiency can be increased, and I am sure that there are more than a few budget items in which efficiency can be markedly increased.
However, ultimately, in order to meet the fiscal challenge, the government will have to act to increase revenues, and it is important to remember that both the actual and statutory tax burdens have declined in recent years and are lower than the OECD average. In choosing the optimal composition of revenues, the first thing to do is to cancel exemptions that do not have economic justification, and to avoid as much as possible distorting taxes that will adversely impact incentives and productivity.
I would also like to say something about the period that we are about to enter. The budget for 2020 looks set to be an interim budget, and each month it will be possible to spend up to 1/12 of the budget for 2019. This on its own will lead to fiscal contraction relative to a “business as usual” budget, by about 1 percent of GDP on an annual level. However, it is clear that this is not the efficient contraction that reflects priorities. As I noted, the fiscal convergence will apparently need to be carried out by some composition of efficiency measures, cuts, and taxation.
Moreover, the 1/12 budget will be particularly challenging in the first months of the year: the budget is supposed to cover the government-debt maturities as well. In total, the debt repayment in 2020 is lower than for 2019, so if the interim budget would continue throughout the year (which we of course very much hope will not be the case), it will be possible to slightly increase the budget on other expenditures in 2020 relative to 2019. However, an analysis of the expected maturities flow indicates that in the first months of the year, they are greater than in the remainder of the year, and therefore the budget that remains for current expenditures will be lower. This means that the 1/12 limitation will be more painful in those months. The Ministry of Finance has a heavy responsibility at this time to prioritize the expenditures and the Accountant General knows how to provide financing solutions within the framework of the requirements of the law, but in any case it will not be possible to provide all the needs and it is clear that important expenditures will be adversely impacted.
The productivity challenge
At this point, I would like to say a few words on the Israeli economy’s biggest challenge. Four months ago, we published the “Research Department Special Report: Raising the Standard of Living in Israel by Increasing Labor Productivity”. The report presented the productivity challenge and its various components—the deficiency in infrastructures and in business capital, the need to improve human capital, and the need to ease the bureaucratic and regulatory burden on the economy. I will begin with human capital.
The data, for the most part, are familiar—we showed, based on PIAAC tests, that the basic skills of workers in the economy are very low in international comparison. We are suffering from marked inequality in skills level—the gap vis-à-vis advanced economies is focused on the lower deciles, which makes the inequality worse. Although the average number of years of schooling in Israel is markedly high in international comparison, it does not translate into higher work skills. We are studying a lot, but getting very little from that. I want to turn your attention to an interesting figure: the skills gaps are not just the result of the variance between the various population segments—in the Jewish non-ultra-Orthodox sector there are also wide gaps. With that, it is important to say that the ultra-Orthodox and the Arab sectors are certainly characterized by a very low skills level relative to the overall population. Recently it has been claimed that the problem is not in the education system’s budget but in its performance. In fact, the expenditure on education relative to GDP per capita has in fact increased in the past decade, but this occurred after a prolonged decline in the preceding years, and in any case we do not see an improvement in results due to the increase in the budget. The problem is apparently a twofold one—our insufficient investment in education, and the manner in which we utilize the budget.
An additional area that requires improvement is physical capital. The capital stock in the economy is low in international comparison, and the share of investment in GDP is also low. Therefore, at this pace we will not be able to close the gap vis-à-vis the advanced economies. Moreover, human capital and physical capital are complementary production factors and therefore investment in one will lead to the improved worthwhileness of investment in the other. There is considerable evidence of employers who claim that the worthwhileness of their investment in advanced technology is negatively impacted as a result of the shortage in a skilled workforce that can operate the technology effectively. The construction industry is a clear example of an unskilled workforce leading to a lower level of mechanization, and the cycle renews.
The shortage in business capital joins the severe shortage in infrastructures, which recently erupted in what appears to be a crisis in the transportation area. The burden on transportation infrastructures increased, and the public transportation infrastructure is such that use of the system is markedly lower than generally seen in advanced economies.
Although regulatory processes did improve recently, even if the improvement we saw this year in the Doing Business index does fully reflect actual improvement, there is still a long way to go. The public sector’s switch to full digitization, a process that is beginning to take hold, should markedly reduce the difficulty in complying with regulatory conditions, and primarily to make things easier for small businesses.
Together with identifying the problems and challenges in the Productivity Report, the Research Department also provided real recommendations for dealing with them, while providing quantitative data for costs vis-à-vis increased productivity. In the area of human capital, the recommendations focused on creating an incentive for shifting high quality teachers to schools from a weak background, and on improving the incentive structure for teachers, with an emphasis on the required subjects (such as math and science), and creating an infrastructure for effective assessment of teachers based on reliable indices of quality. Emphasis was also placed on improving the teaching environment, and in view of the fact that the literature today recognizes how critical the first few years of schooling are, we recommended improving the quality of daycare centers for ages 0–3 alongside enhancing the pedagogical component and increasing the availability to children from a weak socioeconomic background. In addition, we recommended to strengthen professional training and concentrating it within post-secondary frameworks, and to promote the reform to reduce the number of technological colleges and increase the quality and quantity of leading colleges.
