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									                           STATE OF ISRAEL
                       MINISTRY OF FINANCE

                    DIRECTOR GENERAL’S OFFICE


                             June 2005
June 27, 2005


A. Tax Rates on Labor Income in Israel from an International             3

 1. General Remarks                                                      3

 2. The International Comparison Methodology                             3

 3. Main Conclusions                                                     5

B. The Economic and Social Damage Inherent in Increasing the             7
Number of Palestinian Workers in Israel
 1. Preface                                                              7

 2. Literature Review and Historical Background                          9

 3. Characteristics of Employment of Palestinian and Foreign Workers     13

 4. The Effect of Employment of Foreign and Palestinian Workers on the   15
    Employment of Arab Israelis
 5. Sectoral Analysis                                                    15

 6. Claims Frequently Made by Interested Parties                         21

 7. Lack of Handling of Illegal Palestinian Workers                      24

 8. The Palestinian Side                                                 26

 9. Conclusions and Policy Recommendations                               28

 10. Bibliography                                                        29

     A.     Tax Rates on Labor Income in Israel from an
            International Perspective

1.        General Remarks

A position paper by Dr. Adi Brender that compares tax rates on men’s labor income in
Israel with the corresponding rates in twenty-six member countries of the OECD was
recently published.1

The paper examined personal tax payments at eight different income levels ranging
from half of per-capita GDP to ten times per-capita GDP. The tax rates that were
computed include national income tax, employee’s social-insurance contributions, and
local income taxes. Offsets among them were taken into account.2 One of the main
conclusions of the position paper is that Israel’s tax rates today, after reductions in the
past two years, resemble the accepted rates in most developed countries and are
actually lower at the income levels of a large majority of workers. This conclusion, as
we explain in detail below, is based on very problematic computations of the
“average” among the OECD countries and proves to be incorrect if we relate not to
the average “country” but to the average citizen in these countries.

2.        The International Comparison Methodology

A substantive problem in the comparisons in Brender's position paper has to do with
the way the average tax burden in the OECD countries was calculated. The simple
arithmetic averaging of the tax burden in these countries gives each country equal

  Adi Brender, “Tax Rates on Labor Income in Israel after the Tax Reform: International
Perspective,” in Managers and Economists: Articles and Position Papers, Bank of Israel,
March 17, 2005. The data for Israel pertain to the tax rates in effect in 2005. The data on other
countries are based on the last year for which data are available (usually 2004, sometimes
2003). The comparison was performed for several types of households: single man, married
man, and married man with two children aged four and ten, assuming that the workers are the
sole breadwinners.
  The comparison in the position paper assumes that employees’ social-insurance
contributions are tantamount to a tax. This is roughly the case in Israel, but in some OECD
countries employees’ social-insurance contributions are partly forced savings and not a tax.
Consequently, the tax rates in some OECD countries are overestimated.

weight. Thus, the simple average calculation equalizes the weight of large countries
such as the U.S.A and Japan—with populations in the tens or hundreds of millions—
and small countries that are populated by only a few million (or even less than half a
million, in the case of Luxembourg). In fact, most countries in western and northern
Europe, which have relatively high tax burdens, are much less populous than the
countries outside of Europe—mainly the U.S. and Japan—that have relatively low

Therefore, a more relevant comparison would assess Israel’s tax burden against an
average weighted by population size in the OECD countries. The weighted average, in
contrast to the simple arithmetic average, accurately reflects the average tax burden
that citizens in the OECD countries pay as a collective. Also, due to considerations of
“tax competition” in the global economy, it is important to compare Israel’s tax
burden with the “world” standard, and obviously the “world” in this case is affected
more by the economic policies of a large country such as the U.S. than by those of a
small one such as Luxembourg.

Furthermore, tax policy in large countries such as the U.S. is determined largely at the
federal level, even though each of the fifty American states is autonomous in setting
some tax rates. Therefore, the average U.S. tax rates represent the democratic choice
of fifty states and not of one state. By the same token, the tax policies of the twenty-
five EU countries are undergoing gradual harmonization; the differences among tax
rates in the EU countries are expected to narrow.

What is more, the day is probably not far off when the EU countries will form a single
federation, like the fifty states of the U.S., and then, from the formal standpoint, they
will constitute one country instead of many. Obviously, we would not want changes
of this type to influence our conclusion about Israel’s tax rates being high or low by
international standards. However, in the method that the position paper uses to
calculate the tax rates in the OECD countries (simple arithmetic average), this is
exactly what would happen. Israel’s tax burden by international standards would leap
on the day a European federation is established. The weighted-average method, in
contrast, is not sensitive to the formal unification or splitting of countries.

3.        Main Conclusions

Using the data presented in the position paper, we calculated the weighted average of
the twenty-six OECD countries for which Adi Brender’s position paper has data3 and
compared it with Israel’s tax rates. The results are shown in the figure below:

                     Average Tax Rate on Labor Income, Men
                           Israel and OECD countries
               Israel (all groups of men)
               OECD weighted average, single man
    40%                                                                            39%
               OECD weighted average, married man, sole breadwinner

               OECD weighted average, married man, sole breadwinner,
               with 2 children                                         29%



               50              75            100         133     166         200         400     1000
                                      Worker's wage as percent of per-capita GDP
                         (in Israel, an index of 100 represents a monthly wage of NIS 6600)

  The U.S. tax rate was calculated on the basis of a weighted average of the data in the
position paper: California, Texas, and New York City.

