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### Major findings on Israel’s infrastructure and productivity
- Israel characterized as a dual economy with a dynamic high-tech sector and a remainder of the economy with relatively low productivity.
- High-tech sector share: around 21 percent of gross value added, up from 12½ percent in 1995.
- Overall labor productivity growth: only ¾ percent annually in recent decades.
- Total capital stock: around 170 percent of GDP.
- Public investment: fell from around three percent of GDP in the second half of the 1990s to less than two percent of GDP in recent years.
- Cross-country public infrastructure gap: around 35–40 percent of GDP; McKinsey & Company sectoral analysis finds a gap of around 20 percent of GDP.
- Train travel share of total motorized travel in Israel: two percent (compared to eight percent in the OECD or OECD small states).
- Traffic congestion: average loss of 60 minutes per road-user per day in 2012; estimated cost to the economy amounting to 1.5 percent of GDP in 2012.
- “Investment for Growth” program (2017–21) totals NIS 107 billion (8.5 percent of the 2017 GDP); NIS 41.6 billion expected to be financed by the budget and the rest by tariffs, PPPs, and the private sector.
- Government developing “Infrastructure 2030” and accompanying “Employment 2030” initiative.

### DIGNAR model structure and key calibration choices
- Model: DIGNAR (Debt, Investment, Growth, and Natural Resources) adapted for Israel.
- Key entities: (i) households (a portion liquidity constrained), (ii) firms (nontradable goods sector, non-high-tech tradable sector, and high-tech tradable sector), and (iii) the government.
- Horizon: relatively long-run, abstracts from money and nominal rigidities.
- Government financing options modeled: tax increases, tax benefit reductions, spending cuts, and debt financing.
- Treatment of PPPs/PFIs: additional public investment not financed by revenues or spending cuts is assumed financed by higher deficits and debt (and thus higher government liabilities).
- Crowding channels modeled:
  - Crowding-in: public capital enters production function and can raise returns on private investment; in the non-high-tech tradable sector, higher public capital can raise total factor productivity via a “learning-by-doing” channel.
  - Crowding-out: higher public investment can raise real wages, the real exchange rate, real interest rates, and the sovereign risk premium, crowding out private investment and consumption.
- Assumed small elasticity of sovereign risk premium: 0.001.
- Israel-specific adaptations:
  - Replace natural-resource sector with a high-tech sector growing independently by 4.7 percent annually (versus 2.5 percent in the rest of the economy), yielding overall growth of three percent annually.
  - High-tech sector effective tax rate: four percent of high-tech GDP.
  - Dynamic depreciation: roads vs mass transit—mass transit lower initial rate of return with constant depreciation; roads higher initial rate of return but faster depreciation once per-capita GDP exceeds a threshold.
  - Depreciation acceleration: depreciation starts to accelerate when output increases by more than 0.01 (i.e., 1 percent) from its steady state; elasticity of congestion to output growth (߶) assumed to be 0.8.

### Simulation scenario and baseline macro-fiscal results
- Illustrative investment scaling scenario: increase in public investment by 1.5 percent of GDP per year—from two percent of GDP to 3.5 percent of GDP per year—over the next 15 years. Described as roughly the minimum consistent with addressing a public infrastructure need of 20 percent of GDP.
- Baseline financing assumption: all additional public investment financed by higher deficits (debt financing).
- Short-run dynamics: immediate rise in interest rates leads to some initial small crowding out of consumption and private investment; transitory decline in the private capital stock; real exchange rate appreciates immediately and then gradually unwinds.
- Medium- to long-run dynamics: accumulation of public capital increases output and labor supply (hours worked) owing to real wage increases; higher returns on private capital induce crowding-in of private investment with time lags.
- Quantitative end-period deviations from steady state (public investment at two percent of GDP baseline):
  - Public capital: above steady-state level by 35 percent.
  - Private capital: above steady-state level by four percent.
  - Output: above steady-state level by five percent.
  - Labor supply (hours worked) along the intensive margin: above steady-state level by one percent.

### Investment efficiency: definition, scenarios, and outcomes
- Definition: efficiency of public investment is the proportion of investment spending that is actually turned into an increase in public capital. Example: an efficiency rate of 85 percent indicates that 85 cents out of one dollar invested turns into public capital.
- Efficiency scenarios used:
  - Baseline (medium) efficiency: 85 percent.
  - High-efficiency scenario: 95 percent.
  - Low-efficiency scenario: 75 percent.
- Growth impacts after a 15-year period of higher public investment (medium efficiency):
  - Output gain relative to baseline: 5 percent.
  - Stock of public capital raised by: 35 percent from baseline.
  - Private capital: 10 percent above baseline.
  - Labor supply: up by 1 percent.
- High- and low-efficiency end-period outcomes:
  - High efficiency: output 6.5 percent above baseline; public capital increase 44 percent from baseline; private capital rising 5 percent from baseline.
  - Low efficiency: output 4 percent above baseline; public capital increase 25 percent from baseline; private capital rising 3 percent from baseline.
- Debt dynamics if all additional investment debt-financed (initial debt ratio 60 percent):
  - Debt ratio rises to 66 percent at the end of the period in the case of high efficiency.
  - Debt ratio rises to 72 percent in the case of low efficiency.
- Conclusion: GDP gains alone insufficient to self-finance higher investment from an initial debt ratio of 60 percent, implying need to explore nondebt financing (increase revenues or cut spending).

### Comparative financing instruments and mixed financing
- Comparative medium- to long-run growth impacts when financing the entire scale-up:
  - VAT hike: initially weighs on consumption and output, reducing labor demand; higher savings leads to higher private investment; output gains are second only to tax benefits in the long run.
  - Labor tax hike: reduces labor supplied by households, lowering household income and private consumption; results in the smallest output gain in the long run.
  - Cut in tax expenditure (tax benefits): limited impact on labor supply or consumption; delivers the highest output increase.
- Financing higher investment fully with revenues:
  - Debt ratio declines to between 57 to 58 percent of GDP across revenue-financing scenarios.
  - Financing with tax benefits results in a slightly faster pace of debt reduction, followed by VAT financing and labor tax financing.
- Magnitude of tax rate adjustments required for full tax financing:
  - VAT financing: VAT rate would have to increase to near 21 percent in two years, up from 17 percent.
  - Labor tax financing: labor tax rate would have to rise from 25 to 27 percent in two years.
- Mixed financing:
  - Combining tax and debt financing can smooth tax rate increases and contain debt accumulation.
  - Example: assuming one third of higher investment is tax financed smooths the size and pace of tax rate increases while containing debt accumulation.
- Cuts to tax benefits:
  - Financing high investment by cutting tax benefits by 1 percent of GDP per year throughout the projection period has the most positive impact on output in the medium term and helps prevent debt accumulation from the initial level.
  - Israel’s foregone revenue from various tax benefits: around 5 percent of GDP per year — indicating significant scope for revenue gains.

