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Labor productivity—the ratio between GDP and the number of employees—measures the economy’s production capacity over time, taking into account the number of employees available to it. In Box 2.1 of the Bank of Israel Annual Report for 2012, it was found that in 2011 labor productivity in Israel was 14 percent lower than the OECD average, and output per hour of work was lower by 24 percent. The box noted several factors that may explain the lag. In addition, Brand[1] has found that productivity in domestic-market oriented industries is lower than productivity in export industries. In this box, we examine whether the inferior position of these industries is more significant in Israel than in other OECD members, and whether this provides part of the explanation of the lag in productivity in the total business sector.


As Figure 1 indicates, the gaps in labor productivity[2] range from 50 percent to Israel’s disadvantage in the clothing sector and 30 percent to Israel’s disadvantage in the construction sector, to more than 40 percent to Israel’s advantage in the medical equipment, optical equipment and metrology equipment sector. There is a gap to Israel’s advantage in the electronics and chemicals sectors as well. The figure indicates that there is a positive correlation[3] between the share of exports in an industry’s output and the productivity gaps (when they are to Israel’s advantage). An examination shows that this correlation is almost unique to Israel, and that other than Israel, it is notable only in Germany and Denmark.


A possible reason for this phenomenon is that export industries deal with tougher competition than some of the domestic-market oriented industries. The latter therefore have less incentive to become more efficient, particularly if there is little import competition relative to domestic output volume. However, as Figure 2 indicates, there is no evidence of such a connection. No correlation was found between the productivity gap and the share of import competition in total output. While the productivity gap is negative, for example, in the food industry—a field where there is a low percentage of competing imports—it is also negative in industries where competing imports constitute more than half of output that is sold in Israel, such as the clothing, leather goods, wood, paper, and the printing and publishing industries. It is likely that there is no positive connection between the two variables, because in these industries, too, there is basically little competition due to importer exclusivity, or because the high productivity of domestic production does not justify the entry of a competing importer.
A second possible reason for the positive connection between the share of exports in an industry’s output and productivity gaps is that the major export industries exploit Israel’s relative advantage in the field of human capital and innovation. As has been written in this report in the past, the Israeli economy is characterized by duality: there are export industries which are human capital- and innovation-intensive, and there are industries suffering from inferior positions. This leads to the question of whether this duality is an exception in the world.
Table 1 finds clear signs of this. In Israel, relative to the OECD average, there is a high share of people with higher education in manufacturing industries that export most of their output, in the finance and insurance industries, and in the professional, technical and scientific services industries.[4] Productivity in these industries is not lower than the average productivity in OECD countries, and is even higher than it in some industries. In contrast, in industries in which the rate of higher education is similar to the rate in other countries, there is a productivity gap to Israel’s disadvantage.
These findings on their own explain only the accomplishment of the successful industries, but cannot explain the lag in the rest of the industries. To complete the analysis, we compare the share of positions that require higher education[5] in Israel with the share in the OECD: In almost all industries where productivity is low, the share of positions that require higher education —particularly engineers and scientists—is lower than the parallel share in the OECD.[6] This is the case, for instance, in the manufacturing industries with relatively low exports, and in the construction and commerce industries which, by their very nature, are domestic-market oriented. The apparent conclusion is that those with higher education in these industries obtained education that is not relevant to the post they occupy. This finding is consistent with Brand’s important finding that Israel has a very low return to education in primarily domestic-market oriented industries. The conclusion we draw helps to explain both the low productivity in these industries and the low return to education of their employees.
The data from Israel on the development of capital stock[7] per employee are consistent with the lag in productivity in the domestic-market oriented industries. As Figure 3 indicates, between 1995 and 2011, there was rapid and consistent growth in capital stock per employee in the manufacturing export industries[8], while growth was much more moderate in the other industries, reaching near zero by the end of the period.[9] The moderate increase in these other industries may derive from the fact that the marginal productivity of capital in these industries is lower, inter alia because of the weakness of human capital found in them. This moderation is reflected, obviously, in the slow growth of labor productivity, but it may also reflect slowness in the assimilation of innovative technology.
The findings brought herein bring the picture of duality in the economy into sharper focus. The export sector and some of the services industries have gradually exploited Israel’s advantage in the field of human capital and innovation, yielding relatively high productivity. In contrast, the other part of the economy does not properly exploit Israel’s advantage in this area.[10] The industries that have been left behind are labor-intensive industries that have managed by basing themselves on relatively cheap labor, due to the rapid natural growth in Israel and the use of foreign workers who earn low wages.
The National Economic Council found that there is a shortage of engineers in the economy and that there are obstacles to an increase in their numbers. Various functions are working to resolve the problem. It is important to continue to support the export industries that are human capital- and innovation-intensive, by removing the obstacles to further growth in the supply of employees in the engineering professions that are relevant to the high technology field. Yet at the same time, it is possible that the more significant potential for improving productivity in the economy is actually in the manufacturing industries that do not export much currently and certainly in nontradable industries such as the construction industry, the commerce industry and the more low technology part of the services industry, the existence of which is dictated by reality. In order to fully utilize their potential, policy must be formulated and implemented to increase the supply of employees with education that is relevant to these industries, encourage the integration of the latest technology[11], and increase their reliance on employees with skills and human capital. In that way, perhaps the lag in the human capital intensity in some of the industries will be narrowed, the worthwhileness of investment in physical capital will increase, and the productivity lag in those industries and in the economy as a whole will decline.

[1] Brand, Gilad, “Israel’s Growth Paradox: Declining Productivity and Returns to Human Capital,” The Milken Institute Fellows Program, 2014.
[2] The data that will be presented below in this box relate to productivity per employee and not productivity per work hour, since in the OECD there are only partial data on work hours at the industry-specific level. But when we examined the partial data, we found that relative to the OECD average, the number of work hours in Israel is similarly high in all industries. Therefore, the conclusions as to industry productivity gaps are not sensitive to whether productivity per employee is used instead of productivity per work hour.
[3] The connection between the variables was found in a regression to be statistically significant.
[4] This industry includes the computer and R&D industries among others.
[5] Academic professions according to the Central Bureau of Statistics classification of occupations and the parallel international classification. They include, for example, engineers, scientists, economists, and accountants.
[6] Exceptions are the agriculture industry and the electricity and water industry, because in both of these, there is a relatively high share of employees with higher education and low productivity. Apparently, other factors that are unique cause labor productivity to be low relative to the rest of the world in these industries (for example, differences in climate, differences in water prices and in the composition of crops in the agriculture industry, and differences in structural and infrastructural aspects in the electricity and water industries).
[7] It is hard to make an international comparison of capital stock at the industry-specific level, because the data are very partial and of limited reliability.
[8] We focus on manufacturing export industries because data on capital stock of the services export industries—such as the computer and research and development industries—are not available separately from data on other trade and services industries, most of which are domestic-market oriented.
[9] While there was rapid growth of capital per employee in the construction industry during the industry’s previous prosperity period, the growth was volatile between 2004 and 2011, ranging around the same level. The Bank of Israel Annual Report for 2010 also shows that the stock of capital in the industry is lower than elsewhere in the world.
[10] Israel is ranked third in the OECD in the share of people with higher education.
[11] An example of such encouragement is the financing provided by the Ministry of the Economy’s Chief Scientist for implementing innovative production processes in low technology industries, alongside the encouragement of the research and development of innovation.