Below are the conclusions that we derived from our analysis of tax rates paid by men
in Israel as against the weighted average in the OECD countries:
•       At relatively low income levels,4 the average tax rates paid by Israeli men are
        significantly lower than the average rates paid by single and married men5
        without children in the OECD countries and resemble the average rates paid by
        married men with children in the OECD countries.6
•       At medium income levels,7 the average tax rates paid by men in Israel resemble
        the average rates paid by men in the OECD countries.8
•       At relatively high income levels,9 the average tax rates paid by men in Israel
        are significantly higher than the average tax rates paid in the OECD countries by
        men in all groups.10

The comparison shows that the tax burden on labor income is structured more
progressively in Israel than in the OECD countries on weighted average. Thus, the
difference in tax rates between high-income earners and low-income earners is much
higher in Israel than the accepted gap abroad.11 It is true that the OECD countries take

 A wage level of 100 percent of per-capita GDP (corresponding in Israel to a gross monthly
wage of NIS 6,600).
    All data for married men assume that they are sole breadwinners.
  For example, a man who earns 75 percent of per-capita GDP (corresponding in Israel to a
gross monthly wage of NIS 4,950) paid tax at a 10.1 percent rate in Israel as against
19.7 percent on weighted average for single men in the OECD countries, 15.6 percent for
married men without children, and 10.8 percent for married men with children.
 Wage levels of 133–166 percent of per-capita GDP (corresponding in Israel to a gross
monthly wage of NIS 8,800–NIS 11,000).
  The Israeli tax rates are slightly lower (relative to the weighted average in the OECD
countries) for single men and slightly higher for married men, with or without children).
 A wage level of 200 percent of per-capita GDP (corresponding in Israel to a gross monthly
wage of NIS 13,200).
  For example, a man who earns 400 percent of per-capita GDP (corresponding in Israel to a
gross monthly wage of NIS 26,400) paid tax at a 38.8 percent rate in Israel as against 29.8–
34.1 percent in the OECD countries; the range represents different tax liabilities of men in
different household situations.
  However, the extent of progressivity of the Israeli tax system should be examined from an
overall perspective that embraces all taxes and not only those on labor. For example, Israel

workers’ family status into account when they calculate the tax rates that apply to
them. Heads of households, especially fathers, pay lower tax rates than single men do.
In Israel today, no differentiation is made in the worker’s family situation for this
purpose. However, the absence of such differentiation in Israel is not necessary
harmful to low-income heads of household in Israel, because the tax rates applying to
them are similar to, if not lower than, the weighted average tax rate applying to the
corresponding group of workers in the OECD countries.12

B.          The Economic and Social Damage Inherent in
Increasing the Number of Palestinian Workers in Israel

1.    Preface

Within the renewed talks with the Palestinians, against the background of the
disengagement plan and the administration change at the Palestinian Authority, the
Palestinian demand to provide permits for work in Israel to tens of thousands of
unemployed Palestinians has been raised repeatedly. Some in the defense authorities
and in other entities in Israel claim that a relief of unemployment in the Palestinian
population will contribute to security in Israel.

The problem of Palestinian workers is part of the more general problem of non-Israeli
workers’ impact on Israel’s labor market and society. Today it is widely agreed that
foreign workers contribute to reduced demand for Israeli workers with a relatively
low education level, as well as to a decline in their wages; thus, their numbers should
be reduced. The same is not true in regard to Palestinian workers. A large group in the
Israeli public views Israeli consent to Palestinian workers’ coming to work in Israel
primarily as a lever for a “carrot and stick” policy towards the Palestinian Authority,

may have higher indirect taxes; this would lessen the progressivity of the Israeli tax system at
large relative to the OECD countries.
  Similar for married men with children and low for married men without children. (See, for
example, the two left-hand groups in the graph.)

while considering the impact of Palestinian workers on the Israeli labor market as a
secondary priority, if at all.13

In the document below, we present the economic price of increasing the number of
Palestinian workers in Israel, examining the effect on the unemployment rate, the
workforce participation rate, the increase in social inequality in Israel, and decisions
regarding investments and savings in the economy. In addition, we will show that
allowing the entry of thousands of relatively low-educated Palestinian workers into
Israel is also contradictory to Palestinian interests, in the long term. Continued
exposure of the Palestinian economy to the high wages paid to uneducated workers in
the Israeli economy will perpetuate the distortion created over the last thirty years in
the structure of the sectors of the Palestinian economy, negate the Palestinians’
relative advantage of cheap labor, impair industrialization and the volume of
investments in the Palestinian Authority, reduce incentives to acquire human capital,
and perpetuate the Palestinian economy’s dependence on the Israeli economy for
many years to come.

                               Non-Israeli Workers Employed
                                         (Thousands quaterly data)

     300           Palestinian Workers
                    Foreign workers





           1990 1991 1992 1993   1994    1995 1996       1997   1998   1999   2000 2001 2002 2003   2004   2005

  The number of Palestinian workers working in Israel actually increased considerably during
the first quarter of 2005. This increase is inconsistent with the government’s goal of reducing
the number of foreign workers in the economy in general, and the number of Palestinian
workers in particular. On May 6, 2005, 5,900 quotas for work in Israel were added as relief to
the Palestinian population. In addition, on June 21 it was announced that as part of the
positive gestures towards the Palestinian Authority, the intention is to raise the number of
permits for Palestinian workers.

2.   Literature Review and Historical Background

Main Findings in the Literature
A basic question examined in empirical studies carried out elsewhere in the world is
whether and to what extent foreign workers constitute a substitute or complementary
production factor to long-term residents employed in the host economy. Thus, for
example, De New and Zimmermann (1994) found that foreign immigrant workers in
Germany in the 1980s were a substitute production factor to uneducated workers, and
a complementary production factor to educated workers in the economy.

