Israel enacted the Encouragement of Capital Investments Law (ECIL) in order to develop its production capacity. The law awards grants and other benefits to those who establish enterprises or expand existing ones, foremost in peripheral areas. This study examines the effect of the grants on manufacturing productivity in 1990-1999 and the effect of the expansion grants and tax benefits on investment and employment. We use a unique plant-level data base-containing information on all grants and tax subsidies given under ECIL auspices-and additional information about the activity of a representative sample of manufacturing enterprises. We find that capital originating in expansion and construction grants is no less productive than non-subsidized capital and, consequently, that the grants do not distort macro-level capital allocation. We also find, however, that the expansion grants do nothing to increase investments and employment. Although simple estimations show that an expansion grant of USD 35,000-USD 50,000 (in 1999 prices) results in the creation of one new job, the use of the districts and the share of exports as instrumental-variables does not reject the hypothesis that the expansion grants have no upward effect on employment.

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