Productivity, income and wages – how are they linked?

As another decade of disappointingly slow growth in Australia draws to a close, policy makers, business leaders and many others are pondering what needs to happen before growth picks up to the old pre-GFC levels that we had come to expect.

Persistent, painfully slow growth rates are evident across almost every economic metric that counts: real GDP, inflation, business investment, returns on investment, business sales, non-mining business profits, wages, local household consumption and productivity. This is sometimes referred to as ‘secular stagnation’, secular meaning long-term and stagnation meaning lower (stagnating) growth rates. These stagnating rates of growth are felt by everyone, through slower improvements in real incomes and ultimately in our living standards. In Australia, these economic trends are being compounded by the immediate effects of prolonged drought and a rapidly changing climate across much of the country.

The reasons for this extended period of stagnation are complex and multi-faceted. Global as well as local factors are at work, across geopolitics, demographics, investment risk expectations and technologies. The sheer range and complexity of factors indicates that:

  1. There is no single ‘silver bullet’ policy change that will raise growth single-handedly; and
  2. There is no single group in the community that can raise growth on its own. Government, industries, business, households and broader community need to be involved and on board.

There is much debate over why this is happening – and even more debate about what we can or should do in response. With so many factors at play, what should we focus on? And what should be our priority? Some fairly standard economic theory provides a useful framework for pushing ahead.

Productivity is the lynchpin and the key to this puzzle. Productivity is one of the “three P’s of growth” that economists invariably highlight as the fundamental drivers of national activity, incomes and prosperity. The other two P’s are Population growth and labour force Participation. Unlike productivity, the other two drivers are doing remarkably well in Australia at present, with population growth hovering around an historic high of 1.7% p.a. since 2009 and labour force participation rising to record highs, with just over 66% of the adult population now working or actively seeking work, despite (or possibly because of?) our ageing population.

Of these three key drivers, productivity is definitely Australia’s weak link, as it is in many other advanced countries. No matter how productivity is measured (and there are many ways), productivity growth has been relatively weak in Australia for much of this century, and it has weakened further in recent years (table 1 and chart 1).

Sources: Productivity Commission estimates based on: ABS 5204.0, Australian System of National Accounts, 2017 18; ABS 5260.0.55.002, Estimates of Industry Multifactor Productivity, 2017 18; ABS 6291.0.55.003 Labour Force, Australia, Detailed, Quarterly, Aug 2018.

Chart 1. Australian productivity cycles and the national Wage Price Index (WPI)

Based on these latest productivity estimates for Australia, the Productivity Commission concluded:

  • Growth in labour and multi-factor productivity (MFP) for the 16 industry market sectors in 2017‑18 was sluggish at 0.4 per cent and 0.5 per cent, respectively.
  • This continues the recent trend of weakening productivity growth since the end of the investment phase of the mining boom in 2012‑13.
  • Labour productivity growth is well below the market sector’s long‑run trend rate of 2.2 per cent per year from 1974‑75 to 2017‑18.
  • Corresponding to the market sector outcomes, productivity growth has also been weak at the economy‑wide level.
  • The current weakness in labour productivity can be partly attributed to a marked slowdown in investment in capital – so much so that the ratio of capital to labour has fallen (‘capital shallowing’).
  • This is troubling because investment typically embodies new technologies, which complement people’s skill development and innovation. This is especially so for investment in research and development, where capital stocks are now falling (Productivity Commission, May 2019, Productivity Bulletin, 1-4)

Taking a broader perspective, OECD data confirm that slow productivity growth is a long-term global problem (chart 2). Even so, its effects can feel very local and very personal.

Chart 2. Australian and international labour productivity growth cycles, OECD estimates

Source: OECD April 2019, OECD compendium of productivity indicators

In Australia, the effects of weak productivity growth have become increasingly apparent during the extended period of slow incomes growth experienced by private-sector businesses and workers across almost all of the economy, except for mining (table 2). In contrast to other countries, Australia’s experience and understanding of the link between this weak productivity performance and incomes performance has been complicated by two unrelated factors:

  1. Weak inflation, which has kept nominal incomes growth slow, as well as real growth; and
  2. the mining investment boom followed by a mining output and pricing boom, which contributed to sharp rises and falls on our terms of trade and greatly complicated the effects of prices and productivity on our national incomes. This in turn, seems to have muddied our popular understanding of the ‘slow incomes’ problem and our policy responses to it.