In Israel, Gottlieb (2002) empirically examined the effect of non-Israeli workers (both
foreign and Palestinian) on employment, wages, and inequality in Israel. He
concluded that the increase in the number of non-Israeli workers (relative to Israelis)
had a negative effect on the wages of low-educated Israelis in industry, agriculture,
and business services (as a substitute), and a positive effect on the wages of those with
higher education (12 years of schooling or more) in the same sectors (as a
complement). The most far-reaching impact of foreign workers’ entry into Israel was
expressed in a considerable deepening of inequality in economic income, which
resulted both from immigration policy towards foreign workers and from the income
maintenance policy for working-age individuals. Bringing in non-Israeli workers who
work for lower costs relative to the cost of employing unprofessional Israelis led to
the relatively low-educated population being driven out of the workforce, while taking
advantage of the income maintenance system. It was further found that the increase in
inequality was caused primarily as a result of these workers exiting the workforce,
and thereby losing their source of income, and only secondarily by the decrease in
wages of Israeli workers.

Gottlieb found that policy variables, expressed in the relationship between income
maintenance and the alternative wages of income maintenance recipients, have a
significant influence on inequality. Thus an appropriate policy of limiting the number
of foreign workers, effective enforcement of labor laws, and a change in income
maintenance policy can change the situation.

Gottlieb and Amir (2005) found that in the business sector, the entry of non-Israeli
workers drove mainly Israeli men out of employment. According to their research,
between 1994 and 2000 some 18.5 thousand Israeli men dropped out of the
workforce, as a result of the increase in foreign workers, and an additional 13.5
thousand dropped out as a result of changes in workers’ potential wages.

Bartram (2004) compared Japan’s foreign worker employment policy in the 1970s to
Israeli policy in the 1990s. He claims that both countries faced similar challenges;
however, while the Japanese government avoided importing foreign workers and
strove for continual progress in workers’ productivity by adopting capital-intensive
production processes, the decision making process in Israel, and lobbies for those
interested in raising the number of foreign workers, led the Israeli government to
choose the easy but destructive solution of importing foreign workers.

Romanov and Zussman (2003) examined the extent of substitution between foreign
and Israeli workers in the construction industry. They found a very high rate of
substitution between Israelis and foreigners, and presented a simulation according to
which the number of foreign workers in the industry can be reduced, while
considerably increasing wages and the number of Israeli workers, with only a
moderate increase in housing prices.

Historical Review
In July 1968, the Ministerial Committee on Economic Affairs decided to allow the
employment of Palestinian workers in Israel. This contradicted the recommendation
of the Bruno Committee, that the government allow free movement of commodities
between the Territories (West Bank and the Gaza Strip)_and Israel but not movement
of production factors, and in particular, not movement of workers.14 The
establishment of government employment bureaus in cities in the Judea, Samaria, and
Gaza regions and the granting of work permits within Israel to Palestinians began
after an additional decision by the Ministerial Committee on Security Affairs, in
October 1970, to allow the employment of Palestinian workers in Israel. In the early
years of Palestinians’ work in Israel, the arrangement appeared beneficial to all sides;

     See Swirski (2005).

the standard of living in the Territories improved, while due to rapid growth, Israel
did not suffer a significant increase in unemployment rates. Israelis who had been
employed at jobs now occupied by Palestinian workers generally “moved up” and
became junior managers.15

In addition, the social security network expanded considerably during the 1970s and
early 1980s (unemployment payments were initiated in 1973, child allotments in
1975, and income maintenance in 1982). Allowing non-Israeli workers to work in
Israel over a long period of time lowered the wages of Israeli workers in sectors
entered by non-Israeli workers, lowered the wages of Israeli workers with similar
characteristics in other sectors of the economy, reduced their chances of finding jobs,
and caused an increase in unemployment; also, due to the establishment of the social
safety net, which provides a substitute (though an imperfect one) to low-wage work, it
led to a decline in the workforce participation rate.16

It is widely agreed that the large number of foreign workers represents a problem and
should be significantly reduced. However, it appears that a similar consensus has not
been reached with regard to the entry of Palestinian workers, despite the comparable
economic and social consequences. The threat of bringing numerous Palestinian
workers into the Israeli labor market, in itself, reduces Israeli workers’ bargaining
power and their absorption in sectors such as construction and agriculture, while
causing entrepreneurs to avoid investing in industrialization, since decisions about
investments of physical capital have an investment horizon of twenty years or more.
The abundant supply of workers with low wages and few social benefits, which lasted
for over twenty years, until the early 1990s, entirely changed the character of the
sectors in which Palestinian workers were employed (mainly construction and
agriculture). Unlike the same industries in Western countries, these sectors in Israel
became labor-intensive and poor in capital.

     Semyonov and Lewin-Epstein (1987).
     Also see Gottlieb (2002).

Starting in 1991, permits for work in Israel began to be issued based on criteria of age,
sex, and marital status. Riots in the Judea, Samaria, and Gaza regions, Palestinian
terrorism, and the subsequent closures in the early 1990s created a severe shortage of
working hands in the construction and agriculture sectors. Instead of taking advantage
of the circumstances to effect a structural change in the economy, the government,
following intense pressure by employers in construction and agriculture, decided to
import a temporary, cheap workforce without social benefits from other sources. As
of 1993, nearly every terror event led to closure of the Territories, and each prolonged
closure led the government to increase the supply of foreign workers. When closure
was lifted, Palestinian workers returned to work, joining the foreign workers, until the
next closure. This process resulted in a gradual and continuous increase in the number
of non-Israeli workers, while lowering relative wages in these sectors and driving
Israeli workers out of the industry.

Source: UNSCO database, 2005.17

   See, p. 7. These data
do not necessarily match data and estimates of the Ministry of Industry, Trade and Labor and
the IDF.

