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Australian Government Coat of Arms

Budget | 2014-15

Budget 2014-15
Australian Government Coat of Arms, Budget 2014-15

Statement 4 (continued)

Drivers of growth in incomes

The main sources of income growth nationally are growth in productivity, changes in the terms of trade, changes in output from increased labour utilisation, and growth in net foreign income.

Chart 2 shows the sources of growth in real national income per person over the past half century. It also shows two scenarios for income growth in the future given the likely impacts of population ageing and the projected falls in the terms of trade.

Chart 2: Sources of growth in national income per capita

The chart shows real Gross National Income growth decomposed into its source (net foreign income, labour productivity, labour utilisation, terms of trade) spanning the 1960s, 70s, 80s, 90s, the period from 2000 to 2013 and the decade to 2023. Although other factors have had some influence in certain decades, notably the terms of trade in the period from 2000 to 2013, labour productivity has been the key driver of growth in income per capita.

Note: Contributions to income growth in the period 2013 to 2025 are consistent with the forecasts and projections detailed in Budget Statement 2. The hatched area represents the additional labour productivity growth required to achieve long run average growth in real gross national income per capita.

Source: ABS 5204.0 and Treasury.

[View chart data]

Productivity has consistently been the most significant source of income growth. However, over the past decade or so, it has been the dramatic rise in the terms of trade which has maintained growth in gross national income as productivity growth has waned. Over the next decade, the decline in the terms of trade is expected to detract from growth in incomes. This negative impact will be compounded by a declining contribution from labour utilisation as the population ages.

For annual incomes to grow at their historical average of 2.3 per cent over the period to 2025, annual labour productivity growth would need to increase to around 3 per cent per year to counteract the effects of population ageing and a falling terms of trade. This is well in excess of what has been achieved in the past 50 years, and more than double what was achieved in the past decade.

If labour productivity grows at its long‑run average of around 1.5 per cent per year over the medium-term, per capita incomes would grow on average by about 1 per cent per year — or less than half of what Australians have become used to over the past three decades. This difference in growth rates translates to a difference in real per capita incomes of $13,000 per year by 2025 ($84,000 under the high growth scenario versus $71,000 under the low growth scenario) — or around 20 per cent of today's average income of $63,500. The drivers of income growth are discussed further below.

Productivity growth

Growth in productivity means that more or better quality goods and services are generated for a given level of resources.

What happened in the 1990s?

Labour productivity grew strongly in the 1990s, at an annual average rate of 2.1 per cent, well above the long‑run average of 1.5 per cent.3 Productivity accounted for about 96 per cent of annual income growth in that decade, in comparison to an average of 90 per cent of growth in incomes in the past four decades.

The increase in productivity growth rates seen in the 1990s was the payoff from the significant policy reforms of that decade and in the 1980s. These included removing industry protections and opening up the economy to overseas trade; reducing controls over labour, capital and product markets; reforms to improve the efficiency of markets providing essential services, such as electricity; and taxation reforms. Reforms were also made to macroeconomic policy settings, including letting market forces determine the exchange rate, introducing the independent setting of interest rates and placing fiscal policy in a medium term framework.

The reforms created more competitive markets, which encouraged businesses to become more efficient and innovative. The reforms also encouraged businesses to adopt and exploit new and improved technologies developed overseas, including those embedded in new capital, such as information and communications technologies. Further, they provided greater flexibility in the use of resources and allowed relative prices of goods and services to reflect the balance of supply and demand more accurately, improving overall resource allocation and returns on investments in both physical and human capital.

The productivity and price changes in key infrastructure sectors, such as energy and water, have been estimated to have increased gross domestic product (GDP) by 2.5 per cent above what it would otherwise have been over the 1990s.4 The benefits of competition reforms were widely spread across the community, including rural and regional Australia.5

These policy reforms helped halt a long‑term decline in Australia's income growth rates relative to other countries. Without these reforms, it is likely that Australians' living standards would be significantly lower than they are today.

What has happened since the early 2000s?

Labour productivity growth has slowed since the early 2000s, contributing only around 60 per cent of the growth in average incomes since 2000. However, incomes have grown at similar rates over the past 10 years to that recorded in the previous decade due mainly to a significant contribution from the rise in the terms of trade.

The slowdown in productivity growth since the early 2000s has partly reflected the very high investment activity in the resources and utilities sectors.6 This investment of capital and labour has long lead times before increased output comes on line. Productivity in manufacturing has also been poor at an aggregate level. Further, cyclical factors may also have played a role since the global financial crisis.7

Still, these factors do not explain fully the breadth and magnitude of the slowdown in Australia's productivity growth rates, since the majority of industries have seen a slowing. This suggests that more fundamental factors are at play.

