Policies to increase participation and sustain productivity growth

Recent analysis has helped to identify the key policy settings which have been important in encouraging productivity growth, and explaining differences in performance across a group of advanced economies. These same policy settings can also be very influential in widening the choices available to actively participate in the labour force, or in reducing or removing obstacles or disincentives to such participation.

The analysis uses databases that generally cover 21 OECD member countries, over the period from the early 1970s to the late 1990s. It permits generalisations based on the range of policies pursued by those countries over that time period, but the generalisations should not be projected beyond that range of experience. (For example, propositions about the size of government obviously could not be extrapolated to very small government, insufficient to maintain basic services).⁶

Lessons from multi-country comparisons

The central findings of recent research comparing policy consequences for performance in a wide group of OECD countries are that:

• faster innovation, productivity growth and income growth are driven by high competition and flexible, lightly regulated product and labour markets.

• for best effect, these policies need to be set in a stable, low-inflation macroeconomic environment, to facilitate investment and entrepreneurship.

• important, mutually reinforcing benefits come from 'cross-market effects' of reforms in labour and product markets. Product market competition helps produce good employment and productivity outcomes, and flexible labour markets contribute to strong innovation outcomes as well as low unemployment and high participation.

One important implication of these findings is that where long-term joblessness or inactivity are still problematic (as in Australia), mutually supporting product and labour market reforms that improve participation and productivity, and lower unemployment, may tend over time to make society not only richer in aggregate, but also fairer in terms of wider access to flexible employment options.

The research yielding these results uses recently-constructed indicators that estimate the effects on economic performance over the last 20 to 30 years of regulatory burdens, openness to trade, and openness to foreign direct investment in product markets, as well as regulatory, tax and welfare distortions in labour markets.

Such indicators can only approximately capture the subtlety of different national practices. However, they permit examination of the complex way in which policy differences interact to cause performance differences.

The macroeconomic policies that have produced the fastest growth in real GDP per head of working age population in the sample of countries have been those that have delivered stable low inflation, and a relatively small government sector (as a share of GDP).⁷ At any chosen size of government, the way it is financed also matters as taxes on incomes are likely to be more directly distorting of work effort (for those in employment), innovation (for example, for those starting unincorporated businesses) and labour force participation (for those unemployed or exiting unemployment, and facing a discouraging interaction of the tax and benefit systems) (OECD 2003e, pp. 20-22, 66-67 and 81-83).

Regulations and foreign competition in product markets interact with regulations and other policies affecting labour markets (such as personal income taxation and welfare payments), and vice versa. The OECD's main conclusions from comparisons published in 2002 and 2003 of members' experience with labour market and product market reforms were: (OECD 2002c, Chapter 5; OECD 2002b)

• anti-competitive product market regulation (including lack of foreign competition through imports or foreign direct investment) worsens labour market performance. That is, weak competition lowers overall employment. In the worst performing economies with high regulation (including lack of foreign competition), weak competition causes almost 3 percentage points of the shortfall in their non-agricultural employment rate below the OECD average (Nicoletti et al 2001, Figure 8).

• labour market regulation affects product market performance. For example, where industrial relations systems are relatively decentralised, strict employment protection legislation reduces R&D intensity, and might therefore slow innovation. And since new technologies typically require more flexible work arrangements and greater individual responsibilities, the OECD suggests that the deployment of new technologies is likely to occur fastest where working conditions and wages are most flexible.

• regulatory restrictions in product and labour markets may suppress apparently unrelated performance (such as R&D, or innovation and the uptake of new, productivity-enhancing technology). The main channel, further discussed below, may be through raising barriers to new entrants, who are very important in more competitive markets to the revision of work practices and the deployment of new technologies.

• More generally, innovation is just another way of saying 'new work practices'. In countries or industries that are far from the global technology frontier, such new processes for organising work may have little to do with new technologies that need to be discovered by R&D, and which becomes embodied in patents and new capital equipment. It is in these cases that high competition is important in closing the gap in productivity levels by driving the rapid adoption of global best practice.⁸

• employees often share through higher wages some of the revenue extracted by higher prices from consumers in industries where product market competition is low. Such transfers occur not only at the expense of consumers, but also at the indirect cost of consequently reducing demand for other industries' output and hence other jobs.