Disaggregating Australia’s business income data helps to unpick this complex story (table 2). Over the ten years to 2018, weak productivity growth (plus factors including global trade and competition) have contributed to slow growth in aggregate sales, profits and wages in non-mining industries and especially in manufacturing. While mining companies have grown through a boom period of average annual growth in nominal sales of 7% and nominal company gross profits of 10% (and rising to a whopping 42% of all company operating profits earned in 2018-19), non-mining nominal company sales have grown by just 3.0% and have shrunk in manufacturing. After factoring in inflation of 2.4% on average over this period, this means that real sales volumes have grown by only 0.5% p.a. for non-mining companies, their aggregate profits have grown by around 2% p.a. and their aggregate wages (that is the total wage bill paid rather than the wage rate) have grown by 0.8% p.a., which is roughly the same as multi-factor productivity growth over this same period (table 1).

Table 2. Latest Australian business income (nominal aggregate dollars) a

Aggregate wage growth is not the same as growth in wage rates, but the two are closely linked. And the effects of long-term weak productivity growth are evident in both.

During the period since 2011-12, average annual multi-factor productivity growth has risen by around 0.7% p.a. (but declining in more recent years, see Chart 1) and the inflation rate has averaged 2.4% p.a. (but also declining in recent years, see Chart 3). Over the same period, the national wage price index (that is, the nominal price paid in wages for ordinary time excluding overtime and bonuses) rose by an average of 2.65% p.a. (2.7% in the public sector and 2.55% in the private sector), implying very weak (but not zero or negative) real growth in wage rates of just 0.2 to 0.3% p.a. (see Chart 3).

Chart 3. Australian wage and price indexes, to Q2 2019

Research by Treasury, the RBA and others suggests the key reasons for weak wage growth are these two factors – weak productivity growth plus weak inflation – compounded by the presence of ongoing oversupply in the labour market (mainly due to rising participation and high underemployment rather than an overly high unemployment rate).

The RBA recently revised down the unemployment rate at which it expects the labour market to tighten enough to promote stronger wages and inflation, to about 4.5%. With the unemployment rate drifting up to around 5.2%, Australia’s labour market is still a long way from being ‘tight’ enough to push wages growth up significantly, notwithstanding very real skill shortages in discrete occupations, locations and sectors. Other factors (such as changes to industrial relations or bargaining arrangements) may have played a role in national wage trends at the margin, but these three factors – productivity, inflation and labour market dynamics – explain the bulk of what has happened to Australian wages this decade.

As alluded to by the Productivity Commission (quoted above), this problem of weak national productivity growth (and hence weak incomes growth) is affecting individuals across the economy, but the causes are not about individual workers being less efficient, working less hours or working less ‘hard’. It is about the ‘big picture’ challenges of investing and harnessing new technologies and production methods, across whole industries and the whole economy. It is about helping all businesses and workers move closer to the frontier of best practice. This means a direct and immediate policy focus on the nitty-gritty fiscal and regulatory policies that shape:

  • effective and efficient promotion of business investment, and especially business investment in new technologies; and
  • effective and efficient promotion of workforce skills, flexibilities and management.

As noted at the very beginning of this blog, there is no single easy quick fix to these national productivity and income challenges. Ai Group will continue to promote a multi-pronged and multi-faceted policy response. It must encompass tax incentives, education, energy, trade, digital technologies, telecommunications, innovation and more.

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Julie heads the Australian Industry Group’s economics team, producing economics research, comment and policy advice for Ai Group and its members. She is also: Adjunct Professor of Economics and advisory board member at Deakin University; panel member of the Melbourne Economic Forum at the University of Melbourne; and a member of the National Economic Policy Panel of the Economics Society of Australia.

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