Part of the slowdown may reflect the fading impact of past reforms. Also, 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 reduced the incentive for major reform by governments and for businesses to become more competitive.8 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.9

There is little evidence that slower productivity growth has been due to inadequate investment in skills, education and innovation more broadly.10

Australia has not been alone among advanced economies in experiencing slower productivity growth over the 2000s, which suggests that the rate of growth in technological advance — which expands production possibilities — may have been slower than in previous decades. This is discussed further in the section on the prospects for long term productivity growth below.

The impact of the resources, utilities and manufacturing sectors

The resources sector has seen significant increases in capacity that have not yet been matched by growth in output. The rate of productivity growth in the resources sector is likely to improve as this additional capacity is used for production and exports.11

In addition, high prices for commodities have made activities with higher unit costs, such as the extraction of deeper ores and lower yielding resources, financially attractive. The mining of marginal resources is likely to decline as prices for resource commodities decline — although to the extent that fewer high‑value deposits are discovered, the downward pressure on productivity growth may continue into the future.12

The resources sector is expected to experience a very strong turnaround in labour productivity over the next few years. After falling a cumulative 19 per cent over the past five years, labour productivity is projected to return soon to positive rates of growth as output from the resources sector rises strongly. The resources sector generates around 16 per cent of Australia's production and is the highest productivity sector in the economy.13 Therefore, this productivity turnaround will have a sizable impact on national productivity growth.14

This will not lead to a commensurate increase in national average incomes as a large part of the resource investment boom (around four‑fifths) has been funded from foreign sources.15 Australians will receive returns from higher productivity growth that reflect the level of domestic investment in the sector, as well as through employment income.

Productivity levels in the utilities sector should also increase as utilisation of new capacity grows, for example, with population growth. The negative impact of other temporary factors, such as drought, which decreased water output, and expenditure to refurbish or replace assets, for example ageing electricity infrastructure, is also likely to diminish in time.

However, the utilities sector has incurred significant expenditure in recent years in response to policy decisions, including with respect to higher service quality, reliability, environmental and security standards.16 This could represent a permanent shift to a lower measured productivity level, although these decisions may still contribute to higher and more sustainable living standards to the extent that they take a form of investment akin to insurance.

The manufacturing sector saw a marked slowdown in productivity growth over the mid‑2000s and, given its size, was a major driver of the national productivity slowdown over this period.17 The diversity of this sector makes it difficult to infer broad causes of the slowdown in manufacturing productivity, but long‑run trends in the industry show sustained falls in input growth, with larger falls in output growth.

The specific circumstances of these sectors do not explain the aggregate slowing of productivity growth. After removing the effects of these sectors, the slowdown in productivity is still seen, and is broad‑based across industries. This suggests that economy‑wide factors are at play and there is a need for an economy‑wide response.

Chart 3 shows Australia's growth in multi‑factor productivity (MFP), which has been extremely weak, on average, over the past decade. In contrast to labour productivity, MFP is a more comprehensive measure of productivity, as it captures how efficiently producers use both the key inputs of labour and capital.18 Poor MFP performance over the past decade contrasts with solid growth on average over the preceding 30 years.

Chart 3: Multifactor productivity growth

This chart shows that five year average multifactor productivity growth in the 16 industry market sector has declined significantly over the course of the 2000s to date, and has been negative since 2007‑08. When the impact of the mining, utilities and manufacturing industries are removed from the data, multifactor productivity growth has still slowed significantly since the early 2000s, indicating the slowdown in multifactor productivity growth in Australia has been broad-based across industries.

Note: Data are 5‑year period‑end moving averages.

Source: ABS 5260.0.55.002, unpublished ABS data and Treasury calculations.

[View chart data]

What are the prospects for productivity growth in the long term?

The United States (US) is currently the most technologically advanced country. In general, the US can be said to represent the highest levels of productivity achievable from the use of existing resources given current knowledge and technologies.

Chart 4 shows that Australia's productivity levels relative to the US have trended downwards from around 87 per cent at the turn of the century to around 83 per cent in 2013.

US labour productivity growth has fallen since 2002 but Australia's productivity growth has deteriorated more markedly.

Chart 4: Australia's labour productivity relative to the United States

The chart shows the ratio of Australian to US labour productivity levels from 1962 to 2013. Australia's labour productivity rose from around 84 per cent of the US level in 1990 to around 88 per cent at the turn of the century. Since then, it has fallen to around 83 per cent of the US level.

Note: Data are a 5‑year period‑end moving average.