• there are no clear links from anti-competitive product market regulation to job security. That is, as has been seen in Australia, protecting an industry does not result in protection of employment. Nor does product market de-regulation lead to permanent increases in earnings inequality.

The cross-country evidence also shows that a sophisticated, well regulated financial sector is an important contributor to growth. As the OECD notes:

'There is evidence that a well-developed financial system is an important aspect of a favourable environment for growth, especially in a period of the rapid spread of a new technology when they can promote new, innovative enterprises.' (OECD 2003e, p. 24)

It is important not to 'over-interpret' the quantitative results from this analysis. It seems to capture realistically the reasons for the relatively good performance of the above average economies, and the relatively poor performance of the below average performers. It thereby offers a plausible prescription of the direction of policy reforms necessary to do better, whether the starting point performance is above average, or below. But it would be a mistake to interpret small differences in national rankings in the underlying indicators of policy settings as providing precise guidance as to where policy reforms are most needed, or the precise quantitative pay-off that might be achieved.

Lessons from firm-level data

A second body of OECD research uses new, firm-level data to compare productivity experience in the same sectors across 10 European and North American economies.⁹ Typically, higher than national average information and communication technology use arises in the same industries or sectors in different countries (for example, retailing, wholesaling and financial services), but North American high users are also heavier users than European high users (van Ark, Inklaar and McGuckin 2002). Early results of analysis across countries using firm-level data also show that firm turnover is very important to innovation (OECD 2003e, pp. 127-158).

• About 20 per cent of firms enter and exit most markets every year, affecting some 5-10 per cent of employment (that is, exiting and entering firms, especially the latter, are typically smaller than average employers).

• Some 20 to 40 per cent of entering firms fail within 2 years, and only 40-50 per cent survive beyond the seventh year.

• Entry and exit rates are highly correlated within industries - for example, large numbers of new entrants tend to be correlated with large numbers of exits of failing firms.

• The industries with high entry and exit are not constant over time. High change industries in one period can be low change industries 5 to 10 years later, presumably with the ebb and flow of cycles in products or technology.

The important role of entry of small new firms in innovation helps explain how excessive product and labour market regulations suppress innovation and retard productivity growth. They make it harder to start new firms that often deploy new work practices, superior technology or merely a more appropriate capital stock, and to close failing firms that embody old work practices or less appropriate capital stock.

The role of firm entry and exit also underlines the importance of good corporate governance, which allows investors to differentiate between good and bad corporate performance early, and apply timely shareholder pressure to underperforming companies to improve their performance. Good corporate governance improves productivity and the efficiency of resource allocation by facilitating speedy growth of strong performers, and quickly detecting firms that will fail. At this point, good bankruptcy administration and resolution structures can help reallocate the resources of a failed firm to other uses, while minimising disruption.

Applying the lessons in Australia

The OECD noted in its 2003 Economic Survey of Australia that:

'In order to meet the longer-term objective of raising living standards towards the highest in the OECD, further reforms to labour, product and financial markets and to social policies will be needed, that will encourage more people to join the labour force, remain in it, and steadily raise their productivity.' (OECD 2003c, p. 9)

The central messages from research across countries over the last decade emphasises that policy reforms on a wide front are more likely to yield significant dividends than reforms focused in just one set of markets.

The mutually reinforcing benefits of reforms in both product and labour markets for higher participation, lower unemployment, faster innovation and higher productivity growth often could not have been foreseen in detail.

That said, further reforms in areas likely to boost productivity and participation hold distinct promise to offset at least part of the economic challenges posed by demographic change.

In this regard, the Government is taking active steps to address these issues, and has commissioned an interdepartmental task force reporting to the Treasurer. The task force will take a whole-of-government approach to demographic change, focussing on labour force participation, including by older Australians who wish to work; superannuation and retirement incomes policy; and managing expected increased government spending in areas affected by demographic change.

Macroeconomic policies

Stable and supportive macroeconomic policies are a necessary backdrop to efforts to lift Australia's productivity and participation levels. Australia's medium-term fiscal framework and its monetary policy framework produce stable low inflation and contribute to stabilising the business cycle. The certainty and credibility of these policies contribute to an environment conducive to investment and innovation.

A range of microeconomic policies can also play a more targeted role in responding to economic pressures from Australia's ageing population.