### Sectoral composition, absorptive capacity, and pacing
- Roads versus mass transit:
  - Due to dynamic depreciation, investing only in roads initially raises output more than investing only in mass transit, but the impact eventually fades.
  - Investing only in roads leads to a higher debt ratio increase over the 15-year period compared with mass transit.
  - Combining roads and mass transit can maximize the rate of return because synergies between road and mass transit can yield output gains higher than the weighted average.
- Absorptive capacity elements in the model:
  - Threshold of absorptive capacity: the point at which further raising the growth rate in public investment leads to efficiency declines.
  - Severity of absorptive capacity constraints: determines the degree of efficiency losses above the threshold.
  - Net efficiency behavior: below the absorptive threshold, the effective investment rate equals the efficiency rate; above the threshold, effective efficiency declines reflecting severity.
- Pace scenarios:
  - Front-loading capital accumulation can crowd in private investment earlier and have a sustained positive impact on output, but excessive front-loading can exceed absorptive capacity, create larger waste, slow output increases, and result in larger debt accumulation.
  - Back-loading delays crowding-in of private investment; debt accumulation slows initially but limited output impact eventually weighs on debt dynamics.
  - Recommendation: phase any scaling up judiciously to avoid waste.

### Labor force participation, productivity complementarities, and reform scenarios
- Infrastructure can raise labor participation of disadvantaged groups and enhance labor productivity by improving access to transportation, public services, and higher education.
- Illustrative reform scenarios during the 15-year investment period:
  - Halving the labor participation gap relative to non-Haredi Jewish men:
    - Output impact of scaling-up public investment together with halving the labor participation gap is double that from scaling-up public investment alone.
    - Higher output would help stabilize debt at around 66 percent of GDP even if all additional public investment is debt-financed, assuming reforms are funded without raising the deficit.
  - Halving both labor participation and productivity gaps:
    - Output gain would be triple that from just increasing public investment.
    - Debt would be put on a declining path after peaking at around 63½ percent of GDP.
- Recommended reforms: education and training, product market reforms including regulation, and measures to support labor participation of women.

### Key policy-relevant mechanisms and recommendations on public investment
- Principal finding: efficiency of investment is key to achieving growth benefits and containing increases in the public debt ratio. Selecting low-return projects, managing investment inefficiently, or raising investment faster than absorptive capacity can lead to weaker growth and higher debt ratios.
- To enhance efficiency of public investment, Israel should:
  - Establish a body with clear accountability and sufficient powers for upgrading Israel’s infrastructure, supported by staff with necessary technical expertise.
  - Make project evaluation and selection more rigorous and transparent, ensuring consistency with a long-term infrastructure strategy.
  - Streamline zoning and permitting and address other bureaucratic impediments to timely project implementation.
  - Improve coordination between ministries and between central and local governments; broaden coverage of the medium term fiscal framework to the general government to improve coordination and planning as local governments implement around three-quarters of public investment.
  - Phase any scaling up judiciously to avoid waste.
  - Use PPPs only where private sector know-how improves efficiency; design and monitor PPPs carefully to protect the public interest.
  - Maintain high transparency around level and composition of investment to help protect public investment against short-sighted cuts.
- Fiscal recommendation: growth benefits alone will likely be insufficient to prevent a significant increase in debt ratios; revenue measures are preferable, with reductions in tax benefits being least detrimental to growth and most positive for debt dynamics.
- PFIs/PPPs: can defer spending while providing benefits, but fiscal risks (direct costs and contingent liabilities) can be large; restrict use to projects that fit a clear overall investment strategy and provide value-for-money; manage and report liabilities, including contingent liabilities, in line with international best practices.

### Baseline calibration of key parameters and initial values for Israel (selected)
- Calibration sources: annual data with initial values based on macroeconomic data for Israel in 2017; structural parameters from Bank of Israel’s DSGE model (MOISE) and DIGNAR (Melina et al. 2016).
- Elasticity of output with respect to public capital: 0.18 (mid-point calibration), resulting in an initial return of public capital at 30 percent.
- Public capital depreciation (non-high-tech sector): annual depreciation rate of 4.
- Initial efficiency level: 85 percent (high: 95 percent; low: 75 percent).
- Frisch elasticities: model choice — 0.5 for credit-constrained households and 0.8 for optimizers.
- Selected initial values (in percent, unless indicated otherwise):
  - Long-run non-high-tech growth rate: 2.5
  - Long-run high-tech sector growth rate: 4.7
  - Exports to GDP: 38
  - Import to GDP: 35
  - Government consumption to GDP: 39.5
  - Government investment expenditures to GDP: 2
  - Private investment to GDP: 17.3
  - Share of high-tech sector: 20
  - Share of tradables in government expenditures: 42
  - Share of tradables in private consumption: 31
  - General government domestic debt to GDP: 51
  - Private foreign debt to GDP: 16
  - Government external commercial debt to GDP: 9
  - Annualized domestic net real interest rate: 2.9
  - Annualized net real risk-free rate: 1
  - Annualized net real interest rate paid on government external commercial debt: 3.5
  - Labor income share in non-traded sector: 67
  - Labor income share in traded sector: 67
  - Private capital depreciation rate: 8.3
  - Public capital depreciation rate: 4
  - Efficiency of public investment: 85
  - Investment adjustment cost: 3
  - Share of optimizers: 0.8
  - High-tech sector effective tax rate: 4
  - User fees of public infrastructure (in percent of recurrent costs): 10
  - Labor income tax rate: 25
  - Consumption tax rate: 17
  - Capital return tax rate: 23
  - Degree of learning by doing externality in traded sector: 0.1
  - Persistence in TFP in traded sector: 0.1
  - Inverse of the Frisch elasticity of labor supply for optimizers: 1.25
  - Inverse of the Frisch elasticity of labor supply for rule of thumb consumers: 2
  - Inverse of the intertemporal elasticity of consumption: 1.1
  - Elasticity of substitution between two types of labor: 1
  - Elasticity of substitution between traded and non-traded goods: 0.1
  - Home bias for additional government spending: 0.6
  - Elasticity of portfolio adjustment costs: 0.001
  - Elasticity of sovereign risk: 0.001
  - Severity of public capital depreciation when not maintained: 1
  - Severity of absorptive capacity constraints: 25
  - Thresholds of investment scaling up beyond which absorptive capacity constraints start binding: 75

