Shifting the Dial: 5 year productivity review
Chapter 1: Introduction
In this chapter
1.1 Scope and aim of this inquiry
A sound case can be made that the Australian economy has performed very well over a protracted period. Our living standards are high, and we are one of the richest nations globally. Borrowing costs and inflation are low, there is little industrial unrest, and the unemployment rate is well below the long-term average. We are living longer, and enjoy generally healthier lives. There has been no recession in the past 26 years — the longest period of growth in modern history, and this has persisted despite major shocks like the global financial crisis and an abating mining boom. The trend in Australia's labour productivity since 2007 — the amount of output per worker — has not deviated much from the average historical rate over the past 40 years.
Something is awry in our economic fundamentals
On the other hand, income growth, particularly for wage earners, has stalled. Labour productivity is lower than both the 'golden era' of the mid-1990s, and the lengthy prosperous period from 1950 to 1970. The global picture for most developed countries is sombre. Unlike Australia, across the OECD, growth in GDP per hour worked was lower in the decade to 2017 than in any decade from 1950 — a picture that reflects more than the impacts of the global financial crisis. It raises questions about the effectiveness of global technological change as an income generator — a concern for Australia given our reliance on others' technological advances.
While labour productivity gets much of the focus year-on-year, doing things better by applying new knowledge and technologies is the critical X-factor in strong long-run economic growth (sometimes referred to as 'multifactor' productivity). Yet while all around us new digital services, information and ideas are obvious, this form of productivity has been weak since 2004, here and around the developed world. This is a long enough period to suggest something is awry in our economic fundamentals. Since productivity is inextricably linked to maintaining growth in national income and individual opportunity, this is no academic observation. Suggestions that mismeasurement of the new economy are to blame appear simply insufficient to explain the weakness. In this context, the Australian Government has commissioned this report, with the intention that it be repeated every five years. Its aim is to catalyse a reinvigoration of productivity.
Given the ultimate ambition is a more prosperous society, policies that move resources to their most productive uses are also relevant to this inquiry. Tariff reform was one of Australia's most successful policy shifts because it removed incentives to take a job or make an investment in industries where we were inefficient, and whose long-term prospects were weak. That and other fundamental microeconomic reforms delivered benefits throughout the 1990s. The greatest prospective gains now lie in services, especially those that all of us consume regularly, thus spreading the gains widely. As an illustration, when the Commission examined the disability services and aged care sectors, it found funding was allocated according to principles that took very little account of the preferences of people who were the focus of those sectors. Shifting resources to match people's preferences is a key, but often neglected aspect of efficiency.
Another dimension of prosperity is its effect on income growth for higher and lower-income households and, associated with this, inequality. Australia did better than most OECD nations at achieving more equitable income growth, such that all households — from lowest income to highest experienced significant improvements across the decades from the mid-1980s (figure 1.1). Indeed, popular impressions aside, household income inequality does not appear to have risen in Australia this century.
Doing things better by applying new knowledge
and technologies is the critical X-factor
Figure 1.1 Some key aspects of the economy are performing well
Sources: ABS 2017, Australian National Accounts, Mar 2017 , Cat. no. 5206; OECD (2011, p. 23).
A key issue will be to ensure that future economic, social and environmental policies sustain inclusive growth — by no means guaranteed given current policy settings, and prospective technological and labour market pressures. Productivity growth provides a capacity for higher incomes and poverty alleviation — either directly through higher wages or indirectly by increasing the capacity for funding transfers to lower-income households. The motivation for limiting inequality extends beyond its intrinsic value to the desirability of avoiding too great a dispersion in incomes, given evidence that this can, in its own right, adversely affect productivity growth. Public support is also more likely for reforms that offer benefits to the bulk of people.
One of the advantages of better health care, education systems and cities is that they provide strong prospects for improving lifetime outcomes for people from all backgrounds. Indeed, improvements in these areas have the potential to decrease health inequalities, and reduce job insecurity and wage risks for those whose skills are at most risk from technological change (noting the current disparities apparent in health and educational performance — figure 1.2).
Figure 1.2 Health inequalities and educational underperformance present big opportunities for Australiaa
a The fifth household income quintile is the richest and the first household income quintile the poorest.
Sources: ABS 2016, National Health Survey, First Results, 2014-15 , Cat. no. 4364.0; OECD PISA score results (2017b).
This inquiry is the first of a continuing series of reviews.
