Israel has become a global focus of innovation over recent decades, however, the prospering high-tech sector has largely remained insulated and the majority of the economy has yet to gain from its benefits. This presents the Innovation Authority with an important mission: to preserve and strengthen world leadership of innovation while increasing the resultant economic-social yield

Since the industrial revolution, innovation has been the key to sustainable economic growth. Innovation is a significant component in the two central routes to creating a competitive advantage in a free market: the development of better goods and services or the production of existing goods and services at a lower cost. Furthermore, innovation can change existing markets and create new markets in their place, a phenomenon occurring with increasing frequency in recent decades. It is enough to remember that the I-Phone, the prototype of modern smart phones that have changed our lives unrecognizably, is only ten years old.

Technological innovation is also a key to high-quality and well compensated employment. The large technology companies, that succeeded in leveraging their competitive advantage, employ tens of thousands of workers in an innovative and rewarding environment. Productivity (measured as product per hour of labor) and accordingly, average salary, is higher in technology-oriented sectors than in others. For example, the average salary in high-tech sectors in Israel in 2016 stood at approximately NIS 21000, while the average salary in the economy as a whole was approximately NIS 9800 – less than half.[1] Moreover, the Head Economist's Division in the Ministry of Finance pointed out that social mobility, in other words the ability to climb the earnings ladder, frequently passes through relevant studies and subsequent integration in high-tech sectors.[2]

In light of the above, it is not surprising that we are witnessing an increased emphasis on innovation during recent years, both among companies competing on the free markets and among economies interested in joining the route to sustainable growth. Our 2016 Innovation Report cited the innovation revolution in China as one such example, one that receives official expression in the Chinese government's relevant five-year plans. In this report, we discuss South Korea that has been transformed from an agrarian, war-stricken country into a leading developed economy via massive investment in technology.

 

The Israeli Innovation System is Ready to Make the Next Step

Israel burst on to the world scene as a leading center of innovation during the 1990's, after a prudent government investment in the building of a technological infrastructure during the preceding two decades. The leap that Israel made from an economy with an average level of innovation to that a global center of technology, justifiably branded the 'Start-Up Nation', is a role model for both developed and developing countries, and an achievement that we should not relate to lightly.

Today, Israel ranks extremely high in most innovation indices (See Diagram 1), and particularly excels in the intensity of civilian R&D, 4.3 percent of GDP – first in the world in almost every year during the last ten years – and in its entrepreneurial activity. These achievements are the result of decades of intelligent innovation policy at the center of which lies a productive partnership between the private and government sectors.


A wider view of the Israeli economy however, reveals that the high-tech sector has largely remained insulated and the majority of the economy's other sectors have yet to benefit from its prosperity. An important figure testifying to this is the rate of high-tech employees out of the total number of the economy's salaried employees.  For more than a decade this figure stood at approximately 8 percent[3] (see Diagram 2), following a rapid rise during the 1990's. Moreover, despite its high technological innovation intensity, the high-tech industry does not contribute enough to narrowing productivity disparity with the developed economies (see Diagram 3).

In addition, in the 2016 Innovation Report we indicated that the Israeli innovation system, after long years as a world leader, is currently positioned at a crossroads. The increasing investment by other countries in technological innovation, combined with the fierce global competition between technology companies and the swift pace of change in these worlds, requires action to renew the rapid growth of the local high-tech sector and to strengthen its connection to the rest of the economy. Standing still, even for just a few years, may cost us the leading position achieved with so much effort over the previous decades, and widen the gap with the developed economies. We must learn from modern history about the pace at which leading economies in science and technology lose their competitive status, mainly against the background of the erosion of the socio-political agreement regarding the importance of innovation, and the decline in required investment of resources.

Despite all this, it is the Innovation Authority's view that the technological and economic potential embodied in the Israeli innovation system is far from full utilization. We believe that we have the capability to perform another quantum leap similar in intensity and influence to that of the high-tech burst in the 1990's. We also believe that the Israeli innovation system has the ability to maintain and strengthen its leading technological and entrepreneurial position while simultaneously increasing the socio-economic yield from innovation in a manner that benefits wider circles of the economy. In order to do so, we must understand the factors preventing Israeli high-tech from breaking the glass ceiling it has encountered in recent years, while distinguishing between several innovation ecosystems, at different stages of development.

