Economic Aspects of Defense Spending Professor Zvi Eckstein Deputy Governor, Bank of Israel Seminar for Economists of the Defense Services, January 8, 2008

Cost Benefit Analysis of Defense Spending (Eckstein and Tziddon, 2004)  The contribution of increased security to the economy: Reduction of the risk premium in savings, consumption and investment decisions  The cost of security: Taxation and the use of labor resources which reduces disposable income and growth in the business sector  The comparison of per capita GDP in Israel and the US makes it possible to test the theory of the contribution and cost of security

The Trend of GDP over time SOURCE: Eckstein & Tsiddon (2004), Heston, Summers & Aten (2006), CBS. Forecast for 2007 and 2008 Six Day War Second Lebanon War Yom Kippur War First suicide bombing Second Intifada War of Independence First Intifada When there is a worsening in the perception of the security situation, Israel’s per capita GDP declines relative to that of the US

Defense Spending (% of GDP)

Public Expenditure and the Public Debt (% of GDP)

Effects of High Defense Spending The tradeoff: Without a strong feeling of security, it becomes difficult to develop the economy; on the other hand, high defense spending reduces the economy’s growth potential How much should Israel spend on defense?

Economic Objectives of the Defense Budget Military objectives: Effective firepower and deterrence against security threats in order to improve personal, national and economic security –What is the economic objective of defense spending given the total budget? Increasing efficiency of the army by minimizing the cost of effective firepower through the efficient use of manpower in routine activity and in periods of emergency

Manpower in the IDF  The expenditure on manpower accounts for a significant proportion of defense spending  Manpower and technology create effective firepower, while there is substitution between them –The military production function includes the effective quality of manpower, “capital” and technology –In economic terms, there is the possibility of substitution between manpower and technology for a given amount of firepower

The goal: with a given budget, to produce maximal firepower at minimal cost The combination of high-quality manpower and technology is essential to deal with military threats The economic price of a standing army is not taken into account –Distortion of the relative price of technology –Allocation of manpower to non-military tasks –Unemployment Creation of incentives for the army to increase the efficiency of its input allocation Internalization of manpower cost to the economy and allocation of manpower according to alternative cost –Evidence: the reform in the budget for reserves

What is the real price? Employing a soldier in the standing army  Taking into account the economic price in the army's manpower planning and in its selection of technology- - Alternative cost – the wage of a conscripted soldier if he were employed outside the army - This is the marginal cost of each soldier to the economy Ben Bassat Committee: Recommendation to immediately shorten service to 32 months Creation of a flexible system whereby, on the margin, the army will be compensated if it saves the value of the alternative time of a soldier (NIS 4,500-5,000) Definition of minimal and maximal compulsory service

The Proposed Reform A gradual shortening of military service by 4 months at each stage and the adjustment of effective firepower This process will create substitution in the long run between manpower and technology with somewhat of an addition to the budget Compulsory service of two years –Reduced inequality in the sharing of the burden between men and women –More equal allocation of the burden between men in various sectors of the population

The Contribution of the Efficiency Mechanism Assigning an economic price to the use of the conscripted soldier –Introduction of efficiency considerations into the determination of the period of compulsory service Creation of incentives for the army: –Use of outsourcing through the correct calculation of the cost of a conscripted soldier Encouragement of technological and organizational improvements On the national level: Reduction in quantity of manpower in compulsory service and increased efficiency in its use, while increasing its productivity

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