This inquiry is the first in a regular series of inquiries into productivity, undertaken at five-yearly intervals. Its aim is to shift the dial on underlying productivity, jolting it out of the mediocre trajectory of recent history. To do so will require a package of initiatives. No one change is sufficient, as demonstrated by the need for a combination of reforms to make a difference in the 1990s (floating the dollar, tariff cuts, workplace relations, water reforms, competition policy and effective intergovernmental relations). It is a microeconomic complement to the Australian Government's periodic Intergenerational Report, with the same intent to look to the future and to take account of emerging trends, but with the added dimension that it will prioritise the changes with the greatest potential, and advise how to apply them effectively.
We need to shift the dial on underlying productivity,
jolting it out of the mediocre trajectory of recent history
All levels of government — local, state and national — are the relevant policy actors. And if any one level of government has greatest responsibility, it may surprise some to hear that it is the States and Territories. The Commission has sought input from all levels of government in diagnosing problems and recommending solutions. We have also consulted with many people and agencies responsible for health care, city policies and education — which are the themes that have emerged strongly in this first five-yearly review (appendix A).
1.2 What has been happening to productivity?
While over the past 40 years, aggregate labour productivity growth in the market sector (real output per hour) has stayed mainly in the band between 2 and 2.5 per cent per year over the various business cycles (figure 1.3) there is nothing natural or inevitable about labour productivity growth within this tight band. As noted earlier, the 1950s and 1960s showed much stronger growth. Figures calculated on a somewhat different basis suggest that annual labour productivity growth in the first fifty years after 1890 were less than 1 per cent — proof that it is possible to have protracted periods of sluggish growth — a circumstance to be avoided (figure 1.4). Thus, the slowdown in this vital driver of income growth is not something that automatically rebounds to an expected norm. We have to work at sustaining productivity.
While some have celebrated a recent return to average labour productivity outcomes, this has almost entirely reflected the contribution of one production factor — more physical capital. The capacity to 'get more out of all inputs', the dividend known as multifactor productivity (MFP), has fallen away since 2002. MFP has risen slightly over the past few years, but the brevity of the period and the fact that recovery has been limited to only some industries does not provide robust evidence of an enduring recovery.
The capacity to get more out of all inputs, the dividend known as multifactor productivity, has fallen away since 2002
Figure 1.3 Market sector labour productivity decompositiona
Measured using aggregate market sector productivity cycles
a 12-industry market sector (ANZSIC Divisions A to K and R). The long-term trends are not always easy to detect in annual data because of the effects of economic downturns (when labour and capital are only partially used, depressing productivity over the short run). For that reason, most productivity analysis examines trends across the peaks of the business cycle.
Sources: ABS 2016, Estimates of Industry Multifactor Productivity, 2015-16 , Cat. no. 5260.0.55.002, December; Productivity Commission estimates.
Figure 1.4 The long long run — MFP and labour productivity
1890 to 2015a
a The series diverge from that presented above due to different methods for interpolating data, though the results are not markedly different for the overlapping time periods.
Source: Bergeaud et al. (2016).
The slowdown in Australia's capacity to 'do more with the same' is puzzling because scientific and technological knowledge seemingly still advanced rapidly after the early 2000s. Consider that in 2003 there was no Cloud, the 'internet of things' or any smart phone or tablet (with all their portable apps — mapping, email, messaging, and video services). Ubiquitous software like Google Chrome and social media apps did not exist. 3D printing was in its infancy. Music and videos were primarily supplied in physical forms. Underpinning much of this has been a telecommunications network that was more extensive, and far faster. Robotics, gene technologies, material science, machine learning, artificial intelligence, sensor technologies, and drones all progressed strongly. In the period from 1997-98 to 2015-16, the share of businesses using the internet increased from 29 to 95 per cent.
The recent trend in income per capita
— effectively the contents of people's wallets —
is far below that in the decades that preceded
The recent trend in income per capita — effectively the contents of people's wallets — is far below that in the decades that preceded it, and has fluctuated from year to year. Part of this is due to the decline in the terms of trade. But in the decade from 1998, strong growth in disposable incomes without a high terms of trade was possible because multifactor productivity contributed to high growth.
Mismeasurement has been cited as a reason to worry less about Australia's multifactor productivity trends. There are difficulties in measuring productivity, including in times when quality and price move in opposite directions; or when free goods (for example, open source software and other internet services) become significant. The data on which official estimates of productivity are derived include some adjustments for the quality of outputs and inputs, but they are incomplete. Accordingly, mismeasurement is certainly present, though whether it is in any given direction or worse than in previous decades is another matter. Regardless, sound research suggests that the sectors of the economy most subject to mismeasurement are not large enough to explain the shift (Supporting Paper 1 (SP 1)).1 Nor does the timing of the global slowdown coincide with the technological changes that might generate mismeasurement.