Since the mid-1990s, foreign workers have become more dominant than Palestinian
workers in the Israeli labor market. This is because they are cheaper to employ and
more productive, and because of the security events that have prevented Palestinians
from coming to work regularly. As of October 2000, following the Palestinian
terrorist attacks, the number of Palestinians working in Israel dropped dramatically
(from 113,000 in 1999 to 30,300 in 2002). When Abu Mazen was appointed
Chairman of the Palestinian Authority and talks were renewed, the number of
Palestinians permitted to work in Israel rose again.

3.   Characteristics of Employment of Palestinian and Foreign

Is there substitution between Palestinian and foreign workers?

The answer to this question seems simple. Production factors are substitutes if an
increase in the quantity of production factor A lowers the price of production factor B.
However, this is difficult to determine empirically: Israeli law requires a minimum
wage for both types of workers. In other words, under conditions of a rigid lower
wage boundary, an increase in type A workers cannot lower the wages of type B
workers, if their wages are near the minimum wage. Another problem is the large
number of illegal workers and the lack of information regarding their wages.

Substitution between the two types of workers may not be symmetrical: starting in
1993, due to Palestinian terrorism and the closure policy, Palestinian workers became
temporary workers who could not commit to regular attendance at the workplace and
could not remain for long working hours (since they must leave Israel in the evening).
This situation is in addition to the difficulty of obtaining work permits for a foreign
worker and the fee that must be paid for the license. Thus, for example, a farmer who
has obtained a foreign worker work permit and paid the fee would not replace the
worker with a Palestinian, who may be stuck in a closure in the middle of the fruit
picking season.

Advantages and disadvantages to the Israeli economy in employment of
Palestinian workers vs. foreign workers

Relative advantages of employing Palestinian workers:
1. Negative external cost – the employer employing a foreign worker benefits from a
worker at a very low wage and does not bear the costs incurred to the economy by the
worker, due to the exploitation of infrastructures by foreign workers – physical,
educational, and health infrastructures – which are borne by the state rather than the
employers. Palestinian workers, in contrast, return to the Palestinian Authority at the
end of the day and use the infrastructures there.
2. Lower unemployment among Palestinians would reduce international pressure on
Israel with regard to its responsibility for these residents’ livelihood.
3. Once the separation fence is completed, it will be easier to control the number of
Palestinian workers in Israel than the number of foreign workers. Also, it is far more
costly to enforce the law and deport foreign workers.
4. Some claim that a relief of the unemployment and poverty in West Bank cities
would contribute to an expansion of the Palestinian middle class, increase socio-
economic stability in the Palestinian Authority, and contribute to security in Israel as
5. Palestinian workers are culturally closer to Israelis and many of them speak

Relative advantages of employing foreign workers:
1. There is no conflict and burden of past history between the foreign workers and
the Israeli population, which may lead to intentional injuries and damage to property.
For example, Palestinian workers in the construction industry have been known to
intentionally sabotage equipment or construction sites owned by the contractor
employing them. Such incidents increase particularly during periods of tension. 18
2. In cases of security events in the future, Israel will resume the imposition of
security closures, which will lead to uncertainty in the labor market and impair
efficient resource allocation.

  The Marker, March 25, 2005. Arik Meirovski – The inverse relationship between security
calm and building safety.

4.      The Effect of Employment of Foreign and Palestinian Workers
on the Employment of Arab Israelis

The employment of foreign and Palestinian workers has a particularly significant
impact on employment among Arabs in Israel. Arab Israelis constitute approximately
20 percent of the population (or 1.3 million people). The Arab population is
composed of three main religious groups: Muslims (82 percent), Druze, and
Christians (9 percent each). Most Arab Israelis reside in separate settlements
(85 percent), mainly located in peripheral areas, in three geographical regions: the
Galilee, the "Triangle", and the Negev. The Arab sector is characterized by a
relatively low level of economic development, high unemployment rates, a focus on
jobs and occupations on the bottom rungs of the professional ladder in the labor
market, and very low participation of women in the workforce. Arab Israelis were the
first to be ejected from the labor market in sectors in which employment of foreigners
is widespread (construction and agriculture). The prevalence of poverty among Arab
Israelis, which stood at 27.6 percent in 1995, rose to 46.2 percent by 2003, while the
increase among Jewish households was much lower, from 13.4 percent to
14.6 percent.19 Starting in 2002, concurrent with the policy of reducing the number of
foreign workers, the number of Arab Israelis employed increased. Note that a decline
in the number of Arab Israelis employed was recorded again in the last quarter of
2004, along with stability in the number of foreign workers and an increase in the
number of Palestinian workers.

5.      Sectoral Analysis

The extent of the Israeli economy’s dependence on Palestinian and foreign workers is
particularly salient in the data on specific sectors in which they are employed at high
rates (agriculture, construction, tourism, restaurants and hotels).

     Bank of Israel Report, 2004, p. 129.

The Agricultural Sector
In 1999, the number of Palestinian workers20 totaled 9,900 (approximately 12 percent
of all workers in the industry). In the same year, the number of foreign workers stood
at 20,400 (25 percent) and the number of Israeli workers was 50,400 (63 percent).
Due to the shortage in working hands caused by the terrorist attacks and the closure
imposed at the end of 2000, workers’ wages in the sector rose. The lack of effective
restrictions and the increased number of work permits for foreign workers in
agriculture led to the entry of additional foreign workers into the agricultural sector,
stopped the rise in wages, and prevented the entry of additional Israeli workers into
the sector. This resulted in substitution between Palestinian and foreign workers. In
2004, the number of Palestinian workers fell to 3,300 (4 percent of total workers in
the industry), while the number of foreign workers rose to 23,900 (32 percent) and the
number of Israeli workers remained stable at 64 percent.