 

ICT – Expanding the Economic Influence

The ICT innovation system (Information and Communication Technology), the most advanced and developed in Israel, has for many years benefitted from a broad and advanced infrastructure that includes: skilled workers, a military system that produces advanced technologies and trains high-quality and experienced personnel, an entrepreneurial culture that yields hundreds of innovative start-up ventures each year, multinational corporations possessing experience, knowledge and a connection to the markets, and a designated and developed government and private finance system (mainly venture capital).

Nevertheless, Israeli ICT has suffered in recent years from two central weaknesses that have prevented it from surging forward. The first is the significant shortage of skilled personnel that serves as the central element fueling the innovation engine. This shortage constitutes an obstacle in the face of future growth and may even harm this field's competitiveness versus parallel systems around the world. One indication of this is the high employment cost of engineers in Israel, reflecting a low level of supply in relation to demand. As an illustration, between the years 2005-2015, the average salary in high-tech rose by 38 percent, the significance of which is even starker for the companies in this sector in light of the 13 percent appreciation in the value of the shekel against the USD during this period.

The system's second weakness is the gulf between the significant technological value it produces and the relatively limited economic impact on the Israeli economy. The Israeli innovation model is largely based on the creation of technological value, mainly in start-up companies and multinational corporations' R&D centers. However, the Israeli innovation system is still in the initial stages of developing efficient mechanisms to capture the economic value resulting from the technological value it produces. The result is that today, much R&D activity performed within the Israeli economy – mainly that in multinational corporations' R&D centers and start-up ventures – is the base for the creation of significant technological value in Israel, while the economic value is captured outside the country. 

As will be detailed below, it is our view that this is a changeable reality. The ICT sector's economic influence can be expanded via three central steps. The first step is focused on expanding the supply of skilled workers to the sector (mainly in software) while fully utilizing the pools of potential labor in the Israeli market. These pools of human capital exist chiefly in sectors of the population in which the rate of participation in high-tech is relatively low – women, Arabs, Charedim, and older workers.

The second step is to assist further innovation-oriented companies to grow and expand in Israel as "complete companies". Alongside R&D, a complete company includes manufacture of advanced components, global technological support, product engineering and manufacture, design, global operation, accountancy, finance, logistics and others. The high economic influence of these companies is expressed mainly by their ability to employ large numbers of highly paid workers in different professions the fostering of whom is one of the innovation Authority's central strategic objectives. The welcome trend of growth companies' development, to which we referred in the 2016 report, testifies to the fact that the aspiration to increase the economic impact of Israeli innovation is not a mere dream.

The third step is the increase of economic value generated by the multinational corporations' R&D centers in this field. As will be detailed later in this report, multinational corporations possess a significant positive influence on the Israeli innovation system, with emphasis on the knowledge and expertise that they bring with them, and which trickle down to the remaining components of the innovation system. However, here too, the economic potential of the multinational corporations' activity in Israel has yet to be optimized. These corporations, responsible for approximately half of the corporate R&D investment in Israel, largely operate in Israel in the format of R&D centers with only limited financial influence within other circles of the Israeli economy. The more we succeed in creating appropriate incentives for these corporations to expand their Israeli activity to sections of the value change beyond just R&D, so their impact on the Israeli economy will grow.

 

The Manufacturing Industries – Jump Starting Innovation and Productivity

If, in the ICT's innovation system, the challenge is in the improved utilization of high-level innovation's economic potential, in the other sectors of the economy the task is even more complex. While the high-tech sectors in Israel present workforce productivity higher than the average among OECD countries, the majority of the economy's other sectors suffer from low productivity compared to their counterparts in these countries.[4] Despite Israel's small territory and its characteristically dense social and professional networks, the innovation and technology created in the high-tech sectors do not sufficiently reach the other industrial sectors.