Some of the factors other than productivity driving income per capita — labour participation rates and new private investment — have also been weaker in recent years. The investment slump is particularly concerning. It is not isolated to mining, where past strong investment built up the capital stock, requiring less future investment. It implies that capital-intensity in the non-mining sector (that is, the bulk of the Australian economy) will not grow at the historical average, putting future downward pressure on labour productivity. Investment, after all, is what creates the new tools for labour to lift production beyond the previous norm. Finally, the embedded technology in investment is a major source of the new knowledge that underpins future innovation. For example using the web required computers. These factors, and the added uncertainty about the direction of the terms of trade, makes new productivity-boosting reforms one of the few certain ways of raising living standards into the 2020s.
1.3 Government policy and productivity
Businesses are the immediate drivers of long-run productivity improvement in the market economy. In trying to increase their profits, they often seek to do things differently and better — drawing on their own ideas and those of their customers, employees, suppliers and rivals. Research (either inside the organisation or outside) can lead to entirely new products and processes. Firms that fail to keep pace with technology or to provide goods and services valued by their customers will be replaced by those that do, unless government policies frustrate that renewal.
All levels of government play a role in our market economy (figure 1.5). Governments set many of the frameworks for key institutions, laws, standards, regulations, taxes and macroeconomic policies. Some markets are as much creatures of government as businesses and consumers because of the degree and complexity of regulation. As an illustration, version 91 of the National Electricity Rules number some 1454 pages and the Competition and Consumer Act 2010 1621 pages — which are bibles for markets in some industries. Whether they are yet the best regulations is a matter of persistent contest, as highlighted by the recent Harper review.
Government is also a dominant provider, regulator and funder of many non-market services, and its performance is critical to productivity (including the quality of outcomes — SP 2 and 3). Government contributes to the idea pool by supporting research and (when at its best) by being a demanding customer for its own purchases. It can encourage efficiency in the business world by being efficient itself and by being transparent and predictable. It can share its data or withhold it — an increasingly serious issue in the digital age that was considered in the Commission's inquiry into Data Availability and Use . Data applications are the biggest renewable resource discovery of the 21st century.
The extent to which governments can develop and implement policies in line with the public interest depends on the effectiveness of its participation in public debate — convincing people to engage with and trust government — and the set of incentives that punish or reward politicians, governments and officials for their choices and performance. Survey and other evidence shows that distrust in government is high and engagement in politics is low by absolute and historical standards (chapter 6). In the market of ideas, political failures — which impede people's willingness to trust reform proposals and that preserve failing policies that benefit the few at the expense of the many — limit our nation's prosperity.
Conversely, governments are one of a nation's leading tools for change. The pervasiveness of the institutions and frameworks noted earlier — legal, financial, sectoral, consumer regulation — and the capacity to lift public investment in major inputs and enablers — education, health, infrastructure — mean that a failure to apply these mechanisms fully must be a serious opportunity lost. The timing of change, the prioritising amongst the many opportunities, the effective handling of the transition and the distribution of benefits, are all reasonable judgment calls for governments. But they do not justify an unwillingness to apply our most effective catalyst for change.
Figure 1.5 What shapes productivity?
How can Governments influence productivity?
1.4 Identifying a policy reform agenda
There is a long list of things that could be done, but a list per se is not enough to galvanise action. We have consciously sought not to contrive a list of all possible reforms.
Rather, the Commission developed a structured way of identifying the areas for reform that are most promising. We have considered the practicality of reforms, the quality of the evidence base, and cumulatively across the reforms, the likely magnitude of the benefits (figure 1.6).
Figure 1.6 Systematically looking for reforms [Accessible test]
Decision making framework for policy recommendations
Step 1: Harvest ideas
- Theoretical framework for drivers of prosperity (e.g. innovation, human and physical capital accumulation, diffusion, good institutions, competition, fit-for-purpose regulation)
- Parts of the economy performing poorly
- Policy agendas of all governments
- Broad consultation and survey evidence
- Insights from the reform literature and meta-analyses
- Insights from international experiences
- Unimplemented reforms from previous reviews and inquiries
- Auditor-Generals' reports
Step 2: Choose reforms
- Value of having a diversity of options
- Avoiding a fragmented list of disconnected reforms
- Looking beyond the immediate imperatives to reforms that will take some time to implement
- A willingness to consider novel reforms
- Implementability (assessing capabilities and the need for coordination)
- Recognition of fiscal constraints
- Materiality (as single reforms or as a package)
- Reforms that make future reform and learning easier
Step 3: Analyse impacts and implementation
- Explain how policy would raise prosperity
- Qualitative and quantitative evidence of why the policies would work
- Assess impacts (for whom, where, to what extent)
- Indicate the time path for implementation and who would undertake it
- Take into account how new policies would fit with existing or pending policies
- Indicate priorities
- Accountability (how would failure be assessed?)