Regarding the deficiency in physical capital, the report suggests a change in the incentive structure deriving from the Encouraging Capital Investments Law—to allocate the resources in favor of companies with unique knowledge and management methods that will be able to trickle down to the rest of the economy. All this is while maintaining the benefits to knowledge-intensive multinational companies and increasing the attractiveness of the economy to all companies by removing bureaucratic barriers and investing in physical and human infrastructures.
The report indicates the urgent need to increase the scope of investment in public transportation infrastructures with the goal of closing the gap in stock vis-à-vis the OECD, providing preference for using underground public transportation in metropolitan Tel Aviv, and public transportation with designated lanes in less congested areas. In addition, complementary steps are necessary to regulate demand: effectively promoting travel alternatives such as car pools and organized rides, distance-traveled tax/congestion fee, pricing of parking, and dealing with the problem created as a result of salary and tax benefits that encourage use of private cars.
In terms of the need to improve the business environment, we recommended to establish a designated court for commercial issues, to establish targets in wage agreements for adopting digital processes in the interaction between the government and the business sector. Likewise, we suggested to change the business licensing processes required before setting up a business, and replacing them with retroactive declaration and oversight, to adopt international regulation to the extent possible, and to remove from public workers the personal responsibility regarding the materialization of various risks related to the areas overseen regulation-wise, except of course in cases of gross negligence.
Where will the money come from, and what is there to talk about in the current situation?
The annual cost of implementing the report’s recommendations is about 3 percent of GDP, while the benefit in the long term will be markedly higher—more than about 20 percent. With that, the budget situation justifiably raises the question—is it at all possible to implement such ambitious recommendations without further risking the fiscal responsibility? And moreover—in the unexpected political situation that we have reached, how at all is it possible to promote such significant steps?
We were aware of the budget challenge even at the time we published the report in August. We said then, and I repeat it now—the government that is elected will have to prepare, from the fiscal framework perspective, to ensure the stability of fiscal policy and the availability of the sources to finance the investments. Notwithstanding the budget situation and the political situation, we do not have the luxury of waiting. To some extent, the political situation actually provides time to prepare plans, which can then be presented to the government and the Knesset that will be elected, and will begin to work very soon, we hope, after the elections. The required steps are significant, and some of them will require discussion in the political system as they also reflect a choice between various social options. However, there are quite a few steps that do not require notable budgetary investment at this time, but require the preparing of plans and institutional preparations, and for which there is no reason they cannot already begin being planned.
It is now clear to all that in the Tel Aviv metropolitan area we will have to build a mass transit metro system. This is a very large investment, and I will immediately refer as well to the financing issues. However, even in the optimistic scenario, the investment can begin to be carried out only after several years. It is also already clear today that in order for the investment to pay off, a metropolitan authority or similar entity that concentrates all the authorizations regarding the planning and execution will have to be set up. From my conversations with leading foreign investors, I received the impression that they may be very interested in investing in such a project, for example in a turn key model, but they won’t get into it without regulatory certainty that only such an entity can provide. Just to illustrate, the metro will have to pass through the area of quite a few municipalities. If the entrepreneurs will have a concern that one mayor will not be able to reach agreement with another mayor regarding the location of a station, and thus will significantly delay the project, their willingness to enter it will be adversely impacted from the beginning. The establishment of such an entity will require support from the political system, but it is possible to plan it already today.
The issue of financing such a project also needs to be planned, and thus there is significance to the timing of the fiscal challenge as well as the challenge of investments to increase productivity. The coming 2 years should be utilized for fiscal balancing and the stabilizing of the debt to GDP ratio, and at the same time to invest the small amounts required for the planning processes, so that beginning from 2022/2023 and onward we will create fiscal space for large investments, led by the metro project. It is very important that the project is conducted with regulatory certainty and a closed and designated budget, something that in and of itself requires precise planning in advance. Under such circumstances, even if there will be a need to support a project by some increase in the deficit, the financial markets will accept that it is an efficient investment and that it will not create a risk to stability. I emphasize that it is important to reach this point after the debt to GDP ratio has stabilized and the project’s budget is closed and defined.
Another example from education—we showed that in order to improve the results of the education system it will be necessary to use indices of educators’ teaching quality. Such indices will obviously have to be multidimensional and to take into account the area of study, students’ age, and more. The implementation of such a method will apparently require a political discussion as well, but even before that it seems proper that pedagogical experts take advantage of the time and develop a series of such indices, which can be provided to the Minister of Education immediately after the elections.
These are just two examples, and we can think of others. I call on the senior civil servants at the government ministries to utilize the coming period to prepare all those plans that the next government will have to adopt in order to provide a response to the long-term challenges to the Israeli economy. The Bank of Israel will assist in research, planning, knowledge and data.