Australia’s productivity challenge

Rod Bogaards, Economic Policy

Key issue
Productivity growth enables more or better quality goods and services to be produced with the same level of resources.
Policy and regulatory settings can have significant implications for productivity growth and living standards.
The implementation of a significant policy reform agenda is required if Australia is to achieve improved growth in productivity and living standards.

Economic growth is driven by increases in population, increases in participation in the workforce and improved productivity. However, historically, productivity has been the main driver of economic growth in Australia and is the key determinant of rising per capita incomes and living standards.

Productivity growth measures improvements in how much is produced for every unit of input. Productivity growth is achieved by producing more or better quality goods and services with the same or less resources. Productivity growth can result in higher profits and wages, and lower prices for consumers.

There are two major approaches to productivity measurement: labour productivity (LP) and multifactor productivity (MFP) (see ‘Measuring productivity’ box).

Australia’s productivity growth over the last 50 years

Australia’s aggregate LP growth (real output per hour) has stayed mainly in a band between 1.2 and 2.5 per cent per year over the various business cycles during the last 50 years (see Figure).

Most productivity analysis examines trends across the peaks of the business cycle because trends are not always easy to detect in annual data. This is because of the effects of economic downturns when capital and labour are only partially used, reducing productivity over the short run.

Figure: Labour productivity (measured using industry market sector productivity cycles)

Labour productivity (measured using industry market sector productivity cycles)

Source: ABS 2018, Estimates of Industry Multifactor Productivity, 2017-18, cat. no. 5260.0.55.002, December 2018.

About two-thirds of LP growth since 1973–74 has been attributable to capital deepening. Capital deepening is where the capital per worker is increasing. Capital deepening allows more to be produced for each hour worked. The remaining LP growth has been attributable to MFP growth. However, as the Productivity Commission (PC) noted in its 2017 report Shifting the Dial, between 1993–94 and 1998–99, the contribution of MFP growth was significantly greater than historical averages. During this period LP growth averaged 3.9 per cent per year (see Figure).

This superior MFP performance has been widely attributed to micro-economic and macro-economic reforms implemented during the 1980s and 1990s, including the National Competition Policy, which created more competitive and flexible markets by:

reforming Regulations which unjustifiably restricted competition
reforming the structure of public monopolies
providing third-party access to infrastructure
restraining monopoly pricing behaviour
fostering competitive neutrality between government and private business
limiting anti-competitive conduct of firms.

These reforms encouraged businesses to become more efficient and innovative, encouraging them to adopt and exploit new and improved technologies, particularly in communications and information.

According to the Australian Government’s 2015 Intergenerational Report (IGR), other micro-economic reforms included removing industry protections (such as industry assistance and tariffs), opening up the economy to overseas trade and investment, reducing controls over labour, capital and product markets, structural reforms to essential infrastructure services (such as electricity/gas/telecommunications), and taxation reforms (capital gains tax and the dividend imputation system were introduced in 1985 and 1987 respectively, and the company tax rate was lowered progressively from the late 1980s).

Reforms to macro-economic policy settings included allowing market forces to determine the exchange rate, introducing the independent setting of interest rates (by the Reserve Bank of Australia using inflation targeting) and placing fiscal policy in a medium-term framework (by aiming for budget balance over the economic cycle through more prudent taxation and spending decisions).

The slowdown in LP growth since the 1990s has been attributed to a number of factors, including the ramp-up in investment that took place in the mining and utility sectors during the 2000s. This involved increasingly high levels of capital input without a commensurate increase in output. Similarly, the early to mid-2000s also witnessed a lengthy period of drought, which reduced agricultural output. The productivity slowdown has also been attributed to the impact of the Global Financial Crisis (GFC) which reduced the utilisation of capital and labour as businesses waited for improved conditions to return.

Measuring productivity
Labour productivity (LP) measures the output produced per unit of labour input (usually hours worked).
LP growth captures improvements in the efficiency of labour, due to capital-deepening (growth in the ratio of capital to labour) and improvements in the efficiency with which capital and labour are combined, referred to as multifactor productivity (MFP).
MFP measures the output produced per unit of combined inputs of labour and capital.
MFP growth reflects changes in output occurring for reasons other than increases in the quantity of capital and labour. In essence it captures improvements in the quality of inputs and/or how they are combined, and is often treated as an indicator of technological change.
An improvement in labour quality might include a more educated or skilled worker. An improvement in capital quality might include a new machine that has doubled its throughput.

However, according to the IGR, these factors cannot fully explain the decline in Australia’s LP growth since the 1990s: the slowdown has been observed in the majority of Australian industries (not just mining, utilities and agriculture); and, it occurred before the onset of the GFC.

Instead, the IGR suggested that the fault lay with successive governments which had become increasingly complacent about productivity growth:

Part of the slowdown may reflect the fading impact of past reforms. There have been fewer significant policy reforms since the early 2000s. Strong income growth, low unemployment and high rates of profitability through the 2000s may have significantly lowered the pressure on governments to undertake the necessary productivity enhancing reforms and reduced the incentive for businesses to become more competitive during this period.

There is also evidence that policy requirements have constrained how inputs are used in some sectors and increased regulatory burdens, thereby detracting from measured productivity growth. For example, some new environmental, water and electricity service standards have required many utilities service providers to invest in higher cost production technologies, which, while potentially enhancing the quality of service, reduce measured productivity.

Australia has not been the only developed country to experience a productivity growth slowdown over the 2000s; other developed countries have also had similar experiences. The PC’s Shifting the Dial report referred to international research linking the international productivity slowdown to an evolution in market governance which has eroded competition, and reduced incentives to compete, take risks and generate positive spillovers. As a consequence innovations have spread throughout the economy at a much slower pace.

It appears that government policy settings have significant implications for growth in productivity and living standards. While businesses are the immediate source of productivity growth in the economy—by doing things differently and better in their quest to increase profits—it is government policy and regulatory decision making that can affect the extent to which businesses can exploit new and improved technologies and develop better products and services.

What can be done to boost Australia’s future productivity growth?

Future government policy and regulatory settings will be critical to helping businesses take advantage of opportunities from technological innovations so that productivity growth is improved in the future.

As the IGR stated:

Continuing to encourage entrepreneurship and innovation, enhancing resource allocation, investing in and using infrastructure efficiently, facilitating trade with other countries and improving physical and human capital investment will all be critical to Australia’s future productivity performance.

According to the PC’s Shifting the Dial report, governments can enhance productivity growth by supporting education and skills development, improving regulatory design to create the right incentives for private sector investment and ensuring the community benefits of public infrastructure are realised through proper project appraisal processes and appropriate asset management.

The PC’s report puts forward a number of detailed recommendations on how governments can positively influence productivity:

making Australia’s health system more oriented to achievement of outcomes rather than payment for services
creating a good quality and adaptive education and training system and ensuring a well-functioning labour market
improving the functioning of towns and cities by improvements to public infrastructure, road funding and investment, planning and land use policies and access to housing
improving the efficiency of markets by improving competition and reducing unnecessary regulatory burden
making governments work more effectively through better intergovernmental relations and management of public finances and developing stronger policy development and delivery capabilities.

Australia’s productivity challenge

Australia’s productivity growth over the last 50 years

What can be done to boost Australia’s future productivity growth?

Further reading