Source: The Conference Board Total Economy Database and Treasury.

[View chart data]

A large part of the productivity gap between Australia and the US is attributable to differences in historical and geographic circumstances. Australia's large and sparsely populated land mass and geographic distance from key global centres of trade limit opportunities to take advantage of specialisation and economies of scale. Previous work undertaken in Treasury suggests that these factors could explain around 40 per cent of the observed gap in productivity.19

While some Australian industries enjoy higher or similar productivity relative to the US (such as resources), other industries lag behind, such as utilities, manufacturing, and wholesale and retail trade. This indicates that there may be further scope to 'catch up' to best practice, particularly within industries where Australia's productivity is relatively low.

Longer term, Australia's prospects for productivity growth will be affected by advances in technology, which will create new possibilities for production. As a net importer of technology and innovations, Australia's ability to absorb advances and convert them into new business opportunities will be particularly important.

Is the frontier expanding more slowly?

As noted above, Australia has not been alone among advanced economies in experiencing slower productivity growth over the 2000s. This suggests that the rate of expansion of the global technological frontier may have been slower than in previous decades. There is little consensus on the reasons for this apparent slowdown.

There are also differing views as to the scope in future for major productivity improvements. Some suggest that the set of innovations seen over the past 250 years may have been a unique episode in human history.20

This suggests future innovations will be less productivity enhancing, and income growth may be lower in future. If this is true, global living standards can increase as less developed countries get closer to the frontier, but those at or near the frontier may see a slowdown in income growth.

However, others note that it is not possible to predict when technological change will occur, or necessarily how and when innovations will change businesses processes, and what we produce.21

The analyses of slowdowns have generally focused on advanced economies. With the growth of emerging economies, the sources of global economic growth and creative enterprise will expand. This may well boost the stock of 'knowledge workers' contributing to significant advances in the global technological frontier.

To the extent that Australia is geographically closer to new sources of technological advance, there should be greater scope to 'catch up' to, and move with, best practice.

The impact of structural change

Although the resources sector experienced negative productivity growth in recent years, it maintained the highest level of labour productivity. Consequently, over the past decade, the movement of labour to the resources sector has contributed significantly to aggregate labour productivity growth.

Over the decade ahead, changing industry structure is projected to detract around 0.3 percentage points from the 30‑year average labour productivity growth rate of 1.5 per cent per year.22 The expansion of low productivity growth sectors, such as business services, aged care and health, as well as relative declines in high productivity growth sectors, such as financial services, is projected to reduce growth in aggregate labour productivity.23

Australia's services sectors are expected to become a larger part of the economy. These sectors currently account for more than three‑quarters of total employment and are expected to grow further to meet growth in domestic and international demand.24 Services sectors tend to be lower‑productivity as they are more labour‑intensive.

Like Australia, a number of advanced economies are becoming more services‑oriented as lower‑cost developing economies compete for export share in higher productivity manufacturing‑oriented sectors.25

The negative impact on aggregate productivity of a shift to labour‑intensive service industries — many of them provided or funded by governments — and their increasing prominence as a share of the economy highlights the critical importance of improving productivity in these industries.

Changes in the terms of trade

Over the past decade or so, the second most significant driver of income growth has been income derived from the largest rise in the terms of trade in our history. The economic transformation of China and other emerging market economies drove global prices of Australia's mineral commodities, and the terms of trade, to record highs. This enabled strong wage growth in resources‑related sectors, while a higher exchange rate increased the purchasing power of households across the economy. This added 0.8 percentage points a year to growth in average incomes, boosting real incomes per person by about $6,000 since 2000.

Australia's terms of trade peaked in 2011, and has been declining ever since. This decline will continue over coming years as the prices for our key export commodities fall in response to expanding global supply capacity.26 The falling terms of trade has already begun to detract from growth in national income, and will continue to do so over the medium term.

Changes in workforce participation

Australia experienced a 'demographic dividend' in recent decades like many other countries. That dividend, which boosted income growth, is coming to an end as the population ages.

Between 1970 and 2010, the proportion of Australia's population between 15 and 65 (those most likely to participate in the labour market) increased from 62.8 per cent to 67.4 per cent, driven by the post‑war baby boom and a fall in the birth rate in the 1960s and 1970s. This increase in the share of the working age population helped underpin GDP growth, particularly in the 1980s, when labour productivity growth was relatively slow.

This trend is now beginning to reverse as people who made up that demographic 'bulge' begin to retire. The proportion of the population aged 65 and over is expected to increase to nearly 20 per cent in 2030 from 13.5 per cent in 2010.