We place special emphasis on the manufacturing industries which have difficulty competing with the low production costs in developing countries (mainly in the East) but on the other hand, sometimes fail to meet the high-quality threshold of western manufacturing companies. As we elaborated in detail in the 2016 Innovation Report, the main reasons for this are low technological intensity and lack of a sufficient level of innovation, particularly problematic characteristics in an industry that does not benefit from proximity to the main markets or advantages of economies of scale.

It is our belief that the manufacturing industries are also at a crossroads. Without determined and effective action, we will continue to witness the current trends of erosion and the widening of gaps relative to parallel sectors in developed economies. In the face of the wide-scale scope of employment in these industries today, realization of this scenario contains severe ramifications on a socio-economic level: the level of inequality will rise and the separation between the "traditional economy" and "the high-tech economy" will continue to worsen. This polarization also has a geographical aspect, as while high-tech companies are focused in the central region and the other large metropolises, the majority of the manufacturing industry is located in the periphery. 

On the other hand, harnessing the engine of innovation and entrepreneurship to the manufacturing industry may cause a halt in its erosion and develop for it a sustainable competitive advantage. Special importance should be given to the integration of the industry in Israel with current technological trends, primarily the 'Industry 4.0' revolution that is leveraging developments in the fields of robotics, Internet of Things, Machine Learning and Big Data, in order to streamline production processes and increase productivity. Israel's leading position in these technologies, together with the developed local entrepreneurial culture, create the conditions for a significant leap in the level of the manufacture industry's innovation and productivity.

 

Life Sciences, Agriculture and Food: Enhancement of Innovation Systems

Another innovation system we should consider is that engaged in life sciences, agriculture and food. In these fields, Israel possesses a range of advantages and even boasts several success stories; however, they have yet to sprout a surrounding sophisticated innovation system. Specifically, key elements that contribute to the success of the ICT system in Israel, such as a widespread financing infrastructure and multinational corporate activity, are as yet not sufficiently developed in these fields. By developing the lacking elements, it may be possible to leverage these fields' existing comparative advantages to a complete system. In particular, consideration should be given to Israel's ability to create a comparative advantage based on interface with technological strengths in the ICT field. This is especially so in those areas which already present growth potential such as medical equipment, digital medicine, personally tailored healthcare and precision agriculture.

The field of medical devices is one of wide-spread activity with approximately 570 Israeli companies[5] that have already yielded several success stories, especially in the medical aesthetics sub-sector in which Israeli companies lead the world market. A further field evolving in Israel in recent years, and one in which Israel possesses valuable assets that can be leveraged is that of digital health. These include firstly, Israel's technological leadership in the field of data processing and secondly, the information, unique in its scope, stored in Israeli medical files. Government action such as the national program for digital medicine and the Mosaic Initiative seek, among others, to enable Israeli industry and academia to maximize the advantages these assets have to offer.

Israeli scientific excellence contains significant potential for the pharmaceutical field. Although necessary for success in this field, such excellence is by itself not sufficient for success. Several research institutions of world acclaim operate in Israel, most prominent among them the Weizmann Institute that was ranked sixth in the world among life science research institutes by the respected 'Nature' magazine.[6] However, research excellence has yet to crystallize into a complete industrial eco-system and commercial successes are few. Nonetheless, recent years have produced the first signs of maturation of the Israeli pharma industry. In particular, we have witnessed a considerable number of companies reaching the clinical trials stages and it is to be hoped that this trend will continue and grow.

 

Plan of Action: Complete Innovation Systems – Infrastructure Development, Investment in R&D, and Creation of Economic Value

The establishment of the Innovation Authority at this time, signals an understanding that an innovation-based quantum leap necessitates a policy change. This change is expressed by the designation of the Innovation Authority's mission – promotion of innovation as leverage towards inclusive sustainable economic growth. As such, we have a double task: to preserve and strengthen innovation assets and to leverage these assets better towards the widening of the financial influence on the economy at large.

It is our belief that expansion of economic influence must be ultimately expressed in the increase of the level of employment in innovative companies. In order to attain this goal, we must promote and develop all industrial sectors, whether in high-tech or traditional industries. We believe that a significant breakout of the high-techs bounds will occur only if we succeed in developing leading innovation systems alongside the systems that exist today. Our vision is that large numbers of companies, in all sectors of the economy, will therefore adopt a strategy of technological innovation, use it to develop competitive advantages, and employ workers at high levels of pay and productivity.

