The socioeconomic challenge of the Israeli economy—inclusive and sustainable growth
Bank of Israel Governor Dr. Karnit Flug spoke today at the Sderot Conference for Society.  The following are the main points of her remarks:
·     We must examine developments in the global economy, the current path of economic policy, and the trends and composition of the Israeli population, and ask whether growth will continue over time and whether it will reach all segments of the population.  Is the economy on a path of sustainable growth, and is that growth inclusive?
·     The future is already here.  Without a policy focused on increasing productivity and reducing inequality, we face a significant slowdown in growth in the coming years.
·     The key to reducing inequality in the labor market and to an increase in productivity is in the human capital of the population.
·     The performance of the Israeli education system has an effect on the labor market, on future growth of the Israeli economy, and on its ability to serve all segments of the population. Israeli students achieve lower than the OECD average.  The gaps between Israeli students of various population groups is among the highest.
·     We must increase investment in the education system, with an emphasis on expanding affirmative action.  We must increase the scope of technological content in all levels of the education system, including practical engineers and engineers.  We must increase the level of cognitive skills of Israeli workers, which will enable them to more fully integrate into a changing labor market.
·     Improving the Israeli education system carries huge potential.  Improving the achievements of Israeli students from the weaker segments will contribute significantly to the growth rate, in addition to its contribution to reducing social gaps.
The economy is in good macroeconomic shape, mainly given the relatively weak global environment.  Growth continues apace, and the labor market is robust, as reflected in both the rapid increase in employment and continued decline in unemployment to historically low levels, and in the continued increase in wages.  While inflation is below the target range, if the decline in commodity and energy prices does not resume, it is expected to return to within the range within a year, supported by the increase in wages.
In light of the relatively good macroeconomic situation, the question arises as to whether, with the current path of economic policy, developments in the global economy and demographic trends, the economy is on a path of sustainable growth—meaning growth that is expected to continue over time—and whether that growth is inclusive, such that it improves the standard of living of all citizens.
The Israeli economy faces a variety of challenges on the road to inclusive and sustainable growth, and I have spoken about them a number of times previously.  Today, I would like to focus on the issue of poverty and inequality, and on the issue of human capital.
The global environment, demographic trends, and the fact that the contribution to growth made by increased education is reaching its maximum, are acting to significantly slow economic growth in the coming years.  As a result, the message that without a policy focused on increasing productivity, the growth rate will slow down significantly in the coming years is brought into sharper focus.  World trade, which is the basis for growth of the export industries, is slowing down, and this may become worse due to global political developments against globalization and in favor of protectionism; the changes in the composition of the population in Israel, both in terms of ages and in terms of sectoral composition, are expected to lead to a lower labor force participation rate, and may therefore lead to a reduction in per capita GDP; and the increase in education, which was a significant contributing factor to economy growth in previous decades, is reaching its maximum.  All of these will serve as headwinds to growth of the Israeli economy in the coming years.  Continued effort to integrate population groups that tend not to participate in the labor force, and to improve their cognitive skills, may partly offset the effects of these trends.
The growth of recent years has improved the situation of all those who participated in the labor force and contributed to increasing the pie.  However, that increase was not evenly distributed, so we cannot define the growth we have experienced as “inclusive growth”.  The poverty rate in Israel is the highest among the OECD countries, and the level of inequality is also among the highest in the western world.  Before I come to the ramifications of policy and how we can deal with the challenge of reducing poverty and inequality, it is worth analyzing the sources of inequality.
Inequality in financial income, meaning inequality measured by the gross household income from labor, declined in recent years, and is currently lower than the OECD average.  In contrast, inequality in disposable income, meaning income after taxes and transfer payments, remains higher than in most advanced economies.  The difference between these two measures of inequality—the factor that in all countries reduces the gaps between inequality in gross income and inequality in net income—is the government’s income redistribution policy, applied through direct (progressive) taxation and transfer payments, or allowances.  In Israel, the contribution of these factors—particularly allowances—to reducing inequality in net income is relatively low.
Income tax on individuals, which by its nature is progressive, has declined over the years, and allowances were reduced in parallel.  This decline in direct taxes and allowances acted in two opposite directions:  It reduced the contribution of taxes and allowances to lowering inequality in disposable income, and it increased the incentive to participate in the labor force, thereby reducing economic inequality.  In particular, this policy contributed to an increase in labor force participation of the population groups that still have relatively low employment integration—ultra-orthodox men and Arab women.  The sharpest change took place among ultra-orthodox women, whose employment rate increased from less than 50 percent to about 73 percent within 15 years.
From the standpoint of household financial income, the increase in labor force participation is reflected in a decline in inequality in the number of hours of work per household, which contributes to a decline in inequality in financial income.  In contrast, wage inequality, which declined between 1997 and 2003, again increased.  Wage inequality in Israel is also prominent by international comparison, as the average (gross) wage of the upper wage decile is five times that of the lowest wage decile—a higher ratio than any other OECD country.
