Sustaining Israel's Innovation Economy

By: Hideki Uno and Benjamin Glanz

The 21st century has seen Israel develop into one of the world’s foremost innovation hubs. In 2009, foreign policy pundits Dan Senor and Saul Singer wrote what was in essence a celebration of Israel’s booming innovation economy. “Start-up Nation: The Story of Israel’s Economic Miracle” dove into the reasons behind Israel’s thriving economy, highlighting the role of government policy, immigration, and a culture of risk-taking. In the years since, the Israeli innovation ecosystem has continued to grow, asserting leadership in industries such as cybersecurity, fintech, and digital health.­­­ The country ranked second in innovation in the 2016-2017 World Economic Forum Global Competitiveness Report and placed in the top ten in Bloomberg’s Index of Innovative Countries in each of the last five years. Currently, it has nearly 4,000 active start-ups – a number second only to the U.S. – and the most billion-dollar 'unicorns’ per capita in the world.

At the same time, Israel has struggled to create a more inclusive innovation ecosystem, one that more fulsomely integrates women and minorities into its high-tech sector. One result has been a chronic shortage of skilled workers, a state of affairs that stands in the way of a sustained expansion of Israel’s innovation economy. This blog explores some lessons we can learn from both the successes and ongoing challenges facing the Israeli innovation economy.

Less Military, More R&D

Israel was not always an innovation powerhouse. After declaring independence in 1948, Israel was primarily focused on protecting itself militarily. To do this, the government instituted mandatory conscription and spent an outsized portion of its budget on defense. The country fought two major wars – in 1967 and 1973 – and by 1975 military spending represented 30.5% of Israel’s GDP. But as inflation accelerated rapidly amidst the 1973 oil crisis (and the country faced a receding threat from its neighbors), Israel began to pare its defense budget. According to the World Bank database, by 1995, only 7.9% of Israel’s GDP was allocated to military spending; by 2020, it was 5.6%. This development, combined with other market-oriented reforms initiated in the 1980s, eventually allowed inflation to stabilize and helped Israel transform into a successful market economy.

Israel’s sizeable defense budget, however, did lay the groundwork for a successful research- and innovation-based economy. It fostered the growth pool of highly trained researchers, creating the basis for a deeper national research and development (R&D) base. Specifically, it allowed for R&D spending to increase from 2.5% of GDP in 1996 to 5% in 2022 ­– the highest percentage in the world. Importantly, it also supported Israel's efforts to become a “start-up state.” According to Gil Avnimelech et al. in Economics of Innovation and Technology, Israel’s industrial policy can be divided into three phases. Phase one saw an initial effort in the 1970s and 1980s aimed at building the research infrastructure that would later create a high-tech state. During the second phase, from mid-1980 to 1992, the Office of Chief Scientist (the OIS) dramatically increased R&D subsidies to Israeli industry in order to stimulate firm creation and expansion. The law for Encouragement of Research and Development in Industry 1984 further clarified the role of the OIS and strengthened the corporate sector's support for R&D in Israel.

From 1993 onwards, Israel shifted its focus to invest in strategically targeted companies through the formation of “clusters” – concentrated areas of high-tech startups – and venture capital investments. The government’s 1993 capital investment initiative, called the Yozma Program, proved to be an outstanding success, helping to fund ten new venture capital funds which more than doubled in value by 1996. By the end of the decade, Israel trailed only the U.S. in private equity as a percentage of GDP. Today, the high-tech sector in and around Tel Aviv – sometimes referred to as ‘Silicon Wadi’ – is one of the most productive tech clusters in the world.

Military Service and a Culture of Entrepreneurship

In addition to defense expenditures, compulsory military service has fostered an esprit de corps which has had a positive impact on Israel’s startup community. At the age of 18, Israeli citizens are required to serve in the military unless exempted under the Israel Defense Forces Law. During their time in the IDF, young Israelis are exposed to a variety of leading military technologies, helping to cultivate new ideas for market needs, commercialization, and research and development.

This is especially relevant for Israel’s thriving cybersecurity industry. Cybersecurity companies such as Check Point, CyberArk and Solebit all have founders or CEOs that served in Unit 8200, an elite signals intelligence unit in the IDF. In the first six months of 2021, Israeli cybersecurity companies raised $3.4 billion in venture capital funding, and seven became billion-dollar ‘unicorns’.

The required military service also instills responsibility, discipline, and independence in young trainees. These soft skills – combined with a culture that values risk-taking – mean that Israelis are especially equipped to undertake challenging and risky business ventures.  

Benefiting From High-Skill Immigration

A wave of immigration to Israel from the former Soviet Union in the 1990s compounded the effect of the talent, money, and technology that moved from the private to the public sector during the same period. Around 750,000 Jews moved from former Soviet states to Israel in the aftermath of the Soviet collapse, allowing Israel’s population to increase by close to a third in the 1990s.