                 Workers employed in the agricultural sector, 1993 to 2004 (in thousands)

       70                                                                                                                         30

       60                                                                                                                         20

                                                                                    Israeli employees
                                                                                     Palestinian employees (right axis)*
                                                                                     Foreign employees (right axis)

       50                                                                                                                         10

       40                                                                                                                         0
            1993      1994      1995         1996   1997   1998   1999       2000       2001      2002      2003      2004

      Source: Central Bureau of Statistics                               * Including unreported Palestinians working in Israel.

Flooding the agricultural sector with new Palestinian workers within the framework
of an agreement with the Palestinian Authority may turn back the clock. Palestinian
workers, whose potential wages in the Territories have greatly decreased over the last

     Including unreported Palestinians working in Israel.

three years, will lower the real wages in the agricultural sector and replace Israeli and
foreign workers, while Israelis will be ejected from the labor market and foreigners
will move to other sectors. Wages in the sectors to which the foreign workers transfer
will drop, which is expected to lead to additional Israeli workers being ejected from
the labor market.

In the long term, there should be no difficulty in replacing foreigners and Palestinians
with Israelis while raising their wages (unlike the construction industry, crop-based
sectors do not even require training). A decrease in the number of non-Israeli workers
may also bring about a transition to capital- and technology-intensive agriculture. This
process is expected to reduce the total number of agricultural workers and replace
these jobs with more sophisticated ones. For example, the replacement of a milking
plant with an automated dairy21 will lead to a sharp decrease in the demand for
milkers, but will create jobs for technicians and service personnel for the equipment.
The same is true for fruit, vegetable, and flower sorting machines. Naturally, such a
process that leads to increased capital per employee will lead to increased productivity
and higher wages for workers in the industry.

The construction sector
Activity in the construction sector expanded greatly in the early 1990s, in response to
the sharp upturn in demand for housing caused by the immigration wave.
Concurrently, several successive closures were imposed on the Territories, with entry
denied to Palestinian workers for several weeks or months each time. At each closure,
following contractors’ demands, the number of work licenses for foreign workers was

     Such as those at the kibbutzim Beit Alpha and Mishmar Ha-Emek.

                      Workers employed in the construction sector, 1995 - 2004
                                           In thousands
      160                                                                                                                                     80

      140                                                                                                                                     60

      120                                                                                                                                     40

      100                                                                                                                                     20
                         Israeli employees
                          Palestinian employees (right axis)*
                          Foreign employees (right axis)
      80                                                                                                                                      0
               1995         1996        1997          1998          1999           2000       2001        2002        2003        2004
            Source: Central Bureau of Statistics                                     * Including unreported Palestinians working in Israel.

The turnover of workers in the construction sector should be more moderate than in
agriculture, due to the fact that construction work requires experience and a training
period that makes it difficult for new workers to quickly assimilate in the industry.
However, data in the graph indicate that sharp turnovers occur in the sector between
Israeli and non-Israeli workers.

                               Workers employed in the construction sector
                                                               In thousands

120                                                                                                                                           90
                                                Non-Israeli workers*
                                                      (left axis)
105                                                                                                                                           75

 90                                                                                                                                           60
                                                         Arab Israelis
                                                          (right axis)

 75                                                                                                                                           45

 60                                                                                                                                           30
  1995            1996          1997           1998          1999           2000          2001         2002         2003         2004
*Includes foreign workers (reported and unreported) and Palestinian workers
Source: Labour Force Surveys and national accounting data, Central Bureau of Statistics

Throughout the 1990s, foreign workers replaced Palestinians during closures; at the
end of each closure, Palestinians returned to workplaces that had meanwhile been
occupied by foreign workers. Employers took the Palestinians back to work, and
ensured that they replaced the most costly workers – the Israeli workers. As a result,
the foreign workers brought in to temporarily replace Palestinians ended up replacing
Israelis in the sector. At the end of 2000, as the Palestinian terrorist attacks began, the
number of Palestinian workers22 in the sector declined sharply, from 64,700
(27 percent of total workers in the industry) in the peak year of 1999 to 17,100
(8 percent of the total) in 2004. Foreign and Israeli workers in 1999 numbered 59,000
(24 percent) and 120,400 (49 percent), respectively. The number of foreign workers
decreased to 48,500 (25 percent) in 2004, while Israeli workers increased to 128,700
(66 percent). Thus, due to the strict supervision of the number of foreign workers and
the steps taken by the government to raise the cost of employing foreign workers, on
the one hand, and the decrease in transfer payments on the other, substitution occurred
in this sector between Palestinian and Israeli workers (mainly Arab Israelis), rather
than between Palestinian and foreign workers, who, as noted, account for an almost
equal percentage in both periods.

The decision to prevent the entry of additional Palestinians into the construction
industry is a simpler one now than in the past:
•     First, the immigration wave that occurred in Israel in the 1990s has been over for
some time now. The volume of activity in the sector is lower than it was during the
1990s, and the effective limit on the sector’s activity level is on the demand side
(apartment purchases) rather than the supply side (availability of workers and other
production factors).
•     Second, decision makers today know what may not have been known in the past:
that the damage to the Israeli economy and society caused by the increased number of
non-Israeli workers is long lasting, and mainly involves an increase in unemployment
among uneducated Israeli workers, enlarged governmental transfer payments, and
increased inequality in economic income.
•     Third, there will be no problem of a lack of working hands due to the prevention
of Palestinian workers’ entry into the sector. The exit of close to 34,000 Israeli

     Including unreported Palestinians working in Israel.

workers from the industry in 1996 to 2000 and the return of some 12,000 workers
during the four years between 2000 and 2004 (when the number of Palestinian
workers decreased) indicates that there is still a large number of skilled Israeli
workers outside the industry. The fact that the unemployment rate among low-
educated Israeli men is quite high seems to indicate that these workers have remained
without employment.