### Inequality, poverty, and education: key findings
- Poverty and income inequality are high in Israel compared with peers, exacerbated by lower labor participation and productivity of Israeli-Arab, Haredi, and non-Haredi Jewish women.
- Israel’s low redistribution through the budget limits its impact on reducing poverty and inequality.
- Projected demographic shifts: share of Arab and Haredi populations expected to rise from one-quarter in 2015 to almost one-half by 2065; share of Haredi in working age population projected to rise from 7 percent to just over 25 percent by 2065.
- Under current income distributions by group, staff estimates:
  - Gini coefficient will rise by two percentage points (ppt) by 2065.
  - Poverty rate will rise by four ppt by 2065.

### Education, skills, and productivity gaps
- PISA and PIAAC evidence: PISA scores substantially lower for students in Arab schools compared with Hebrew system; PIAAC (2015) shows substantial adult proficiency gaps between Haredi and non-Haredi Jews; gaps larger for younger generations.
- Group-specific issues:
  - Arab students: lag in STEM enrollment; higher dropout rates; Arab women often major in education.
  - Haredi men: study full-time in yeshiva until 40 years old on average; enter labor market late without core education in math, science, English.
  - Occupational concentration: high share of women in public sector; Haredi men in low-paid sectors; Arab men in low- to medium-low wage jobs.
- Gender skill and wage gaps:
  - Non-Haredi Jewish women hourly wages below benchmark by around 20 percent.
  - Haredi (men and women) below benchmark by around 30 percent.
  - Arab (men and women) below benchmark by around 50 percent.
  - Israel has a 47 percent gap in share of men and women who are managers; a 76 percent gap in share who are entrepreneurs.
- Potential output impacts of closing employment and wage gaps (illustrative, based on 2015 data):
  - Reducing employment gaps by half and hourly-wage gaps by half (keeping part-time shares unchanged) yields potential output gains of around 14 percent.
  - Reducing employment gaps by half and monthly-wage gaps by half (increasing full-time work toward non-Haredi Jewish men) yields potential output gains of around 22 percent.
  - About two-thirds of potential output increase associated with closing gaps for non-Haredi Jewish women and Arab women.
  - MoF (2016) estimate: closing monthly wage gender gap between non-Haredi Jews by 40 percent could yield long-term output gain of about 7 percent; staff simulation finds similar impact of around 7¾ percent.

### Policy recommendations on education, participation, and redistribution
- Overarching approach: multi-pronged strategy to reduce gaps in labor productivity and participation through reforms and additional resources (education and training), reduce gender gaps, and design redistribution to avoid work disincentives; additional fiscal costs should be recurrent and financed from recurrent sources.
- Education and training:
  - Increase effectiveness of schools via higher standards for teachers.
  - Cover core subjects at all grades in Haredi schools.
  - Improve Hebrew teaching in Arab schools.
  - Extend the short school day.
  - Vocational training: involve business experts, deliver modalities facilitating Haredi and Arab participation, provide training cost support for low-wage workers, consider conditional transfers tied to training completion.
  - Active labor market programs (ALMPs): Employment Circles program pays for itself after seven months; modest ALMP spending of 0.2 percent of GDP can be raised to expand impact.
- Female participation constraints:
  - Expand childcare support; 2019 budget allows for additional NIS 0.75 billion in afterschool programs.
  - Improve commutes, incentivize economic hubs close to minority areas, develop flexible work practices.
- Redistribution while preserving work incentives:
  - Israel’s redistribution through transfers reduces the Gini coefficient by 4 ppt versus peer average reduction of 14 ppt.
  - New measures should focus on strengthening work-conditional support while ensuring adequate support for those who cannot work.

### Redistributive impact of taxes and transfers and the EITC
- Redistributive trends:
  - Impact of taxes declined moderately and broadly flat since 2010.
  - Impact of transfers declined markedly to about half of the level in 2000.
  - Excluding old-age and health spending, public social expenditures share in GDP declined by about 1½ percentage points since 2000 (or two percentage points from the peak in 2001).
  - Notable reductions in shares of GDP: child allowances 0.8 ppt; housing assistance 0.3 ppt; cash benefits for socially excluded 0.3 ppt; income support benefits 0.3 ppt.
- EITC design and coverage:
  - Payment began in 2008 pilot; nationwide in 2012.
  - Eligible: workers (including self-employed) with at least one child, or of 55 years old or above.
  - 2016: benefits for single parents and disabled populations raised; 2019: benefits expected to be further expanded to raise men’s benefits to level of women and introduce 30 percent spouse-work bonus.
  - Israel’s EITC expected to reach 0.16 percent of GDP in 2019 (low compared to 0.4–0.5 percent of GDP in the U.S. or the U.K.).
- Simulation: raising the EITC ceiling by 100 percent would lift EITC spending to 0.4 percent of GDP annually (assumes no change in marginal tax rates for phase-out; take-out rate 70 percent; maximum monthly household gross income NIS 30,000 as simplification).
- Simulated distributional impacts of EITC expansion:
  - Such an EITC increase could reduce the poverty rate and Gini coefficient by ½ ppt.
  - Limitations: EITC insufficient to lift some household types above the poverty line; most vulnerable groups cannot be reached through EITC alone.
- Implementation and take-up:
  - Current EITC take-up around 70 percent.
  - Measures to improve linkage and take-up: enhance timeliness and frequency of refunds; consider deducting EITC from monthly withholding (caveats apply); use National Insurance Institute infrastructure for timeliness.
- Complementary measures:
  - Conditional transfers tied to education/training can reduce education outcome inequality.
  - Targeting social supports to lower income deciles would free substantial resources for reforms; current transfers provide similar amounts in shekels to all households, including top income decile.
  - MoF (2018) note: allowances for those unable to work (old-age, disability) have largest contribution to poverty reduction.