The Innovation Authority is striving to fulfill this vision. The Authority's strategy, in accordance with the analysis presented in this chapter, is based on three levels: infrastructure, technology and economic value – while distinguishing between different innovation systems. It should be mentioned that this strategy constitutes a change in innovation policy in Israel, that hitherto concentrated mainly on the second level, i.e., encouraging R&D processes and the creation of technological value.

 

First Level of Action: Innovation Infrastructures

The first level turns to the development and strengthening of the infrastructures necessary for creating technology and a leading innovation system, and is expected to occupy a more significant function in government innovation policy than in the past. This level, in which the Innovation Authority acts in conjunction with other government bodies, is built on three central pillars. The first focuses on the fostering of skilled human capital – the heart of the Israeli economy's advantage and the basis for all R&D and innovation activity. Here too, the distinction between different innovation systems is beneficial: in the ICT field, there is upmost importance to solving the shortage of skilled human capital for R&D positions, while expanding the participation of sectors of the population underrepresented in the high-tech worlds. In the field of life sciences, there is a sufficient supply of skilled R&D workers. It seems clear however that this industry will benefit greatly from the cultivation of the knowledge and skills necessary to translate scientific research into leading commercial development, such as managing regulatory processes and advancing from prototype to manufacture. Another aspiration should be to enable mobility of skilled workers and knowledge between innovation systems, that would be especially beneficial for sectors not characterized by high technological intensity.

The second pillar focuses on the investment in research infrastructures. These infrastructures are essential in many cases in order to enable efficiency and collaborations for creating advanced technologies. In the manufacturing industries, for example, investment in research infrastructures such as innovation laboratories or designated research institutes is critical for the cultivation of an innovation system based on advanced technologies. Occasionally, the public system itself maintains infrastructures that can be made accessible to industry such as valuable medical information in the field of digital medicine.       

The third pillar is that of the development of financing infrastructures. In a perfect market, there is no need for governmental intervention in this sphere but in a small industry such as in Israel, focused government intervention may assist in the growth of private sources of finance that are currently lacking. In this framework, we have identified a shortage of debt instruments in the Israeli innovation system, restricting the local growth ability of innovative Israeli companies. Accordingly, we are striving to encourage this activity within the framework of a program of guarantee for banks with the aim of increasing the scope of credit for growing high-tech companies. In addition, we are examining the need for a designated fund for the clinical trials stage in life sciences.

The Innovation Authority – In Practice: Human Capital, Research and Financing Infrastructures  

The Innovation Authority is active in developing and strengthening three important aspects of innovation infrastructure - human capital, research and financing – and will continue expanding its activity in the near future in accordance with the strategy detailed in this chapter.

In the aspect of human capital, the Authority has begun operating the 'coding bootcamps', aimed at promoting the establishment of extra-academic coding training programs. These programs are intended to increase the supply of skilled workers for the high-tech industry (for a detailed description, see the Human Capital Challenge chapter in this report). In the research infrastructure aspect, the Innovation Authority conducts a variety of programs within the framework of the Technological Infrastructure Division, including programs for supporting industrial research institutes that provide the research infrastructure for the manufacturing industries. In the financing infrastructures aspect, the Innovation Authority is active in increasing the scope of credit to growing high-tech companies via a program providing guarantees to banks, currently being formulated.     

 

Second Level of Action: R&D Investment

The second level includes addressing market failures in R&D investment, and particularly, bridging the "death valleys" that prevent good companies from reaching the markets, and participating in risk in order to encourage companies to take larger technological risks. Until recently, this activity was the core of government support for innovation in Israel. It continues to constitute a central level in the Innovation Authority's strategy, however if in the past its main objective was to increase the scope of R&D in Israeli industry, today greater importance is attributed to reinforcing the quality of R&D, its market influence and its ability to leverage the company towards significant economic activity.

Addressing market failures in R&D investment is required to an even greater extent in manufacturing industries and other innovation systems in growth stages, in order to establish a global competitive advantage. This activity will also continue to exist in the ICT innovation system whilst focusing on projects of the highest R&D risk, and in additional technological arenas that generate pioneering innovation.