A decrease in the number of Palestinian workers will lead to an increase in wages for
workers in the sector. As a result, more Israelis will want to return to the industry or
enter it for the first time. Concurrently, costlier workers will serve as an incentive to
increase industrialization of construction. Residential construction methods are
currently characterized by a very low ratio of capital per employee, and are
economically feasible due to the low cost of Palestinian and foreign workers in Israel.

        Unemployment rate of men, by nationality and education, 1995 - 2003


                                                           Arabs with 0 to 8 years of education

                                                      Jews with 0 to 8 years of education



  6                                          Arabs with 16+ years of education

                                          Jews with 16+ years of education

   1995             1996            1997            1998             1999           2000          2001   2002   2003
       Source: Labour Force Surveys, Central Bureau of Statistics.

The tourism, restaurants and hotels sector
Another sector that has employed many Palestinian and foreign workers is the
tourism, restaurants and hotels services sector. In 1999, Palestinian workers
(including unreported workers) totaled 7,000 (approximately 6 percent of total
workers in the industry). In the same year, the number of foreign workers stood at
34,000 (27 percent), some in Oriental restaurants, while Palestinians and Israelis
mainly competed in the subsector of hotels and tourism. Due to the Palestinian
terrorist attacks and the resulting damage to the tourism sector, the industry contracted
between 2000 and mid-2003. In 2004, the number of Palestinian workers fell to 1,900

(1 percent) and the number of foreign workers fell to 30,200 (23 percent), while the
number of Israeli workers rose from 85,600 (68 percent) in 1999 to 99,400
(76 percent) in 2004.

In this sector as well, the return of Palestinian workers is expected to drive out Israeli
workers without impairing employment of foreigners, since some of the foreign
workers are employed at specialized Oriental restaurants, while Palestinians and
Israelis mainly compete in the hotel sector.

                       Employees in the hotels and restaurants services sector, 1995 - 2004
                                                  In thousands
     100                                                                                                                        50

      90                                                                                                                        40

      80                                                                                                                        30

                                                                             Israeli employees
      70                                                                      Palestinian employees (right axis)*               20
                                                                              Foreign employees (right axis)

      60                                                                                                                        10

      50                                                                                                                        0
               1995        1996        1997       1998   1999        2000       2001        2002        2003        2004
           Source: Central Bureau of Statistics                        * Including unreported Palestinians working in Israel.

6.          Claims Frequently Made by Interested Parties

•           In certain jobs in the fields of construction and agriculture, it is not possible
to obtain workers other than Palestinians or foreigners. Israelis are unwilling to
work in these jobs.
This is one of the basic claims made by employers, according to which they would be
happy to employ Israelis rather than foreign workers, even at a higher wage than that
offered to foreign and Palestinian workers, but there are no Israelis willing to work in
construction and agricultural occupations. This is a strange argument for several
reasons. First, not many years ago there certainly were Israelis working in these

Where did tens of thousands of people disappear to within just a few years? Second,
everything is a question of price. An Israeli worker will demand a much higher wage
than a foreign worker, and from the employer’s point of view, the trade is not
particularly worthwhile, if he can obtain, with government approval, a license to
employ a non-Israeli worker at a low wage. However, this issue has another side.
Employers insist it isn’t about price, but rather the image and physical hardship of the
construction and agricultural occupations. If so, why is there no similar image for jobs
that are no less difficult, such as sanitation and porters’ jobs, which are dominated by
Israeli workers? The answer may be one of the two:
(A) The employers’ claim is invalid; it is untrue that Israelis will not work in
construction and agriculture. Israelis will be willing to work in these jobs, just as they
work in sanitation, and just as Japanese and Scandinavians work in construction in
their countries.
(B) As the percentage of foreign and Palestinian workers in the industry increases,
its image and attraction for Israeli workers declines. In this case, once the number of
Palestinians is gradually reduced to zero and the number of foreigners is lowered, the
industry’s image will necessarily improve.

•     Reducing the number of Palestinian and foreign workers will cause Israelis
to be fired.
A basic question is whether and to what extent foreign and Palestinian workers
constitute a substitute or complementary production factor to Israelis employed in the
industry. The accepted definition is that two production factors are substitutes if an
increase in the supply of one lowers the price of the other, and complementary if an
increase in supply leads to an increase in the price of the other production factor.

Gottlieb (2002) and Gottlieb and Amir (2005) found that non-Israeli workers are
substitutes for uneducated Israeli workers.

With regard to the construction industry, it was found that in 2002 to 2004, concurrent
with the decrease in the volume of activity, the number of non-Israeli workers
decreased, while the number of Israeli workers actually increased. This fact is in line
with foreign workers as a substitute for Israeli workers, and contradicts the claim that
a reduction in the number of foreign workers would have the effect of reducing the

number of Israeli workers (which would be correct for complementary production

•     An increase in labor costs of foreign workers will lead to an increase in
housing prices.
An analysis of developments in housing prices and input prices immediately points to
a weak link between these variables. Labor costs comprise less than 20 percent of the
price of an average apartment, so that the impact of changes in workers’ wages on
housing prices is not large. Moreover, housing prices, like prices of other assets, are
not determined by the “cost plus” method. Sharp changes in labor costs (or in cement
or iron prices) will be partially absorbed in land prices (approximately 40 percent of
the cost of an apartment) and in contractors’ profits, and their effect on housing prices
will be relatively small and dependent on the flexibility of supply and demand in the
industry. The effect of a greater number of immigrants entering Israel, expectations of
rising asset prices (due to an improvement in the security situation or possible
progress in the diplomatic process, for example), and heightened demand following
the evacuation of settlements on housing prices in Israel is far greater than the effect
of a change in the price of one of the inputs of construction.