*Source: IMF staff analysis as presented in the supplied chapter content.*

### References _______________________________________________________________________________ 20

### References

### Major findings on Israel’s infrastructure and productivity

- Israel is characterized as a dual economy with a dynamic high-tech sector and a remainder of the economy with relatively low productivity.  
- The high-tech sector comprises around 21 percent of gross value added, up from 12½ percent in 1995.  
- Overall labor productivity in Israel rose by only ¾ percent annually in recent decades, leaving sizable productivity shortfalls virtually unchanged.  
- Israel’s total capital stock is estimated to be around 170 percent of GDP.  
- Public investment fell from around three percent of GDP in the second half of the 1990s to less than two percent of GDP in recent years.  
- Cross-country benchmarks suggest a public infrastructure gap of around 35–40 percent of GDP; a sectoral analysis by McKinsey & Company finds a gap of around 20 percent of GDP.  
- The share of train travel in total motorized travel in Israel was two percent, compared to eight percent in the OECD or OECD small states.  
- Traffic congestion caused an average loss of 60 minutes per road-user per day in 2012, with an estimated cost to the economy amounting to 1.5 percent of GDP in 2012.  
- Israel’s “Investment for Growth” program (2017–21) totals NIS 107 billion (8.5 percent of the 2017 GDP), of which NIS 41.6 billion is expected to be financed by the budget and the rest by tariffs, public private partnerships (PPPs), and the private sector.  
- The government is developing an integrated long-term national infrastructure strategy through 2030 (“Infrastructure 2030”) and an accompanying “Employment 2030” initiative.

### DIGNAR model structure and key calibration choices

- Model used: DIGNAR (Debt, Investment, Growth, and Natural Resources) adapted for Israel.  
- Key model entities: (i) households (a portion liquidity constrained), (ii) firms (nontradable goods sector, non-high-tech tradable sector, and high-tech tradable sector), and (iii) the government.  
- Model horizon: relatively long-run, abstracts from money and nominal rigidities.  
- Government financing options modeled: tax increases, tax benefit reductions, spending cuts, and debt financing.  
- Treatment of PPPs/PFIs: additional public investment not financed by revenues or spending cuts is assumed financed by higher deficits and debt (and thus higher government liabilities).  
- Crowding channels explicitly modeled:  
  - Crowding-in: public capital enters production function and can raise returns on private investment; in the non-high-tech tradable sector, higher public capital can raise total factor productivity via a “learning-by-doing” channel.  
  - Crowding-out: higher public investment can raise real wages, the real exchange rate, real interest rates, and the sovereign risk premium, crowding out private investment and consumption.  
- Assumed small elasticity of sovereign risk premium: 0.001.  
- Adaptations specific to Israel:  
  - Replace natural-resource sector with a high-tech sector growing independently by 4.7 percent annually (versus 2.5 percent in the rest of the economy), yielding overall growth of three percent annually.  
  - High-tech sector assigned a lower effective tax rate: four percent of high-tech GDP.  
  - Dynamic depreciation rates for roads vs mass transit: mass transit has lower initial rate of return with constant depreciation; roads offer higher initial rate of return but faster depreciation once per-capita GDP exceeds a threshold.  
  - Depreciation acceleration specification: depreciation starts to accelerate when output increases by more than 0.01 (i.e., 1 percent) from its steady state; the elasticity of congestion to output growth (߶) is assumed to be 0.8.

### Simulation scenario and baseline macro-fiscal results

- Illustrative investment scaling scenario: increase in public investment by 1.5 percent of GDP per year—from two percent of GDP to 3.5 percent of GDP per year—over the next 15 years. This scenario is described as roughly the minimum consistent with addressing a public infrastructure need of 20 percent of GDP.  
- All additional public investment in baseline simulations assumed financed by higher deficits (debt financing).  
- Short-run dynamics: immediate rise in interest rates leads to some initial small crowding out of consumption and private investment, and a transitory decline in the private capital stock; real exchange rate appreciates immediately and then gradually unwinds.  
- Medium- to long-run dynamics: accumulation of public capital increases output and labor supply (hours worked) owing to real wage increases; higher returns on private capital induce crowding-in of private investment with time lags.  
- Quantitative outcomes by the end of the projection period (deviations from steady state with public investment at two percent of GDP):  
  - Public capital: above steady-state level by 35 percent.  
  - Private capital: above steady-state level by four percent.  
  - Output: above steady-state level by five percent.  
  - Labor supply (hours worked) along the intensive margin: above steady-state level by one percent.

### Key policy-relevant mechanisms and considerations

- Investment efficiency, financing choices, pace of capital depreciation, pace of scaling up public investment, and spillovers to labor participation and productivity are key factors shaping the impact of public investment on output and debt.  
- The model includes channels that can both amplify (crowding-in, productivity spillovers) and offset (crowding-out via higher rates and sovereign premium) fiscal efforts to raise public investment.  
- Sectoral allocation matters: roads may deliver higher initial returns but face faster depreciation and congestion externalities as vehicle ownership rises; mass transit may offer more sustainable returns when accounting for congestion and urban density constraints.

*International Monetary Fund*

### 11. The efficiency of public investment is the proportion of investment spending that is

### 11. The efficiency of public investment is the proportion of investment spending that is

### Definition of investment efficiency
- The efficiency of public investment is the proportion of investment spending that is actually turned into an increase in public capital.
- Example: an efficiency rate of 85 percent indicates that 85 cents out of one dollar invested turns into public capital.
- Baseline and scenarios used in the analysis:
  - Baseline (medium) efficiency: 85 percent.
  - High-efficiency scenario: 95 percent.
  - Low-efficiency scenario: 75 percent.

### Growth impacts under different efficiency scenarios
- End of a 15-year period of higher public investment (medium efficiency):
  - Output gain relative to baseline: 5 percent.
  - Stock of public capital raised by: 35 percent from baseline.
  - Private capital: 10 percent above baseline.
  - Labor supply: up by 1 percent.
- High- and low-efficiency end-period outcomes:
  - High efficiency: output 6.5 percent above baseline; public capital increase 44 percent from baseline; private capital rising 5 percent from baseline.
  - Low efficiency: output 4 percent above baseline; public capital increase 25 percent from baseline; private capital rising 3 percent from baseline.

### Debt dynamics and the need for nondebt financing
- If all additional investment is debt-financed (initial debt ratio 60 percent):
  - Debt ratio rises to 66 percent at the end of the period in the case of high efficiency.
  - Debt ratio rises to 72 percent in the case of low efficiency.
- Conclusion: GDP gains are not sufficiently large to self-finance higher investment from an initial debt ratio of 60 percent, implying a need to explore nondebt financing (increase revenues or cut spending).

