By Kristina Clifton, Senior Economist at CBA:
Key Points:
- Trends in productivity are important as they are a key factor in determining living standards.
- Productivity growth has been weak in recent years across a number of measures and has been a factor behind weak real wages growth.
- There has been a huge list of specific recommendations for productivity improvements put forward by the Productivity Commission, NSW Productivity Commission, the IMF and others.
- Changes to the tax system, improvements to the education system, policies to promote innovation and infrastructure spending are common recommendations made to lift productivity growth.
Productivity is a topic that gets mentioned often as the key to increasing real wages growth and living standards. Productivity measures the amount of output that can be produced for a given level of inputs. So an increase in productivity means that the economy is essentially producing more all else being equal. Productivity gains tend to result in higher inflation adjusted profits and wages.
There are many factors that increase productivity. The factor that most often comes to mind is improvements in technology. But others including changes in processes, improvements in knowledge, changes in management, reallocation of inputs, economies of scale, investment, government policies and external shocks like weather conditions all influence productivity too.
In this note we take a look at the trends in productivity in Australia and find that productivity growth has been weak in recent years. One part of the explanation is that business investment was soft through this period.
We find a positive relationship between labour productivity and real employee earnings. As a result sluggish growth in real earnings has occurred alongside the weaker productivity growth of recent years. In the last section of this note we discuss some of the recommendations put forward to help lift productivity growth.
Trends in productivity
There are a couple of different productivity measures produced by the ABS. The timeliest is GDP per hour worked, contained in the quarterly National Accounts. GDP per hour worked has been on an upward trend for many decades, although the pace of growth has varied over time (chart 1). Over the past four years growth in GDP per hour worked has been very sluggish, notwithstanding some spikes over the COVID period.
The short coming of GDP per hour worked as a measure of productivity is that labour is the only input accounted for. However capital is another input to GDP. As a result the ABS also produces annual estimates of multi-factor productivity. Multi-factor productivity measures the amount of output achieved given the combined inputs of both labour (as measured by hours worked) and capital.
While less frequent, this is the better measure of technological change and efficiency improvements.
Growth in multi-factor productivity varies over time and was negative from 2004/05 through to 2008/09 when there was a large amount of additional hours worked and capital investment in the mining sector (chart 2). Multi-factor productivity rose again in the following decade as the mining sector moved from the investment to output phase. More recently growth in multi-factor productivity has been very low.
Chart 3 shows a decomposition of GDP into hours worked, capital and productivity. Over 2019/20 and 2020/21 hours worked fell because of COVID19 lockdowns and restrictions which detracted from GDP. Capital and gains in productivity made small contributions to GDP.
Another measure related to productivity is the change in the ratio of capital to labour. An increase in the ratio of capital to labour can be referred to as capital deepening. Capital deepening means that on average each unit of labour has more capital to work with to produce output. Capital deepening can help lift productivity. Strong growth in employment alongside sluggish business investment saw capital deepening stall through the late 2010’s (chart 4). A stalling in capital deepening was a factor behind the weakness in multi-factor
productivity growth in the late 2010’s.
Why do we need productivity growth?
Growth in productivity, i.e. the ability to produce more with the same amount of inputs, is a key factor in increasing living standards. One way to measure changes in living standards is by growth in wages after adjusting for consumer inflation.
The key drivers of wages growth over the longer term are productivity growth and inflation expectations (based on the assumption of full employment in the long run). This means that real wages growth is largely determined by labour productivity growth. Indeed chart 5 shows that there is a positive correlation between growth in productivity and growth in real employee earnings (wages plus superannuation). More detailed analysis on productivity and wages by the Australian Government Treasury finds that “that higher-productivity businesses pay higher real wages and employees at these businesses have also experienced higher real wage growth” (see here).
How do we lift productivity growth?
There has been a lot of research devoted to ways to increase productivity growth. The Australian Productivity Commission (PC) finds that focus on three key areas will influence productivity:
- incentives – the external pressures and disciplines on organisations to perform well,
- flexibility – the ability to make changes to respond efficiently to market pressures, and
- capabilities – the human knowledge capital, infrastructure and institutions that are needed to make changes.
In terms of incentives, there is a large body of research that finds that competition is a key to incentivising firms to lower costs, and undertake process and product improvements. The issue of unnecessary tariffs, subsidies and other assistance to industries falls under this category as they often reduce competition.
Flexibility in the way that firms undertake production can drive improvements in productivity. Flexibility in work place arrangements plays a key role in the flexibility of production. More flexible work arrangements are a factor behind rising labour participation for females and older workers. Flexibility in work arrangements allowed people to remain attached to the workforce through the current pandemic with hours worked falling by more than employment during periods of lockdowns and restrictions. Continued work force attachment
allowed a quicker rebound in the labour market than would have otherwise been the case. Labour market flexibility also helps labour to be allocated to the most productive industries.
Chart 6 shows that reallocated resources like hours worked and other inputs between industries and companies have at times made significant contributions to growth in labour productivity. These reallocations have also detracted from productivity in some years.
The third category of capabilities captures the improvements in productivity that can come from have an educated workforce, investment in research and innovation, good infrastructure and appropriate government services. There has been a strong focus on public sector infrastructure spending over the past seven years, particularly in the area of transport (chart 7). A lift in public capex over the pandemic to help support the economy alongside a drop off in population growth means public capex per capita is close to the record high
reached in the GFC. Infrastructure Australia is an independent institution that provides research and advice on the priorities for infrastructure spending in Australia.
As discussed above, capital deepening can also help to lift productivity. The latest ABS capex shows businesses intend to lift their capex spending strongly in 2021/22 (chart 8). A stronger lift in capex relative to hours worked will see capital deepening.
As well as the general principals of increasing incentives, flexibility and capability the PC produces specific recommendations on actions that could be taken to increase productivity. The last comprehensive report from the PC was released in 2017 (see here). Some of the key recommendations centred on improving healthcare with a focus on prevention and management, improving the education system, removing stamp duties, funding for better roads, improving the functioning of energy markets, remove redundant regulations and fixing
known deficiency in workplace relations policy.
The intention was to produce a productivity review and specific recommendations every five years. On this schedule a report is due this year, although no details of whether this report will be delivered are publically available as yet.
More recently the NSW Productivity Commission released a report in May 2021 outlining a new productivity reform agenda for the state (see here). Sixty recommendations were made in the report under the areas of workforce talent, innovation, housing and infrastructure.
Under the housing agenda, the first recommendation was the replacing of stamp duty on property purchases with a broad-based property tax. This change would lower upfront costs for purchasing a property and encourage more housing turnover and increase the mobility of the population. A proposal for this change was flagged in the 2021/22 NSW state budget although has not yet been implemented.
The International Monetary Fund (IMF) has also flagged the need for structural reforms to boost Australia’s productivity (see here). The 2021 Country Report concluded that Australia’s priorities should be prompting innovation and competition, supporting housing affordability, reducing uncertainty in climate change mitigation policies, and pursuing tax reforms to shift from direct (levied on income and profits) to indirect taxes (levied on products and services). The IMF has long suggested that removing stamp duty on real estate in favour of a land tax would promote labour mobility. The IMF has also recommended for some years now that company taxes should be lowered and good and services tax lifted.
Summary
Australia has experienced weak productivity growth for the past several years. Weak productivity growth has weighted on growth in real wages. There have been many recommendations made with the aim of lifting productivity. Some common themes include tax reform, including removing stamp duties, incentivising research and innovation, improving the education system and ensuring the necessary infrastructure is in place. Increasing the amount of capital relative to labour also helps to lift productivity.
