The Encouragement of Capital Investments Law-Experience in Israel and Other Countries, and the Changes Needed

7.8.07

The Encouragement of Capital Investments Law––Experience in Israel and Other Countries, and the Changes Needed

	It is recommended that the Encouragement of Capital Investments Law be amended such that its objective would be to boost employment in low socioeconomic areas. The aid should include grants on capital and labor, with one-third to capital subsidies and two-thirds to labor subsidies, in line with the division of business sector income.
	Preference should be given to initiatives that incorporate specialized knowledge and technological innovation that require skilled, highly paid labor, and initiatives that involve widespread training.
	It is recommended that most of the benefits be granted via the tax system. However, the limitation on the total amount of the tax benefits, which was removed in 2005, should be reinstated.
	It would be advisable to set a downward path that would gradually reduce the budget cost of the Law. The average budget cost of encouraging investment in the EU member countries is lower than that in Israel.
The Encouragement of Capital Investments Law in its current form defines objectives1 which, it has been found in Israel and abroad, are not being achieved via the means being employed under the Law. Various studies show that capital subsidies distort the allocation of resources, and thus have an adverse effect on efficiency and the development of productive capacity. Intervention intended to improve the current account against market forces should therefore be avoided, and is indeed unnecessary in the light of the exceptional high current account surplus, high both historically for Israel and also by international comparison. The Bank of Israel 2006 Annual Report2 also shows that it was difficult to point to any improvement in employment in areas where investments were undertaken with the benefits granted under the terms of the Law.
The purpose of the subsidy should be to boost employment and raise the standard of living in low socioeconomic areas. It would be advisable to give preference to initiatives that incorporate specialized knowledge and technological innovation that require skilled highly paid labor, and initiatives that involve widespread training. Choosing companies according to these criteria will probably raise the ability to survive of firms eligible to a subsidy under the Law, and will help to create stable employment. In addition, the map of development areas should be redrawn so that the aid should be focused on outlying areas far from the main centers of employment and that are counted among the lower socioeconomic localities or regional councils.
The aid should include grants on capital and labor, with one-third to capital and two-thirds to labor subsidies, in line with the division of business sector income. In order to encourage projects based on skilled, highly paid labor, the grants should be graded, rising with the level of wages. Tax benefits should be granted, on condition that the investment and employment targets––defined when the project was submitted––have been met. Some of the tax benefits could be granted via exemptions or reductions in the employer’s and employee’s National Insurance payments.3 Such benefits will validate the employment targets, and will help to preserve the mix of support for physical capital and labor. It is recommended that most of the benefits be granted via the tax system; such benefits, as they depend on companies’ profitable activity, encourage high quality initiatives. That said, the limitation on the total amount of the tax benefits, which was removed in 2005, should be reinstated.
It would be advisable to set a downward path that would gradually reduce the budget cost of the Law, particularly in the light of Israel’s candidacy for membership of the OECD. In the EU a process of reducing expenditure on encouragement and subsidization of companies has been underway since 1997, and in 2005 the issue was formalized and made binding. The figure below shows a comparison of the budget cost of encouraging capital investments in the EU countries and Israel. It can be seen that in 2005 the public cost of grants and tax benefits to encourage capital investments was higher in Israel than the EU average.

1	The Law’s objectives are: to develop productive capacity and make efficient use of economic potential, improve the current account of the balance of payments, boost regional development and create employment.
2	Box 2.3, pp. 73–76
3	National Insurance payments include payments of 4.14 percent by the employer and 0.4 percent by the employee on up to 60 percent of the average wage, and on the part of the wage above 60 percent of the average wage the employer pays 5.68 percent, and the employee, 7 percent.

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