Israel’s innovation laurels are several– highest gross expenditure on R&D, largest amount of companies listed on NASDAQ outside of North America, highest level of venture capital as share of GDP, etc. How did this success come about?
According to Israeli venture capitalist Dr Orna Berry, there is no doubt smart policies played a key role in spurring innovation. “The Israeli government made a crucial strategic decision to jump start a sciencebased sector by providing financial support for commercial R&D,” says Ms Berry. “This policy made up for market failures and the heightened risk in operating in a geographically isolated market like Israel.” She knows the system well, having seen it through both the private and public sectors. In addition to a 25-year career in science and technology industries, she was the chief scientist from 1996 to 2000, a post that embodies the Israeli government’s hands-on approach to innovation. The Office of the Chief Scientist was created in 1969 within the Ministry of Industry, Trade and Labour, and would eventually become an important player during the high-tech boom.
But at the time of the Chief Scientist’s creation, Israel’s economy followed a distinctly corporatist approach, with widespread public ownership and heavily restricted trade. The so-called “lost decade” that followed the 1973 Yom Kippur War saw public debt rise to almost 300% of GDP. Israel wouldn’t find its feet again until 1985, when it tackled hyperinflation and public debt through its Economic Stabilisation Programme.
It was the emergence of Israel’s exportbased high-tech sector in the early 1990s that really put the country’s economy on track, with GDP growth of at least 4% a year. Specialising in computer hardware and software, medical technologies and pharmaceuticals, this sector became worldrenowned for innovation. Flash drives, cardiac stents, instant messaging and shopping.com are only a few of Israeli-bred innovations that have emerged in the last few decades. High-tech industries represent almost 50% of total industrial exports today, according to OECD data. Between 1995 and 2004, Israel increased its spending on R&D, calculated as a percentage of GDP, from 2.7% to 4.6%, a rate higher than any OECD country.
Israel certainly had the human capital by the early 1990s to fuel the boom. Israel’s compulsory military service provides early training in sophisticated technologies. Furthermore, the country saw the influx of almost one million ex- Soviet Jewish immigrants in the 1990s. These highly educated immigrants, whose ranks included 82,000 Russian-trained engineers, assimilated into the local labour market, providing key scientific and IT skills. The Jewish diaspora also provided a large pool of researchers.
“Government policy was instrumental in unleashing the potential of this abundant human capital,” says Ms Berry. The technological incubator programme was set up in 1991, in part to provide these skilled immigrants with funding and know-how to become successful entrepreneurs. It was run by the Office of the Chief Scientist, which funded potential entrepreneurs. Since the first companies emerged from the incubator programme in 1993, 61% have secured follow-on funding and 40% are active to this day. The private sector has since invested over $2.5 billion in incubator graduates, according to the OECD.
At the core of Israeli innovation policy is the chief scientist’s matching grants programme. Through this initiative, firms submit R&D proposals to the chief scientist, and grants are awarded on a competitive basis, with between 66 and 90% of the research costs covered. “We reviewed proposals according to their technical and commercial feasibility, risks and the potential for projects to generate expertise,” says Ms Berry. These grants are actually high-risk loans–successful projects must pay back the Office of the Chief Scientist the funding received via a deduction of a small percentage of annual sales.
Another government programme set up in the early 1990s, Yozma, has been credited with creating Israel’s vibrant venture capital industry. Founded with a budget of $100 million in 1993, Yozma established 10 venture capital funds, contributing up to 40% towards the total capital investment. The rest was provided by foreign investors, who were attracted by risk guarantees. Nine of the 15 companies that received Yozma investment went public or were acquired. “In 1997 the government received its original investment with 50% interest and the funds were privatised,” recalls Ms Berry. A recent OECD report on innovation calls Yozma “the most successful and original programme in Israel’s relatively long history of innovation policy.”
Although these programmes have benefited Israel’s export-led growth and offered a model for other OECD countries, their legacy is mixed today, says Mario Cervantes, OECD senior economist. “The returns in terms of longer-term job creation and income growth have not kept up, despite continued investment in high-tech,” he says. “Many Israeli start-ups are sold to the US market and get absorbed into global firms, never really expanding in Israel. This is expected given the small size of the internal market, but it does raise questions about how much of the returns from innovation end up back in the economy in terms of jobs created.” According to OECD data, Israel’s information and communication technology sector accounts for about 20% of total industrial output and 9% of business sector employment.
Moreover, Israeli businesses can be just as held back by excessive red tape as they are encouraged by government innovation policy. The OECD’s Product Market Regulation Database, a set of indicators to measure how policy promotes or inhibits competition, gives Israel a worse score than any other OECD country. The OECD’s 2009 Economic Survey of Israel called for more work to be done in reducing regulatory barriers and other channels of state influence on business.
While government policy has actively promoted high-tech industries, other sectors seem to have been left out. “With the exception of the information and communications technology services sector–which is very R&D intensive– innovation in other service sectors has received less attention, as illustrated by the weaker labour productivity performance of the business service sector compared to the US, Korea or the UK,” says Mr Cervantes. “Perhaps this is because of–or despite–the competition as well as regulatory barriers that limit incentives for innovation.” Israel’s economy remains heavily reliant on its high-tech sector, which provides a narrow base for growth, the OECD argues. Innovation policy will have to reach out to Israel’s traditional industrial and service sectors as well. Indeed, the OECD’s landmark Innovation Strategy stresses a broader view of innovation, beyond R&D, that encompasses both technological and non-technological forms of innovation such as design, organisational change and marketing.
Authors Senor and Singer found another trait in Israeli culture behind the “start-up nation” worth mentioning. They credit Israeli chutzpah, an almost untranslatable word meaning gall, audacity and guts (or bold arrogance, depending on the context). In Israel, chutzpah in business is most often seen in the country’s risk-taking culture and is something other OECD countries might do well to adapt to their innovation policies. However, Israel should not sit on its laurels either, since innovation is an ongoing enterprise. “Maybe there is still scope for some more chutzpah in Israel’s innovation policy as well,” Mr Cervantes adds.
Senor, Dan and Saul Singer (2009), Start-Up Nation: The Story of Israel’s Economic Miracle, Hachette Book Group, New York.
©OECD Observer No 285, Q2 2011