In the early 1980s, more than a third (34%) of Israel's GDP went to government consumption spending (most of it military spending). Meanwhile, tax rates were very high and inflation was even higher, while the collectivist kibbutz movement played a significant role in the economy.
While Israel was very strong militarily, having defeated in wars the much larger nations of Egypt and Syria (helped in varying degrees by other Arab governments and particularly in the 1973 war by the Soviet Union) repeatedly, in 1948, 1956 (only Egypt that time), 1967, 1973 and 1982 (only Syria that time), its economy wasn't strong. While per capita income was well above the level in Arab countries with little or no oil, it was well below the levels in the West (and more oil rich Arab states). With its strong military and weak economy, Milton Friedman (who was himself Jewish) remarked half-jokingly that "Israel disproved every Jewish stereotype. People used to think Jews were good cooks, good economic managers and bad soldiers; Israel proved them wrong."
However, the share of GDP going to government consumption fell steadily from the mid-1980s to 2000, to 26%. At the same time a lot of other free market reforms were made, including a reduction in the top marginal income tax being reduced from 66% to 48%, deregulation and last but not least a reduction of triple digit (200%) inflation rates to the normal single digit levels normal economies have.
As a result of these more market oriented policies, as well as the global tech boom and the large inflow of Jewish immigrants from the former Soviet Union, Israel enjoyed a very strong boom during the 1990s.
Between 2000 and 2003, Israel's economy suffered a serious setback, however. This was in part due to the end of the tech bubble, which hit the high tech oriented Israeli economy particularly hard. The collapse of the Camp David peace talks and the "second intifada" that followed made matters worse. The second intifada was much more damaging to Israel than the first. The first intifada involved mainly rock throwing Palestinians in Gaza and the West Bank. The second meant a wave of suicide bombings inside pre-1967 Israel. As the suicide bombers targeted places where they hoped to kill or maim as many Jews as possible, for example busses, night clubs and cafes, the service sector was damaged as people increasingly stayed at home out of fear of the suicide bombings.
The result of the bursted tech bubble and the second intifada was a significant (though not dramatic) drop in per capita income between 2000 and 2003, and because of the weak economy and the increased spending on counter-terrorist military operations, the share of the economy going to government consumption rose.
After 2003, however, the situation started to improve. The success of many of these operations in destroying Palestinian terror cells combined with the gradual construction of the security fence gradually reduced the number of suicide bombings, and during the last two years (As the fence has been completed) suicide bombings have disappeared completely. With the end of suicide bombings, the civilian service sector has been able to recover and boom.
Meanwhile, the global high tech sector have again started to boom, benefiting Israeli manufacturing. Also, because of the free market reforms and the radically reduced need for counter-terrorist military operations after the completion of the security fence, military spending has been reduced, enabling the government to reduce the budget deficit and also cut taxes.
As a result, Israel's economy has boomed since 2003. Between 2003 and 2009, GDP growth averaged 4% per year, far more than in just about all other Western economies. Even if you adjust for Israel's high population growth, per capita GDP growth was an impressive (Since it includes the crisis years of 2008 and 2009) 2.2%.
Because of the boom, the reduced need for military spending and a deliberate policy of reducing the role of government, government spending has dropped significantly as relative to the size of the economy. Between 2003 and 2009, government consumption fell from 27.8% of GDP to 24.2%. Military spending in particular fell, from 8.6% of GDP in 2003 to 6.5% in 2009, but non-military government consumption also fell, from 19.2% to 17.7%.
Government spending and tax rates are now lower than in most Western European countries, even including military spending, and even more so excluding it. And after the Bush tax cuts expire next year, the top income tax rate (at 45%, scheduled to be reduced to 44% in 2012 and 39% in 2016) will be lower than in many American states, including California and New York. And the corporate income tax rate will be lower than in all American states.
There are likely several reasons behind this transformation. With regard to the reduced role of the military, that is mainly a result of a reduced threat of an Arab invasion, something which in turn is the result of the peace treaties with Egypt and Jordan and the end of the former backer of Arab attacks on Israel ( By that I am of course referring to the Soviet Union). And with the completion of the security fence, the need for military operations in the West Bank has been dramatically reduced.
The causes of the general orientation towards free markets include that after the Israeli economy hit the wall in the 1980s, it became evident for most that the Israeli economy needed reform. Similarly, the dismal results of the Kibbutz communities more or less compelled them to become more market oriented. Another reason is Benjamin Netanyahu as a person. He has argued for free market reforms relentlessly since the early 1990s, and given the influence he has had (as Prime Minister, Finance Minister and pundit) since then this is a key reason for the transformation. Netanyahu has even expressed a vision that Israel should try to become "the Hong Kong of the Middle East" (referring to Hong Kong's reputation as the freest economy of the world).
Israel may still be far away from Netanyahu's long-term vision of becoming a "Hong Kong of the Middle East", but it has in fact gradually moved in that direction since the 1980s, and as a result it has enjoyed an economic boom most of the time (With the 2000 to 2003 period being the worst setback). And as a result of this, it has also moved further and further away from the "Socialist Sparta" status.