Productivity action? Tax is a distraction
If tax reform is the answer, it is hard to see how boosting productivity growth was the question. Other initiatives are likely to be quantitatively more important.
- Why are we even worried about boosting productivity growth? For some, it stems from a (somewhat misplaced) concern about international competitiveness better addressed through the exchange rate. The real reason to care is that higher productivity boosts living standards, and the other supports of living standards (labour force participation and higher terms of trade) are unlikely to contribute as much in the future as they did in the past quarter-century.
- Labour productivity (Stuff Divided by Time) is in turn determined by the Skills of the workforce, the Stock of capital and the Smarts with which the two are combined and organised.
- Changing tax policy is said to encourage business investment and so deepen the capital stock and boost productivity. But, even on the Productivity Commission’s own modelling in support of the change, the level of productivity will only increase by 0.4%. This is not nothing, but other reforms seem likely to be more fruitful.
The current debate and impending roundtable take it as given that productivity is an appropriate policy goal. Why, after all, should it matter how ‘productive’ we are? And why do so many people think that changing the tax system is the answer?
For some, the concern stems from a fear of a loss of international competitiveness. If we are not more productive, this line of thinking goes, we will not be able to sell our wares overseas and so will forgo income. But this kind of competitiveness actually boils down to price. Plenty of economies with low productivity levels manage to be competitive by being low-priced, just as plenty of others (think Switzerland) can be highly competitive with high wages because their productivity is high. Where there is some misalignment or underperformance, the issue is usually an overvalued exchange rate, and that is where the solution also usually lies.
The real reason we should be concerned about productivity levels relates to living standards more broadly. Treasury has long focused on ‘3Ps’ – population, participation and productivity – as a framework for thinking about long-run growth. Living standards are inherently a per-person concept, so population growth does not necessarily help on that front. The other two ‘P’s do matter for living standards as well as overall growth. We can enjoy higher living standards if more of us are working, or working longer. We can also enjoy higher living standards if we get more out of each hour worked: recall that productivity is just ‘Stuff Divided by Time’.
There is also another ‘P’ specific to living standards – price, specifically relative prices of the things we export versus those we import (the terms of trade). If we can enjoy more stuff by selling the same amount of other stuff, that results in a higher standard of living.
Higher participation and the higher terms of trade have certainly boosted Australians’ living standards over the past quarter-century. Thanks to rising participation of women and older workers, population ageing has not resulted in a shrinking workforce. Increased part-time working has partly offset rising participation in terms of the hours of labour supplied, but the number of available working hours per working-age person has been broadly stable since 2000. Higher prices for iron ore and our other minerals exports have also been a significant support to Australia’s living standards over the same period.
As Westpac colleague Senior Economist Pat Bustamante pointed out recently though, there might not be so much upside from these sources in the future as there was in the past. There are limits to how far participation can rise when the working-age population includes 15-year-olds still in school, full-time parents, people with health issues and people in their 90s. And Australia’s terms of trade are unlikely to stay as high as they have been, let alone increase, now that China has reached the ‘Peak Steel’ stage of development. Thus the focus is on productivity growth, where there is no ceiling and the only constraint is our ability to innovate and adapt.
The drivers of productivity come in threes
To the ‘3Ps’ driving living standards, we can add the ‘3Ss’ driving labour productivity: the Skills of the workforce, the Stock of capital, and the Smarts with which we put the two together (also known as ‘multifactor productivity’ or MFP, but don’t let the jargon bamboozle the discussion).
It is intuitive to expect that highly skilled workers produce more than lower-skilled ones doing the same job. The ABS produces estimates of ‘Quality Adjusted Labour Input’, where quality is imputed from age (a proxy for experience) and education. Both drivers have increased significantly – and note that this is another reason not to catastrophise too much about the ageing population. Recent RBA research suggests that labour quality increased in the post-pandemic period and accounted for much of the roughly 6% increase in market-sector productivity over the past decade. So this cannot be the source of disappointing productivity growth.
‘Smarts’, known as MFP, has been part of the drag on productivity growth, though caution is needed when drawing conclusions here because MFP is not directly observed and must be inferred as a residual. Previous work by the Productivity Commission (PC) has highlighted that MFP has slowed or even gone backwards in some industries. Part of this seems to be that the ‘frontier’ of what is possible with current inputs has not been rising as quickly as it did in the 1990s. There also seems to be an increase in ‘inefficiency’, the shortfall between the theoretical result of combining current labour and capital resources, and actual output. A third issue, that obsolete capital has not been appropriately deducted from measures of the capital stock, might also be at play.
The focus on tax reform as a means of boosting productivity stems from the role of the capital stock in productivity, giving workers better, more effective tools. Consider that a worker driving a forklift can shift more in an hour than the same worker with a wheelbarrow, and that an automated warehouse where the worker supervises robots will shift even more.
Investment has been weak outside the mining sector ever since the GFC. This is partly because it has been squeezed, first by the mining boom and more recently by public infrastructure spending. It is at least arguable that the higher productivity and spillovers from the investment that did occur in these (high-productivity) sectors outweighed the productivity boost that would have occurred had the investment spend occurred in other industries.
The weakness goes beyond the squeeze from mining and public spending, though. This is the context for the PC’s advocacy for changes to the tax system. It is intuitive that lower corporate tax, by reducing the (post-tax) cost of capital, encourages business investment, and so boosts the capital stock and thereby labour productivity.
It should be noted that weak investment is not an Australian-specific issue but rather is evident across advanced economies. Indeed, the decline since the GFC in the rate of growth in the capital stock in Australia was smaller than in many other peer economies, according to recent OECD research. This should make us sceptical that a relatively less competitive tax system is really the issue here.
Perhaps more germane is the question of how much difference the proposed tax changes would make. The PC, appropriately, commissioned modelling of the impact of the proposals on investment and productivity. This exercise found that the proposed tax changes lift productivity by just 0.4%. This is a levels effect not a boost to the growth rate every year. That is not nothing, but in the scheme of things it is small beer. To put a 0.4ppt increase in labour productivity in perspective, you could achieve the same result if measured labour market productivity in the mining sector had fallen only 17½% instead of nearly 20% since 2020, or if only one-third of the shift from the market sector to the care economy had happened. The annual revisions to overall labour productivity can also be as high as 0.4ppts in some years, though usually they are closer to 0.1ppt a year.
There might well be good reasons to reform the tax system. But if tax reform, especially corporate tax reform, is the answer, it is hard to see how boosting productivity growth was the question. Other initiatives, including the deregulation initiatives proposed in the same interim PC report, are likely to be more fruitful, and deserve more attention.
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Australia and NZ Weekly 4 August 2025
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