The immigrants were generally highly educated, especially in STEM fields. More than half had 13 or more years of education. Of those who worked, two-thirds were employed in scientific, academic, professional, or technical occupations – much higher than the Israeli proportion – and about one-tenth of them were engineers or architects.

While the integration of such a massive inflow of human capital was not seamless, it helped develop the human capital base for the Israeli innovation ecosystem to thrive. After 15 years of economic stagnation, the 1990s saw a substantial rise in productivity, which some analysts attribute in part to the high-skill immigration boom.

An Inclusivity Challenge

While Israel’s innovation economy has made significant gains, sustaining this growth is now a key challenge. According to Start-up Nation Central’s 2020 High-Tech Human Capital Report, Israeli high-technology industries suffer from a long-term worker shortage. Open positions in the sector abound: about 60% of Israeli high-tech companies reported difficulties recruiting for their R&D departments in 2020. This supply gap is not a short-term consequence of the pandemic, as the 2019 and 2018 versions of the report raised similar concerns about Israel’s human capital shortage.

Instead, much of the shortage seems to be driven by a lack of diversity in Israel’s high-tech sector, which is disproportionately Ashkenazi Jewish and male. Women have only 28% of high-tech jobs. Significantly, Arabs – about 21% of Israel’s population – make up a mere 2.3% of the sector. The 13% of Israelis that are ultra-orthodox Jewish (a population that is growing rapidly) compose only 3%. Though these numbers have generally trended upwards in the past decade, they either plateaued or decreased from 2019 to 2020, suggesting that many minorities occupy the entry-level jobs that were most likely to be cut or furloughed during a pandemic.

The Soviet influx in the 1990s was a one-time phenomenon; while there has been a second exodus of Russian technology professionals following the Russian invasion of Ukraine, only 10,000 of them have come to Israel. Start-up Nation Central, among others, stresses that Israel must expand its talent pool from within if it hopes to continue its success as an innovation power. But there are significant obstacles: the high-tech sector requires a high level of education and training, as well as fluency in English. A 2018 OECD survey found that Israel has some of the highest basic skill gaps among OECD countries. The Israeli Innovation Authority has instituted multiple entrepreneur and training programs for women, Arabs, and the ultra-orthodox in an effort to solve the human capital shortage, but if early education gaps are the problem – as the OECD report suggests – then these initiatives will continue to have little impact.

Some Takeaways from the Israel Model

Israel is geopolitically, economically, and culturally unique. But there are still some important takeaways from its experience.

First, Israel’s high-technology sector benefitted from an influx of human capital in the 1990s. An obvious takeaway is that policies to attract high-skilled immigrants should be an important part of any nation’s innovation strategy. The U.S. should focus on resolving its worsening green-card backlog, which reached 9 million earlier this year due to regulations that limit immigration as well as a lack of processing capacity. Current provisions within the COMPETES Act call for removing caps on immigration for those with advanced STEM degrees.

Second, Israel shows the importance of sustaining high levels of public R&D spending. Israel spends a larger percentage of GDP on R&D than any other country. It pairs this investment with targeted programs designed to boost basic research and maximize economic strengths. In the United States, by comparison, there has been a pronounced shift in R&D expenditures from the public to the private sector. As of 2019, the business sector accounted for 70.7% of total U.S. R&D expenditures. As a result, basic research, traditionally funded largely by the government, appears to be gradually declining, falling from 19% in 2010 to 15% in 2019. Such long-term support for basic research plays an important strategic and pre-competitive role in developing new technologies like quantum computing.

Another lesson from Israel is the impact of government and technology-intensive military service on fostering entrepreneurship in related areas. The Israeli cybersecurity industry – making up 65% of all financial transactions conducted by software-related startups from 2017 to 2022 – is largely a byproduct of military crossover. By comparison, U.S. cybersecurity startups account for only 13% of total spending by software-related startups.

Finally, Israel is not alone in its shortage of high-tech human capital and its lack of diversity in the sector. The United States should follow the recommendations of a
recent National Academy of Sciences report on how to expand our talent pool, starting with better and more equitable STEM education and continuing through better-aligned skills training. Congress recently allocated a 9% increase to the Minority Science and Engineering Program, but more needs to be done in this area.

If the United States is to remain competitive in an increasingly complex and technologically advanced global economy, it must learn from the successes and failures of other countries. Israel’s innovation economy has thrived because of targeted R&D spending, high-skilled immigration, and public-private talent crossover, but it has also struggled to solve its human capital shortage. Examining the experiences of Israel and other global innovation hubs can help draw out important lessons for sustaining a successful high-tech economy.

Hideki Uno is an intern with the Renewing American Innovation Project at the Center for Strategic and International Studies in Washington, DC. 
Benjamin Glanz is an intern with the Renewing American Innovation Project at the Center for Strategic and International Studies in Washington, DC. 
The Perspectives on Innovation Blog is produced by the Renewing American Innovation Project at the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).