As noted, Eckstein and Perlman (2001) demonstrated that over two thirds of the
savings in construction costs derived from the employment of foreign workers
reached contractors.

Romanov and Zussman (2003) presented a simulation examining a gradual reduction
of up to 30,000 illegal foreign workers in the construction industry over three years,
and absorption of Israeli recipients of income maintenance benefits or unemployed
Israelis in their place. The results: the number of Israeli workers in the sector would
increase by nearly 38,000, and their wages would increase by approximately
16 percent. The increase in housing prices, in contrast, would be relatively moderate,
up to 4 percent annually.

In addition, a relative increase in the price of labor inputs relative to the price of
capital inputs (particularly taking into account technological improvements in
equipment) will provide an incentive for transition to capital-intensive construction

methods. This incentive has passed over Israel, where tens of thousands of
professional workers from the Territories were employed at low wage. The
opportunity granted by the imposition of closures on the Territories in 1993 to
completely change the construction industry in Israel was not exploited, and the
number of foreign workers has steadily grown. An additional opportunity is before us
now, and should not be missed.

•     Why should we allow free imports of cheap products manufactured in
poorer countries that compete with local products, but object to free imports of
cheaper workers? What is the economic logic behind the distinction between free
passage of products and free passage of workers?
A “liberal” policy of product imports and a “non-liberal” policy in imports of workers
is a recipe for high employment rates – one of the main goals of economic policy.
Imports of cheap products enhance consumers’ purchasing power, while concurrently
diverting the workforce into sectors in which the economy has a relative advantage,
such as advanced export sectors or non-tradable sectors. Imports of more cheap
workers will lead to a replacement of local workers in non-tradable sectors and their
ejection into unemployment.

Furthermore, the fact that the Israeli economy is exposed to imports and competition
in tradable sectors is all the more reason to protect the employment capability of
unskilled workers in non-tradable sectors. This policy has been enacted by most
developed countries. Despite the progress made in this area in recent years, Israel is
still exceptional in the number of foreign workers as a percentage of the workforce.

7.    Lack of Handling of Illegal Palestinian Workers

The considerable discrepancy between the number of permits to work in Israel
granted to Palestinians (approximately 20,000 in the first quarter of 2005) and the
Central Bureau of Statistics’ estimate of the total number of Palestinian workers
actually employed in Israel during the same period (43,300 workers23) derives from

  The Israeli Central Bureau of Statistics bases its estimates of the number of Palestinians
working in Israel on data from the Palestinian Bureau of Statistics, among other sources.

the large number of Palestinians who work in Israel illegally. In fact, there is currently
no entity in Israel responsible for handling this issue, and there are therefore no
reliable statistical data on its dimensions. Despite the inaccuracy, a clear trend of
growth in the number of Palestinian workers since 2002 can be identified.

Handling and deporting of illegal Palestinian workers are not carried out by the
Immigration Police and the Immigration Administration, which were formed to
handle the problem of illegal foreign workers. Instead, they are handled by various
units of the “blue police”, which suffer from extensive workloads, while preventing
the entry of illegal Palestinian workers is under the responsibility of the IDF.

Police data indicate that in 2004, for example, the police filed 15,623 cases against
persons entering Israel illegally, virtually all Palestinians. Only 5,460 were arrested.
This number represents only part of the illegal Palestinian workers who were in Israel
in 2004 (many of those arrested are criminals rather than workers). Among
employers, criminal charges were filed against only 2,444 employers, and just 202
were detained for questioning.

In most cases which do not involve a Palestinian who constitutes a security risk or one
who has been caught multiple times, the Palestinian worker is released at the nearest
IDF roadblock; he is thus free to try his luck infiltrating Israel again the next day. The
lack of a designated entity to carry out enforcement, and the transportation of persons
illegally present, using police cars, back to the roadblocks deprives the police of
patrol units used for ongoing security. The sanction for a worker caught is deportation
back to the Territories, while a worker caught several times risks being denied a
permit to work in Israel in the future. The sanction does not include a monetary fine.
The sanction against the employer of a Palestinian illegally present in Israel is a
monetary fine in the amount of NIS 10,000 for each worker caught (with an additional
fine in case of overnight stays), filing criminal charges, and even jail time. However,
the low number of employers against whom charges have been filed indicates that in
practice this sanction is not always enforced. Another entity operating in this field is
Ministry of Labor inspectors.

It appears that the deportation method, which may be effective in the case of foreign
workers, is not effective with regard to illegal workers from the Territories. While the
cost of reaching Israel for a foreign worker can reach hundreds or thousands of
dollars, and deportation for such a worker is a significant financial sanction, the cost
of arrival for Palestinian workers from the Territories is very low due to the
geographical proximity and lack of a physical barrier. The absence of an effective fine
for workers caught and of more significant enforcement of fines for employers, and
the lack of a designated entity in Israel handling the problem of illegal Palestinian
workers, creates a situation in which a Palestinian worker who is caught loses a day of
work, at most, and returns again the next day to seek work in Israel.

8.   The Palestinian Side

Some commentators abroad voice the claim that during the years in which Israel held
civilian control over the Judea, Samaria, and Gaza regions, the State of Israel avoided
investments in physical or human capital in the Territories, in order to guarantee for
itself a stream of cheap workers and a market to absorb its products. These claims are
clearly biased and exaggerated. However, the investment in physical and human
capital in the Territories was in fact minimal. It appears that one of the key reasons for
this was the sudden exposure of the Palestinian economy, in the 1970s, to the Israeli
economy, its wages, and the forces of the free market.