### Comparative growth impacts of financing instruments (when used to finance entire scale-up)
- VAT hike:
  - Initially weighs on consumption and output, reducing labor demand.
  - Higher savings leads to higher private investment; output gains are second only to tax benefits in the long run.
- Labor tax hike:
  - Reduces labor supplied by households, lowering household income and private consumption.
  - Results in the smallest output gain in the long run.
- Cut in tax expenditure (tax benefits):
  - Limited impact on labor supply or consumption.
  - Delivers the highest output increase.
- Financing higher investment fully with revenues:
  - Debt ratio declines to between 57 to 58 percent of GDP across revenue-financing scenarios.
  - Financing with tax benefits results in a slightly faster pace of debt reduction, followed by VAT financing and labor tax financing.

### Magnitude of tax rate adjustments required for full tax financing
- VAT financing (if all additional investment financed by VAT):
  - VAT rate would have to increase to near 21 percent in two years, up from 17 percent.
- Labor tax financing (if all additional investment financed by labor taxes):
  - Labor tax rate would have to rise from 25 to 27 percent in two years.

### Mixed financing and cuts to tax benefits
- Combining tax and debt financing can smooth tax rate increases and contain debt accumulation.
- Example: assuming one third of higher investment is tax financed smooths the size and pace of tax rate increases while containing debt accumulation.
- Financing high investment by cutting tax benefits by 1 percent of GDP per year throughout the projection period has the most positive impact on output in the medium term and helps prevent debt accumulation from the initial level.
- Israel’s sizable foregone revenue from various tax benefits: around 5 percent of GDP per year—indicating significant scope for revenue gains.

### Sectoral composition: Roads versus mass transit
- Due to dynamic depreciation, investing only in roads initially raises output more than investing only in mass transit, but the impact eventually fades.
- Investing only in roads leads to a higher debt ratio increase over the 15-year period compared with mass transit.
- Combining roads and mass transit can maximize the rate of return because synergies between road and mass transit can yield output gains higher than the weighted average.

### Pace of scaling up and absorptive capacity
- The efficiency of investment can depend on the pace of scaling up investment.
- Absorptive capacity constraints arise from technical capacity limits affecting project selection, management, and implementation, leading to waste and leakage.
- Model elements for absorptive capacity:
  - Threshold of absorptive capacity: the point at which further raising the growth rate in public investment leads to efficiency declines.
  - Severity of absorptive capacity constraints: determines the degree of efficiency losses above the threshold.
- Net efficiency behavior:
  - Below the absorptive threshold, the effective investment rate equals the efficiency rate.
  - Above the threshold, effective efficiency declines reflecting severity.
- Pace scenarios:
  - Front-loading capital accumulation can crowd in private investment earlier and have a sustained positive impact on output, but excessive front-loading can exceed absorptive capacity, create larger waste, slow output increases, and result in larger debt accumulation.
  - Back-loading delays crowding-in of private investment; debt accumulation slows initially but limited output impact eventually weighs on debt dynamics.
  - Phasing any scaling up judiciously is recommended to avoid waste.

### Labor force participation, productivity gains, and complementarities with investment
- Good infrastructure can raise labor participation of disadvantaged groups and enhance labor productivity by improving access to transportation, public services, and higher education.
- Illustrative reform scenarios during the 15-year investment period:
  - Halving the labor participation gap relative to non-Haredi Jewish men:
    - The output impact of scaling-up public investment together with halving the labor participation gap is double that from scaling-up public investment alone.
    - Higher output would help stabilize debt at around 66 percent of GDP even if all additional public investment is debt-financed, assuming reforms are funded without raising the deficit.
  - Halving both labor participation and productivity gaps:
    - The output gain would be triple that from just increasing public investment.
    - Debt would be put on a declining path after peaking at around 63½ percent of GDP.
- Recommended reforms include education and training, product market reforms including regulation, and measures to support labor participation of women.

### Key findings and policy recommendations
- Principal finding:
  - The efficiency of investment is key to achieving growth benefits and containing increases in the public debt ratio. Selecting low-return projects, managing investment inefficiently, or raising investment faster than absorptive capacity can lead to weaker growth and higher debt ratios.
- To enhance the efficiency of public investment, Israel should:
  - Establish a body with clear accountability and sufficient powers for upgrading Israel’s infrastructure, supported by staff with the necessary technical expertise.
  - Make project evaluation and selection more rigorous and transparent, including by ensuring consistency with a long-term infrastructure strategy.
  - Streamline zoning and permitting processes and address other bureaucratic impediments to timely project implementation.
  - Improve coordination between ministries and between the central and local governments. Broadening the coverage of the medium term fiscal framework to the general government could contribute to improved coordination and planning as local governments implement around three-quarters of public investment.
  - Phase any scaling up of public investment judiciously to avoid waste.
  - Use public-private partnerships (PPP) only where private sector know-how improves efficiency; design and monitor PPPs carefully to protect the public interest.
  - Maintain a high level of transparency around the level and composition of investment to help protect public investment against short-sighted cuts.
- Fiscal recommendation:
  - Growth benefits alone will likely be insufficient to prevent a significant increase in debt ratios; revenue measures are preferable, with reductions in tax benefits being least detrimental to growth and most positive for debt dynamics.
- PFIs/PPPs:
  - PFIs/PPPs can defer spending while providing benefits, but fiscal risks (direct costs and contingent liabilities) can be large.
  - Restrict use of PFI/PPP to projects that fit a clear overall investment strategy and provide value-for-money.
  - Liabilities, including contingent liabilities from PFIs/PPPs, should be managed carefully and reported in line with international best practices.

*Source: IMF staff analysis as presented in the supplied chapter content.*

### 26. Growth benefits can be substantially augmented if higher public investment is coupled

### 26. Growth benefits can be substantially augmented if higher public investment is coupled

### Growth benefits and structural reforms
- Expanding public transportation can improve access to better jobs and education, which in turn can raise labor participation and productivity.
- Providing public infrastructure that can enable workplaces to locate within or close to minority communities would:
  - enhance labor participation, and
  - allow increased work hours, especially for Arab and Haredi women.
- Structural reforms are needed to make more substantial progress in reducing participation and productivity gaps.
- The government is preparing strategies to enhance labor participation and productivity along with Infrastructure 2030.