In addition to our analysis of the reform opportunities for Australia and normal consultation processes, we examined hundreds of recommendations from other studies and reviews in making our choices. These included similar initiatives looking to address similar objectives globally, such as OECD's annual Going For Growth report.
Using this approach, the Commission developed five broad areas for close examination.
The 5 yearly productivity review has given us an opportunity to take a more future oriented approach to a breadth of policy issues rather than our usual focus on a sector or specific policy area. The Commission has deliberately floated ideas that cannot always be implemented immediately, but where preparation and further testing is needed for fruition. We have dived into three areas where reform is longer term and more fundamental. We chose health care, education and cities, and even in these areas, only some aspects of them (chapters 2, 3 and 4).
We did so because they share some important characteristics.
While some reforms are great in their ambition — as was the competition reform packages of the 1990s — much is not like that, and can be nicely summarised by a quote from a well-known management guru's rumination on personal productivity, which could equally apply to a nation's:
Sometimes the biggest gain in productive energy will come from cleaning the cobwebs, dealing with old business, and clearing the desks — cutting loose debris that's impeding forward motion. (Allen 2004)
In other words, it is time to take out the microeconomic garbage — those practices that have been seen as in the 'too hard basket' to change. These can be big and important — like tax reform and flaws in the way different governments interact with each other. Or small — like restrictions on the entry of Uber, some messy remnants of trade barriers, and the relic of trading hour restrictions that still persists in some jurisdictions. The cumulative impacts of changes to all the collective things that stymie people's lives, income generation, and other endeavours is large. In a messy house, there are many cobwebs, and so we document these carefully in chapter 5 and appendix B.
It is time to take out the microeconomic garbage
There are other microeconomic reforms that cover the whole economy, and that are not part of the orthodox suite of cobweb-cleaning reforms. The large benefits of a national policy approach to better data availability and use epitomises the new agenda, as do reforms to intellectual property arrangements, standards for new transformative technologies and developments in regulatory arrangements for fintech. Accordingly, chapter 5 explores both the old and the new reforms that can make markets more efficient.
The fifth theme recognises that policymaking is a creature of governments, whose institutions, capabilities, rules, operational methods, norms and interactions determine the scope and content of policies. If the fundamentals of governments are not functioning well — say intergovernmental relations or the capabilities of the public sector — then it is hard for even the most proficient of governments to achieve reforms. There is scope to improve this foundation (chapter 6).
Taken across their disparate areas, the Commission's recommendations represent an ambitious reform agenda. The agenda should have the Australian Government as a key proponent. However, a national approach to productivity requires active engagement and consensus across multiple levels of government.
The services where the greatest opportunities lie are typically shared responsibilities. Indeed, at the grass-roots level, State and Territory Governments often have the most responsibility for service delivery, and therefore the strongest capacity to introduce policy innovations. Any realistic model of reform cannot conceive of such governments as playing second fiddle to the Australian Government. Nor, given the need for trust in a reform agenda, can engagement with the community, non-government organisations, businesses and other agents for change be mislaid.
It is hard to put an exact number on the cumulative benefits of all the policy recommendations that this report advocates. Many benefits are hard to value even within a range — say an avoided limb amputation for a person with type 2 diabetes. This means that in some areas, we have made assessments of potential economic benefits (specifically, key recommendations in chapters 2, 4 and 5), while in others we have not. Our assessment, without accounting for the inestimable, is that the benefits of these reforms would increase over time, eventually generating about $80 billion each year in economic gains, which would continue to grow with the economy.
- The Commission has undertaken detailed analysis to support each of these chapters. Sixteen supporting papers are available on the Commission's website at www.pc.gov.au and are referenced throughout this report using the abbreviation 'SP' and the relevant number. Where the sources of a fact or statistic is not referenced in this report, readers will find them in the accompanying supporting papers. Locate Footnote 1 above