An increasing proportion of older people are continuing to work, but their levels of participation in the workforce are lower than the average of other groups of working age.27 This suggests that, as more people move into older age groups, the aggregate workforce participation rate is set to decline even if individuals in the 65‑plus age group increasingly work beyond traditional retirement ages. In addition, younger people are delaying entry into working careers, instead choosing lengthier periods of study, overseas travel, and part‑time employment. The combined effect of these phenomena is already placing downward pressure on participation, a process that is likely to continue over the coming decade.

Through this workforce participation effect, population ageing is likely to slow economic growth in coming decades and, in turn, is likely to reduce growth in incomes and the future revenue base of government. Population ageing is also likely to create additional demands on government spending, particularly in health, aged care and pensions. By 2050, it is projected that there will be only 2.7 people of working age to support each Australian aged 65 and over, compared with five working age people per aged person in 2010, and 7.5 in 1970.

3 Labour productivity is a measure of output produced per unit of labour, usually per hour worked.

4 Productivity Commission, 2005.

5 The only region to experience a decline in regional output over the 1990s was the 'Great Southern' area of Western Australia, which includes Albany, Denmark and Katanning. This region experienced a slight fall of 0.74 per cent. Productivity Commission, 2005.

6 The resources sector comprises the mining and metals manufacturing industries as defined by the ABS.

7 Productivity performance fluctuates with economic and business cycles. During downturns, businesses often lower their utilisation of labour and capital, rather than laying them off. This avoids the costs involved in re-employing them when times improve, although it can temporarily reduce productivity. Demand conditions in the non-resources sectors of the economy have generally been below their long-run trends since the onset of the global financial crisis in 2008.

8 See, for example, Eslake, 2011 and Dolman, 2009.

9 Productivity Commission, 2013, IPART, 2010, Eslake, 2011. One prominent example is new environmental and water and electricity service standards, which have required many utility services to invest in higher cost production technologies.

10 Indicators of innovative activity for Australia generally point to higher rates of innovation in the 2000s than in the 1990s (Connolly & Gustafsson, 2013, and Carmody, 2013). When adjusted for education and work experience (a proxy for human capital), estimates of labour inputs similarly show strong increases across the 2000s.

11 Bureau Resources and Energy Economics, 2014.

12 Productivity Commission, 2014.

13 Methodology for constructing resources sector data as in Gruen, 2011. Sectoral output share based on real gross value added.

14 Were labour productivity in the resources sector simply to stop falling, it would raise aggregate labour productivity growth by 0.6 per cent per annum relative to the past five years. Given the sharp increases in output in prospect in the next few years detailed in Budget Statement 2, the sector's contribution to aggregate productivity could be significantly larger than this.

15 The estimate of foreign investment funding in the sector is from Arsov, I, Shanahan, B and Williams, T, 2013.

16 These include, for example, the construction of desalination plants to ensure water security and asset enhancements to meet higher electricity reliability, water quality and dam safety standards.

17 Productivity Commission, 2014.

18 Labour productivity (output produced per unit of labour input) ascribes all the value added from resources used in production to labour. As such, it is a more limited measure of the efficiency with which firms use their resources than MFP (output produced per unit of combined inputs of labour and capital).

19 Davis & Rahman, 2006.

20 For example, Gordon, 2012.

21 As noted by Syverson, 2013, it may simply take time for innovations, such as information and communications technologies, to result in significant growth in productivity. Brynjolfsson and McAfee, 2011, further suggest there is significant growth potential stemming from advances in computing and digital technologies that are yet to be seen.

22 Treasury calculations based on the Monash Multi-Regional Forecasting model. This finding is consistent with a recent study by the Productivity Commission, (2012).

23 Productivity Commission, 2013a. It is particularly difficult to measure productivity in the services sectors. Many public services, for example, are not priced or have prices that do not reflect their full costs, and improvements in the quality of services, such as in the areas of health and ageing, are difficult to quantify. The true values of these services are, therefore, often not reflected in output measures.

24 The international dimension represents predominantly the rapidly increasing membership of the Asian middle class with their rising demand for a broad range of services, including tourism, education, aged care and health, entertainment, financial and professional services. Employment in the Australian services sectors is projected to grow by around 30 per cent to 2030. Gruen, 2014.

25 Spence & Hlatshwayo, 2012.

26 Parkinson, 2014.

27 The employment rate of workers aged between 55 and 64 has increased from 53.5 per cent in 2005 to 61.4 per cent in 2012. This is now well above the OECD and G7 averages of approximately 56 per cent. Australia ranked 11th amongst the OECD countries in 2012, up from 14th in 2005.