Alongside the decline in economic inequality in the past 15 years, there was an increase in inequality between districts (between the periphery and the center of the country) until 2012.  Since 2012, there appears to be a change toward reducing this aspect of inequality.
The high wage gaps in the Israeli labor market, and the low level and moderate increase in labor productivity about which I have spoken previously, are closely linked to the level of human capital in the population, as reflected in various indices.  The performance of the education system will have an effect on trends in this area in the future, when today’s students join tomorrow’s labor market.
The questions we will want to answer are:
q  Does the education system improve the level of cognitive skills in order to support an increase in labor productivity?
q  Does today’s education system reduce gaps in skill levels, thereby reducing future wage gaps?
q  Does the professional training system work to reduce gaps in skills and in wages?
The results of the TIMSS study published yesterday indicate worrying trends in response to these questions.  The achievements of Israeli students are among the lowest in the OECD countries sampled in the study in mathematics and sciences.  Moreover, the gaps in Israel are also among the highest.  The grade spread (the difference in grades between the 95th percentile and the 5th percentile) is among the highest of the OECD countries that participated in the sample, both in sciences and in mathematics.
These findings are consistent with the results of the PISA tests conducted in 2012 (the 2015 findings will be published soon), and raise a worrying picture in this context.  The achievements of Israeli students in all areas examined are lower than the OECD average in those areas, and by this measure as well, the gaps in Israel are high.  For instance, the gaps between Hebrew and Arabic speaking students is high in all areas.  And the response to the question of equality of opportunity is also worrying:  The chances of a student from the lowest quarter of the socioeconomic scale achieving in the highest quarter on test scores are very low.  In other words, the education system is not acting to create affirmative action that will increase the equality of opportunity.

Now what about the working-age population, or those that will soon be of working age?
The findings of the PIAAC survey on cognitive skills indicate Israel’s weakness compared to other countries, in numeracy, literacy and problem-solving in a digital environment.  Here too, the gaps between the different population groups within Israeli society are large, and what is particularly worrying is the increase in the gaps among the young population compared with the older population, where the gaps between the ultra-orthodox and the non-ultra-orthodox Jewish population are lower.  In other words, young people from the ultra-orthodox community come to the labor market today less equipped with cognitive skills than ultra-orthodox Jews in previous generations.
How did it happen that the Israeli students of today, and the graduates of the past few years, are characterized by low levels of cognitive skills?  At least some of the explanation has to do with the fact that per student expenditure in the Israeli education system is lower than in most of the advanced economies, particularly in elementary and secondary school.  While it is easy for us to measure this expenditure, it is more difficult to compare relative efficiency and the quality of study content.  However, it is clear that the scope of technological content in secondary schools, as well as post-secondary technological training, are insufficient.  Another part of the explanation has to do with the low expenditure on professional training which, in Israel, totals about 0.06 percent of GDP, compared with an average of 0.14 percent in the OECD.  Expenditure on broader active labor market policy is also low by international comparison.
What can we learn from these things?
v  Government policy has incentivized entry into the labor market, thereby contributing to an increase in employment rates in all population groups, and to a decline in economic inequality.
v  Government policy makes a relatively low contribution to reducing inequality in disposable income, due to relatively low direct taxation, and mainly due to low allowances.
v  The education and professional training systems do not sufficiently provide the skills necessary for all parts of the population to successfully integrate into the labor market.  These skills are low by international comparison, despite the relative abundance of workers with higher education.
And what do we need to do?
v  We must act to raise the level of cognitive skills of Israeli workers, which will enable them to integrate into a changing labor market.  We must increase investment in the education system, with an emphasis on expanding affirmative action.  We must increase the scope of technological content in all levels of the education system, including practical engineers and engineers.
v  We must increase government investment in training by subsidizing professional training programs.  We must measure the effectiveness of training programs and revise them according to their efficiency and the findings of the measures.
v  Expanding the Earned Income Tax Credit will improve the state of workers with low incomes without reducing the incentive to work.
v  Investment in education and training to maximize the potential human capital of the Israeli population is the key to increasing long-term productivity and growth in a way that will include all citizens.
To end on a positive note: An OECD study indicates the immense potential in improving the output of the Israeli education system.  A simulation carried out, even if it is quite technical, indicates that if we succeed at improving the achievements of those with low achievements on the PISA tests, and bring them up to reasonable levels (a score of 420), the contribution to annual growth will be almost half a percent of GDP!  That is more than almost any other country.  And obviously, this kind of a change will contribute tremendously to reducing inequality.
The road to inclusive sustainable growth passes through a significant improvement in skill levels and a reduction in gaps in the human capital of the Israeli population.  It is vital that we act now in this area, in order to harvest achievements in the future.