### Baseline calibration of key parameters (model for Israel)
- Model calibrated using annual data with initial values based on macroeconomic data for Israel in 2017.
- Many structural parameters drawn from the Bank of Israel’s DSGE model (MOISE); some follow the DIGNAR model by Melina et al. (2016).
- Returns on public capital depend on:
  - Elasticity of output to public capital:
    - Meta-analysis by Melo et al. (2013) lists estimates for elasticity of output to transport infrastructure from -0.148 to 0.315.
    - Bom and Ligthart (2014) suggest an elasticity of core infrastructure installed by a national government to be 0.17 and by local government to be 0.193.
    - Mid-point calibration used: 0.18, resulting in an initial return of public capital at 30 percent.
    - Comparison estimates: 22 percent for World Bank transportation projects and 25 percent for scaling up public investment in developing economies (Box 3.4 WEO October 2014).
    - Cumulative 15-year fiscal multipliers are in line with estimates for advanced economies.
  - Depreciation rates:
    - Public and private capital depreciation rates based on country income from the Investment and Capital Stock Database 2017.
    - For Israel public capital depreciation (focusing on the non-high-tech sector), an annual depreciation rate of 4 is applied.
  - Initial efficiency level:
    - Assumed 85 percent for Israel (meaning for every dollar spent on investment, 85 cents translate into public capital stock).
    - Calibration scenarios: high efficiency at 95 percent, medium efficiency at 85 percent, low efficiency at 75 percent.
    - Regional Economic Outlook 2016 suggests Israel shows an average score of 0.95 relative to frontier economies.
- Frisch elasticities for labor supply:
  - Literature ranges: for men zero to 0.8, for women 0.5 to 1 (Reichling and Whalen 2012).
  - Macro models examples: 1.9 (Smets and Wouters 2007), 2.6 to 4.0 (Cho and Cooley 1994, King and Rebelo 1999).
  - Chetty et al. (2011) suggests matching a Frisch elasticity of aggregate hours of 0.75.
  - Model choice: Frisch elasticity of 0.5 for credit-constrained households and 0.8 for optimizers.

### Initial values for Israel (in percent, unless indicated otherwise)
- Long-run non-high-tech growth rate: 2.5
- Long-run high-tech sector growth rate: 4.7
- Exports to GDP: 38
- Import to GDP: 35
- Government consumption to GDP: 39.5
- Government investment expenditures to GDP: 2
- Private investment to GDP: 17.3
- Share of high-tech sector: 20
- Share of tradables in government expenditures: 42
- Share of tradables in private consumption: 31
- General government domestic debt to GDP: 51
- Private foreign debt to GDP: 16
- Government external commercial debt to GDP: 9
- Annualized domestic net real interest rate: 2.9
- Annualized net real risk-free rate: 1
- Annualized net real interest rate paid on government external commercial debt: 3.5
- Labor income share in non-traded sector: 67
- Labor income share in traded sector: 67
- Private capital depreciation rate: 8.3
- Public capital depreciation rate: 4
- Efficiency of public investment (share of investment turned into actual capital): 85
- Investment adjustment cost: 3
- Share of optimizers in the economy (non-credit-constrained households): 0.8
- High-tech sector effective tax rate: 4
- User fees of public infrastructure (in percent of recurrent costs): 10
- Labor income tax rate: 25
- Consumption tax rate: 17
- Capital return tax rate: 23
- Degree of learning by doing externality in the traded sector: 0.1
- Persistence in TFP in traded sector: 0.1
- Elasticity of output with respect to public capital: 0.18
- Inverse of the Frisch elasticity of labor supply for optimizers: 1.25
- Inverse of the Frisch elasticity of labor supply for rule of thumb consumers: 2
- Inverse of the intertemporal elasticity of consumption: 1.1
- Elasticity of substitution between the two types of labor (in tradables and nontradables): 1
- Elasticity of substitution between traded and non-traded goods: 0.1
- Home bias for additional government spending: 0.6
- Elasticity of portfolio adjustment costs: 0.001
- Elasticity of sovereign risk: 0.001
- Severity of public capital depreciation when not maintained: 1
- Severity of absorptive capacity constraints: 25
- Thresholds of investment scaling up beyond which absorptive capacity constraints start binding: 75

### Inequality and poverty in Israel — key findings
- Poverty and income inequality are high in Israel compared with peers and are exacerbated by lower labor participation and productivity of some population groups (Israeli-Arab, Haredi, and non-Haredi Jewish women).
- Israel’s low redistribution of income through the budget limits its impact on reducing poverty and inequality.
- Projected demographic shifts (rising shares of Haredi and Arab populations) make addressing structural issues behind low participation and productivity urgent.

### Characteristics and trends in inequality and poverty
- Market-income based inequality and relative poverty have declined since 2000 and are currently moderately below peers.
- Disposable-income based inequality:
  - Rose during the 2000s, declined in recent years close to the level in 2000, but remains among the highest in advanced economies.
  - Relative poverty based on disposable income has risen notably since 2000 and is the highest among advanced economies at roughly double their median.
- Poverty is particularly high among Arab and Haredi households (above 50 percent), as well as households with a female breadwinner or with a single parent.
- Even excluding Arab and Haredi groups, inequality remains higher than the OECD average.

### Demographic projections and implications
- The share of the Arab and Haredi populations is expected to rise from one-quarter in 2015 to almost one-half by 2065.
- The share of the Haredi in the working age population is projected to jump from 7 percent to just over 25 percent during the same period.
- Arab share in working age population stabilizes from 2025 at around 22–23 percent due to declining fertility.
- Assuming current income distributions by group are maintained, staff estimates:
  - Gini coefficient will rise by two percentage points (ppt) by 2065.
  - Poverty rate will rise by four ppt by 2065.

### Factors behind employment and wage gaps
- Significant wage gaps across genders and population groups:
  - Hourly wage gap comparable to peers, but monthly wage gap is larger due to fewer hours worked by women.
  - Compared with non-Haredi Jewish men (benchmark):
    - Non-Haredi Jewish women hourly wages are below benchmark by around 20 percent.
    - Haredi (men and women) below benchmark by around 30 percent.
    - Arab (men and women) below benchmark by around 50 percent.
  - Shorter work hours for women lead to larger monthly wage gaps, especially for Haredi women.
- Employment rates particularly low among Arab women and Haredi men.
- Drivers of wage and employment gaps include:
  - Skill and productivity differentials (high correlation between skills indicators and market income).
  - Occupational preferences.
  - Impediments to higher participation (cultural factors, time allocation to religious studies for Haredi men, lower female employment in Arab communities).

