The Non-Observed Economy in Israel
Author: Labib Shami Policy Research

Executive Summary

This study estimates the size of Israel’s non-observed economy – also known as the black or shadow economy – using a currency demand approach that is modified for the Israeli economy. Such estimates are important because the unreported economic activity from the non-observed economy erodes the tax base, and is likely to lead to greater public debt and a decrease in the scope and quality of public services.

The study finds that the share of the non-observed economy out of GDP has been declining in Israel in recent years, that the share of the tax evasion component within the non-observed economy has been on a downward trend over the last decade while the crime component has been on a clear upward trend, and that indirect taxes and transfer allowances contribute to the expansion of the non-observed economy in Israel.

Estimating the size of the non-observed economy

The non-observed economy includes all economic activity where the resulting income evades the tax authorities and government supervision. It is defined by the OECD as having four main components: underground production (legal, but hidden); illegal production; informal sector production (by unregistered agents); and statistical underground (unreported economic activity due to deficiencies in government data collection).

  • According to estimates, the non-observed economy represents about 12% of economic activity in Anglo Saxon countries, 20%-30% in Southern Europe, and 40% in developing countries.
  • The OECD survey of member countries’ non-observed economies estimated Israel’s non-observed economy in 2008 at about 6.6% of GDP (not including “illegal production”).
  • The OECD survey shows that 45% of Israel’s non-observed economy in 2008 was from statistical underground, about 33% was from underground production, and almost 22% was from informal sector production.
  • Other international estimates place the size of the non-observed economy in Israel between 1995 and 2015 between 23% and 19% of GDP.

Israel’s non-observed economy as measured by the currency demand approach

The modified currency demand approach employed in the study uses the ratio between total cash withdrawals from the public’s personal checking accounts and total non-cash transactions in order to allow for the measurement of the demand for anonymous payments against every shekel used to pay transactions that are traceable. This is based on the central assumption that business transactions in the non-observed economy are based on cash transactions. In addition, this study is the first to include the influence of the type of tax (direct, indirect, or transfer payments) as well as the impact of illegal activities on the size of the non-observed economy in Israel.

  • The model shows that the size of the non-observed economy in Israel declined from 14% in 1996 to 10% in 2018, resulting in a non-observed economy of NIS 134 billion in 2018.
  • The share of tax evasion in the economy has declined in the past decade, standing at only 1% of GDP in 2018. This is due to a decrease in cash withdrawals from personal checking accounts and an increase in non-cash business transactions since 2016, alongside a decline in the tax burden over the past decade.
  • Indirect taxes and transfer allowances to households – child allowances, unemployment benefits, and income assurance payments – contribute to the expansion of the non-observed economy. This happens both because income-based benefits encourage people to evade reporting income in order to ensure their entitlement and because indirect taxes, like VAT, contribute to a preference to pay with cash.
  • Alongside the decline in the share of tax evasion, the share of criminal activity in the non-observed economy rose over the past two decades, reaching 90% of the non-observed economy in the past two years.

Factors affecting Israel’s non-observed economy

One method of depressing the non-observed economy proposed in the past few years, by policy makers around the world, is the idea of eliminating cash transactions.

  • As of the first of January 2019, a new law went into effect limiting the use of cash in accordance with the recommendations of the Locker Committee (2014).
  • The law sets an upper limit for the use of cash in transactions of NIS 11,000 for a business and NIS 50,000 for a private individual, and limits the use of blank or open checks.
  • Implementing the policy improperly could hurt Israel’s weakest populations and deepen the gaps between the rich and the poor.

It is reasonable to assume that the outbreak of the coronavirus crisis will affect the non-observed economy in Israel.

  • The study’s model estimates that the share of Israel’s non-observed economy peaked during the world-wide economic crisis of 2008, reaching 18% of GDP. It is therefore likely that during the current economic crisis, the extent of which is not yet completely known, the share of the non-observed economy will grow.
  • The budget that has been allocated to lessen individuals’ economic distress in 2020 (NIS 135.5 billion) has been distributed through grants, some of which have eligibility requirements. This is likely to encourage small business owners to hide income in order to meet the requirements, and thus to increase the size of the non-observed economy.
  • Small businesses and workers operating in the non-observed economy will not benefit from grants related to the coronavirus crisis, since their incomes are unreported to the authorities.