The Innovation Authority – In Practice: Addressing Market Failures in R&D Investment

The Innovation Authority invests in research and development at all stages of technological development and in all branches of innovation. In 2016, the Authority's budget stood at approximately NIS 1.6 billion. The Authority operates via designated innovation arenas that conduct a range of support programs. These programs provide a response for challenges that arise during the various life-cycle stages of companies investing in R&D. The Technological Infrastructure Division is responsible for research infrastructures, groundbreaking technologies, and bridges between academia and industry; the Startup Division assists young and innovative companies in reaching financing milestones; the Growth Division encourages growth of technology companies via R&D investment and the creation of designates supplies of finance; the International Division acts to strengthen and finance R&D collaborations with multinational corporations; the Advanced Manufacturing Division strives to encourage R&D investment in manufacturing infrastructures and to assist in transforming them into innovative and advanced industries; and the Societal Challenges Division supports investment in technology for social and public purposes.     

 

The Third Level of Action: Economic Value Capture

The third level, especially relevant today for the ICT sector, focuses on the capture of economic value, i.e., encouraging companies to increase the economic value resulting from their core of innovation. Two central directions of operation in this level are encouraging the cultivation of complete companies in Israel via development of a suitable finance and regulatory infrastructure, and the creation of incentives for multinational corporations to expand the scope and range of their operations in Israel. In this case too, a window of opportunity has evolved around preparations for the implementation of the OECD's BEPS Regulations,[7] as will be explained in detail later in the report. A further direction of operation at this level relates to the leveraging of the operations of innovative Israeli companies in global markets. Special emphasis has been placed in recent years on building a bridge to emerging markets and to the strengthening of cooperation with leading countries in Europe, America and the East.

The Innovation Authority – In Practice: Encouraging Technology Companies to Increase the Economic Value of their Activity in Israel

The Innovation Authority has recently begun acting in order to encourage technological companies to increase the economic value of their activity in Israel, and will continue expanding this activity in the near future in accordance with the strategy detailed in this chapter. Accordingly, in 2017, the Authority launched a program for encouraging the establishment and expansion of multinational corporations' R&D centers in the biotechnology and medicine fields. The program emphasizes the expected economic contribution to the economy as the result of the centers' expanded activity. For further details, see the chapter on multinational corporations' R&D centers in this report. In addition, the Authority is striving to expand the supply of credit to high-tech companies in Israel. This activity is directed at supporting the companies' growth and the maximization of economic value from their technological innovation.

 

If so, the State of Israel can no longer be content with the wonderful achievements of the high-tech industry as an insular system. The Innovation Authority has therefore taken upon itself an ambitious and challenging mission: a quantum leap for Israel's innovation system. We are striving to preserve and strengthen Israel's standing as a global focus of innovation; to spread the high-tech flame – of technological innovation and entrepreneurship – to additional sectors of the economy; and to increase the economic value generated by the bustling technological activity in the field of ICT. Action on all these fronts demands strict strategic planning, broad agreement of all relevant national parties and determined and continued action.

 

[1] National Bureau of Statistics, Statistic Yearbook 2017, Panel 12.33 (2016 data).

[2] Chief Economist's Wing, Ministry of Finance (16.6.2017). For more on the connection between academic studies and ascending the socio-economic ladder, see: The Weekly Survey.

[3] Calculated after processing by the Strategy and Economy Division of the Innovation Authority, based on NBS data. The processing included valuation and historic adaptation of the total number of salaried employees by retroactively adding the number of salaried employees in the I.D.F. before 2012 (the year in which the NBS began publishing the total figure).

[4] 'Basic Financeability of the Workers in Israel and Productivity in the Market's Sectors', from the Periodical Fiscal Survey and Assorted Research Issues, Research Division, Bank of Israel, July 2016

[5] Israel’s Life Sciences Industry IATI Report 2017

[7] The regulations determine that only the country in which intellectual property has been developed may grant tax benefits on the derived income, thereby providing an opportunity for countries that hitherto hosted multinational corporations R&D activity to create a competitive tax regime.