The high wages in Israel for unskilled workers, relative to the wages of a Palestinian
worker in the Judea, Samaria, and Gaza regions, derives, among other causes, from
the standard of living in Israel, social legislation (such as the Minimum Wage Law),
and the activity of trade unions. For example, the median hourly wage earned by a
Palestinian worker in Israel in the last quarter of 2004 was 65 percent higher than the
median wage paid in Judea and Samaria, and 78 percent higher than the median wage
in the Gaza strip. The considerable disparity in wages, against the background of the
lack of a physical barrier between the Judea and Samaria region and the state of Israel,
drew many Palestinians to respond to job offers in Israel, both legally and illegally.

The exposure of workers in the Palestinian economy to the high wages in Israel has
created a severe bias in the Palestinian labor market:
•     The high wages for unskilled workers have damaged the incentive to acquire
human capital.
•     After 30 years of working in Israel in the non-tradable service sectors (primarily
construction and tourism) and providing services in the Gulf states, service sectors
occupy an excessive proportion of the Palestinian economy (the “Dutch disease”). In
these sectors, the Palestinian relative advantage of comparatively cheap labor cannot
be commuted into local manufacturing and marketing of products abroad.
•     The increase in wages in the Territories, beyond wages in Jordan and Egypt,
together with the security problems, have made the Territories less attractive
destinations for investments of physical capital, compared to those countries. For
example, the textile industry left Israel for Jordan rather than the Palestinian Authority

In fact, work in Israel is a sort of “addiction” that increases the income of individuals
and of the Palestinian Authority and lowers unemployment in the short term, but
harms the development process of the Palestinian economy in the medium and long
term. A lack of intervention by the Israeli government against this market failure and
a lack of encouragement of initiated investments in Palestinian cities over the years
have further exacerbated the problem.

The drastic decline in the number of Palestinian workers in Israel at the start of the
Palestinian terrorist attacks, along with the frequent closures and restriction on
Palestinian    movements    for   security    reasons,   have   significantly   increased
unemployment and decreased workforce participation in the Palestinian Authority
territories. This process creates a good starting point for large-scale investments in
physical capital in the Palestinian Authority, once the Authority is able to enforce a
calm in the security situation within its area, and at a later stage the acquisition of
human capital as well. The return of masses of Palestinian workers to physical labor
in non-tradable sectors in Israel would constitute a severe failure to take advantage of
this opportunity, turn back the clock, and cause long-term damage to both the Israeli
and the Palestinian economies.

There are many ways in which Israel can aid the Palestinian economy in the short
term. For example, the establishment of industrial zones along the border may be
considered. These industrial zones would be located on Israeli territory (in order to
allow for Israeli security) and would take advantage of Israeli capital and knowledge
along with cheap Palestinian labor in order to create joint output. In addition, the
establishment of trade zones and joint investments in water, electricity, and road
infrastructures may be considered. The return of Palestinian workers to work in Israel
is not one of these solutions, and the extent of its potential damage exceeds its

9.    Conclusions and Policy Recommendations

An increase in the number of Palestinians working in Israel (legally and illegally) will
exacerbate the long-term economic and social problems created by the substitution of
Israeli workers with cheap foreign workers. A policy supporting the return of Israeli
workers to the construction and agriculture sectors can bring about a decrease in the
unemployment rate, contribute to reducing inequality in the distribution of income,
lower poverty rates, and assist in increasing industrialization in the economy. The
positioning of Palestinian workers at the bottom of the Israeli pay scale may cause
downward stretching of the scale, replacement of Israelis with Palestinians, and the
transition of foreign workers pushed out of these sectors into other sectors (illegally),
which would impair the employment and wages of Israelis in additional sectors.

It is in Israel’s vital interest, both from the economic point of view (the labor market)
and from the social point of view (unemployment and inequality), to implement
Government Resolution No. 1996, Section 10E, dated June 2004:
“In the longer term, and in line with Israel’s interest in encouraging greater
Palestinian economic independence, the State of Israel expects to reduce the
number of Palestinian workers entering Israel, to the point that it ceases
completely. The State of Israel supports the development of sources of
employment in the Gaza Strip and in Palestinian areas of the West Bank, by
international elements.”

In the short term, the following is proposed:
1. Not to increase the number of permits beyond those valid in 2004. The
government of Israel should publicly release this number and avoid raising it, even
temporarily. This will reduce uncertainty in the labor market and enable the various
sectors to prepare for the absorption of Israeli workers and plan the volume of
investments in physical capital.
2. The State of Israel should establish a clear, transparent, decreasing future
trajectory for the rate of decrease in the number of persons entering Israel to work,
and release it publicly. The number of Palestinian workers should decrease gradually
in the future, to a minimum by the end of 2008, concurrent with the decrease in the
number of foreign workers.
3. As long as Palestinians work in Israel, the cost of their employment should be
equalized to the cost of employing an Israeli worker, by enforcing minimum wage
laws, among other things. On the other hand, a fee should be deducted from the
worker’s wages, to bring the Palestinian worker’s wage to a level similar to the
average wage in the Palestinian Authority. The exact rate of the fee should be
determined in agreement with the Palestinian Authority. Funds from collection of the
fee should be transferred to the Palestinian Authority and can serve to increase
investments in physical and human capital.
4. In order to handle the tens of thousands of Palestinian workers working in Israel
illegally, enforcement as well as punishment of workers, and particularly of their
employers, should be significantly increased. In addition, transfer of the enforcement
to a designated entity within the police or the Immigration Police should be

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