_International Monetary Fund — Israel chapter content unit_

### 8.      Skill and productivity gaps between ethnic groups are closely linked to education

### 8.      Skill and productivity gaps between ethnic groups are closely linked to education

### Education and skill gaps: evidence and magnitudes
- PISA scores are substantially lower for students in the Arab schools compared with students in the Hebrew system; Haredi boys did not participate in PISA.
- PIAAC (2015) shows substantial gaps in adult proficiency (Literacy, Numeracy, Problem solving) between Haredi and non-Haredi Jews; gaps are larger for younger generations.
- Key numeric references from PIAAC and PISA presented in the source:
  - PIAAC scores plotted on a 500-point scale (average score, 500-point scale) for Young (16-40) and Old (40+) by group.
  - PISA overall average reported on a scale with an approximate OECD average of 500 and standard deviation of 100.
- Underlying socioeconomic conditions largely explain performance gaps after secondary education for Arab students; low proficiency in Hebrew is a key barrier to employment.

### Group-specific education and labor-market issues
- Arab students:
  - Lag in STEM enrollment in tertiary education and have higher dropout rates.
  - Arab women outperform Arab men in math and science overall, but many Arab women major in education, limiting future income because teachers face lower wages and hours.
- Haredi men:
  - Study full-time in religious school (“yeshiva”) until 40 years old on average.
  - Enter the labor market late and without core education in math, science, English, and other marketable skills.
  - Late market entry reduces years of work experience and seniority, limits ability to explore professions, and comes when learning abilities tend to be lower for older entrants.
  - Haredi men who pursue tertiary studies tend to have lower skills and higher dropout rates; many major in subjects with lower employability (e.g., law).
- Occupational concentration:
  - High concentration of women in the public sector (lower wages, higher job security).
  - Haredi men largely employed in low-paid sectors; Arab men mostly in low- to medium-low wage jobs.
  - Arab women often work in education due to cultural perceptions, transportation and childcare constraints, and family-friendly hours.

### Gender skill and wage gaps
- Numeracy skill gaps:
  - Numeracy skill gap between men and women starts in early education; boys’ overperformance in math and science is comparable to other advanced economies on average, but larger among top performers.
  - Women enroll less in advanced secondary math and science and are less inclined to major in STEM in tertiary education.
- Returns to skill:
  - Men in the workforce have higher numeracy skills and also higher returns to skill, amplifying wage gaps.
  - Higher returns reflect a higher share of men in high-return fields (IT and senior management) and a tendency for higher-skilled women to work fewer hours.
- Part-time work:
  - Shorter work hours reduce current earnings and limit career progression, especially in Israeli high-tech (long hours, less flexibility).
  - National estimates point to a gender gap in part-time work that exceeds OECD norms by over 10 percentage points.
  - Childcare at home is the main driver for non-employment for half of the women out of the labor force (2013 data).
  - Public spending on pre-primary childcare in Israel was low compared with other advanced economies in 2013.
- Leadership gaps:
  - Israel has a 47 percent gap in the share of men and women who are managers.
  - Israel has a 76 percent gap in the share of men and women who are entrepreneurs.

### Potential output impacts of reducing employment and wage gaps
- Illustrative staff calculations (based on 2015 data) find:
  - Reducing employment gaps by half and hourly-wage gaps by half (keeping share of part-time workers unchanged) yields potential output gains of around 14 percent.
  - Reducing employment gaps by half and monthly-wage gaps by half (increasing share of full-time workers toward the level of non-Haredi Jewish men) yields potential output gains of around 22 percent.
  - About two-thirds of the potential output increase is associated with closing employment and wage gaps for non-Haredi Jewish women and Arab women.
  - The current impact of closing Haredi gaps is small due to a seven percent share in the working-age population, but will grow in the future.
- Prior related estimates:
  - MoF (2016) estimates that closing the monthly wage gender gap between non-Haredi Jews by 40 percent (with no change in gender gaps of other populations) could yield a long-term output gain of about 7 percent; a staff simulation finds a similar impact of around 7¾ percent.

### Policy recommendations: strengthen productivity while protecting participation
- Overarching approach:
  - A multi-pronged strategy is required: reduce gaps in labor productivity and participation through reforms and additional resources (especially education and training), reduce gender gaps, and design redistribution to avoid work disincentives.
  - Additional fiscal costs are recurrent; financing should come from recurrent sources (savings through reforms/reprioritization or revenue increases).
- Increase productivity and participation via education and training:
  - Education reforms:
    - Increase effectiveness of schools through higher standards for teachers.
    - Cover core subjects at all grades in Haredi schools.
    - Improve Hebrew teaching in Arab schools.
    - Extend the short school day.
    - Note: Education spending has been raised recently, primarily through increases in teachers’ pay, but academic qualifications expected of teachers remain low and the teaching day is unusually short.
  - Vocational training:
    - Involve experts from the business community in selection and design of vocational courses.
    - Deliver training in modalities that facilitate participation by Haredi and Arab communities.
    - Career centers should guide job seekers to suitable training, including business-oriented Hebrew.
    - Low-wage workers should receive support for training costs to upgrade skills.
    - Consider a transfer program conditional on completing eligible classes/courses or participating in job training.
  - Active labor market programs (ALMPs):
    - Evidence: Employment Circles program shows significant employment gains, especially among the Arab population, with the program paying for itself after seven months.
    - Subsidizing mobility to jobs outside a job seeker’s home town has preliminary positive results.
    - Government spending on ALMP of only 0.2 percent of GDP can be raised to expand impact on participation.
- Reduce constraints on female participation:
  - Expand childcare support, especially for younger children and afterschool care programs.
    - The 2019 budget allows for additional NIS 0.75 billion in afterschool programs.
  - For women in minority groups, improve commutes (public transportation), incentivize new economic hubs close to minority areas, and develop flexible work practices compatible with socio-cultural constraints.
- Improve redistribution while preserving work incentives:
  - Israel’s redistribution through transfers reduces the Gini coefficient by 4 ppt, substantially below the peer average reduction of 14 ppt through transfers.
  - Tax progressivity reduces the Gini coefficient by 4 ppt, broadly in line with advanced-economy averages.
  - New measures to increase redistribution should focus on strengthening support conditional on work while ensuring adequate support for those who cannot work.

*Source: IMF staff summary of "8. Skill and productivity gaps between ethnic groups are closely linked to education" (cr18112).*

### 21.      The redistributive impact of taxes and transfers has declined since the early 2000s

### 21.      The redistributive impact of taxes and transfers has declined since the early 2000s

### Decline in redistributive impact and composition of social spending
- The impact of taxes has declined moderately and has remained broadly flat since 2010.
- The impact of transfers has declined markedly to about half of the level in 2000.
- Excluding old-age and health spending, the share of public social expenditures in GDP declined by about 1½ percentage points since 2000 (or two percentage points from the peak in 2001).
- Items with large reductions in public social expenditures (shares in GDP):
  - Child allowances: 0.8 ppt
  - Housing assistance: 0.3 ppt
  - Cash benefits for socially excluded: 0.3 ppt
  - Income support benefits: 0.3 ppt

### Redistributive policy trade-offs and conditionality
- Reductions in social benefits—especially child allowances—in the early 2000s aimed to strengthen incentives for labor participation.
- Progress:
  - Rapid increases in participation of Haredi women since the early 2000s; progress with Haredi men has been smaller and appears to have leveled out in recent years.
- Policy design principles:
  - Conditionality helps mitigate poverty while promoting labor participation or skill development.
  - Targeting helps contain fiscal costs by prioritizing resources to the population segments most in need.

### The Earned Income Tax Credit (EITC) — design, coverage, and planned changes
- The EITC incentivizes labor participation because only those who pay income tax are eligible.
- Benefits are calculated on an individual basis according to trapezoidal schedules.
- Timeline and eligibility:
  - Payment of EITC began in 2008 as a pilot; extended nationwide in 2012.
  - Eligible populations: workers (including the self-employed) with at least one child, or of 55 years old or above.
  - In 2016, benefits for single parents and populations with disabilities were raised; eligibility requirements for the self-employed were modified to align with employees.
  - In 2019, benefits expected to be further expanded to raise men’s benefits to the level of women, and to introduce a 30 percent bonus in benefits if the spouse has work income above the entry point of the benefit ceiling.
- Design features providing joint-spouse incentives:
  - Combination of individual benefits and spouse-related bonuses provides incentives for participation of both spouses in the labor force.
- Specific schedule note:
  - Workers above 55 years old without children currently have the same schedule as men with one or two children.
  - The increase in EITC payments in 2019 will not apply to old-age workers.

### Magnitude of EITC spending and potential expansion
- Current and comparative magnitudes:
  - Israel’s EITC is expected to reach 0.16 percent of GDP in 2019.
  - This remains low compared to 0.4–0.5 of GDP annually in the U.S. or the U.K.
- Simulation: raising the ceiling of the EITC schedule by 100 percent
  - A simple estimate suggests raising the ceiling by 100 percent would lift EITC spending to 0.4 percent of GDP annually, assuming no change in the marginal tax rates for the phase-out.
- Simulation assumptions used in staff calculations:
  - Maintained phase-out marginal rate (which moves the upper income threshold).
  - Kept remaining income thresholds constant.
  - Assumed take-out rate of 70 percent.
  - Used a maximum monthly household gross income of NIS 30,000 as a simplification of additional income controls in EITC eligibility.

### Simulated distributional impacts of EITC expansion
- Simulated effects (aggregate magnitude):
  - Such an EITC increase could reduce the poverty rate and Gini coefficient by ½ ppt.
- Limits to EITC effectiveness on poverty incidence:
  - Benefits for a household comprising a couple with two children with a single earner are insufficient to lift them above the poverty line under current schedules.
  - Even for households with two earners, only those in a narrow range of incomes can be lifted above the poverty line through the EITC.
- MoF (2017a) findings (CBS Household Expenditure Survey 2015):
  - The EITC reduces the poverty gap by 2.9 ppt to 35 percent.
  - The EITC reduces the Gini coefficient by 0.2 ppt to 0.364.
- Scenario indicators (illustrative levels reported in simulations):
  - Without EITC: Gini: 0.360; Poverty Rate: 22.0%; Poverty Gap: 34.8%
  - Current rule (2017–18): implied improvements relative to without EITC
  - Planned changes (2018–19) and larger ceiling increases (50%, 100%, 135%) move total EITC expenditure toward an EITC near 0.5 percent of GDP in the most ambitious simulation (with simulated outcomes: Gini: 0.351; Pov. Rate: 21.3%; Pov. Gap: 33.8%)

### Implementation, take-up, and timeliness
- Current take-up:
  - Israel’s take-up of the EITC is currently around 70 percent, with varied participation across population groups.
- Measures to improve incentive linkage and take-up:
  - Enhancing the timeliness and frequency of credit refunds could tighten the perceived linkage between benefit and work.
  - One option: deduct the EITC from the monthly withholding of payroll tax to increase frequency.
    - Caveats: such schemes may be complex for households with multiple earners or fluctuating incomes; not applicable to the self-employed; employees may be concerned employers would reduce wages to offset the EITC.
  - Use existing infrastructure of social programs managed by the National Insurance Institute to improve timeliness.

### Complementary measures: conditional transfers, targeting, and reallocations
- Conditional transfers to support skill development:
  - Introduce a transfer program conditional on completing eligible core classes (e.g., mathematics, science, technology, and English) or participation in job training.
  - Attaching conditionality to some cash transfers can reduce inequality of education outcomes and support education as part of inequality-reduction strategy.
- Targeting to free resources for structural reforms:
  - Around 37 percent of the poor population have transfers as their main source of income.
  - The most vulnerable groups cannot be reached through the EITC; other transfer schemes are needed.
  - Israel’s current transfer system is not targeted to the most vulnerable; in aggregate, it provides a similar amount in shekel to all households, including those in the top income decile.
  - Targeting social supports to lower income deciles would free substantial resources to implement reforms addressing underlying causes of low incomes.
- MoF (2018) note:
  - Allowances intended for individuals who cannot participate in the labor market, such as old-age and disability benefits, have the largest contribution to poverty reduction.

*Source: IMF staff summary of chapter "The redistributive impact of taxes and transfers has declined since the early 2000s."*

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_Source: https://www.imf.org/-/media/files/publications/cr/2018/cr18112.pdf_