Education and training policy

Investment in education and skills is critical to improving productivity and participation levels throughout the economy.

Improving education and training outcomes can increase productivity directly by increasing the skills and abilities of individual workers and indirectly by raising the flexibility of workplace teams. It also allows more rapid utilisation and transmission of new skills and production technologies, having a dynamic effect in increasing productivity. Literacy and numeracy skills obtained during schooling form the foundation for the capacity of individuals to participate productively in the labour force and adapt to its changing nature.

An ageing population, with an older labour force, will need to engage increasingly in lifelong learning to improve labour force participation choices. The education and training system will need to be flexible and responsive enough to adapt to changes in the age of its key clients, as well as to continual change in the skills required as the economy evolves.

Similarly, it is essential to have a strong higher education sector. The higher education reforms announced in this Budget will establish a more efficient and responsive higher education sector, which should improve flexibility in responding to changing patterns of demand in higher education and deliver better higher education outcomes. As part of this, individuals will have greater incentives and capacity to invest in their education, as well as having greater choices among educational institutions.

Labour market policy

As discussed above, OECD research has highlighted the central role of labour market flexibility in improving economic performance.

A flexible workplace relations system allows employers and employees to tailor wages and conditions to the specific skills and needs of particular individuals and jobs. Increased flexibility will be crucial in achieving higher participation. For example, it would allow older workers to choose whether to remain attached to the labour force for longer by working part time as they approach retirement. Enhanced flexibility in the workplace relations system should also increase incentives for workers to upgrade their skills to increase their attractiveness to employers.

By making it easier for workers to change between jobs and occupations, a flexible labour market can assist workers in avoiding periods of involuntary unemployment. The more flexible the labour market, the easier firms (particularly small businesses) can employ workers in areas of growth in the economy, enhancing job creation, innovation, deployment of new technologies and productivity growth.

Workplace relations are now focused on agreement making, with awards performing a safety net role. The wages and conditions for most federal workers are now determined at the workplace or enterprise level through either formal or informal agreement making. Increased flexibility in wage negotiations has enabled employers and employees to jointly pursue improvements in productivity, wages and conditions taking into account the specific circumstances of the individual firm and workers involved.

While there has been significant reform, there is scope to do more. Proposed amendments to the Workplace Relations Act simplify procedures and increase labour market flexibility in areas such as unfair dismissal cases. Under the current arrangements, industrial disputes have fallen significantly, suggesting that past reforms have not proven contentious. Enacting further reform would provide substantial dividends.

Taxation policy

Productivity and participation are affected by the level of taxation and the design of the taxation system.

When determining the overall level of taxation, the government's role of providing public goods and services and redistributing income needs to be weighed against the distorting impacts of taxation on work effort, risk taking and relative prices. The design of the taxation system is also important. Tax on the returns to capital can affect savings and investment behaviour, while tax on the returns to labour can affect participation decisions.

Taxes on labour income can discourage participation by reducing the returns from additional hours of work. With high taxes on labour income, some workers may substitute into other activities outside the paid labour force, or may restrict their hours of work more than they would choose with a lower tax rate. Skilled workers such as teachers, nurses, lawyers and accountants are increasingly aware of the different personal income tax treatments that apply to work in different jurisdictions. Maintaining internationally competitive personal income tax arrangements will be an important ongoing factor in sustaining participation and productivity in Australia.

Welfare and health policy

Australia has a unique welfare system, providing flat rate (rather than earnings-related) benefits financed from general revenue. It is highly targeted, providing a reliable safety net for those in need.

However, different rates of assistance and means testing arrangements for various social security benefits for people of working age may discourage labour force participation and job search, especially if individuals are able to access more generous payments and less restricted means testing. For example, the Disability Support Pension and the Parenting Payment (single) are more generous than unemployment payments.

The eligibility criteria for, and the obligations that are placed on recipients of, social security payments can also have an important impact on participation decisions. For example, Newstart (unemployment benefit) recipients who are capable of working (including part time work) are required to regularly look for work in return for their taxpayer-funded assistance. However, overall only around 15 per cent of social security recipients of labour force age are currently required to look for work as a condition of receiving their benefit.

The interaction between income tests for social security payments and the personal taxation system can also directly influence participation decisions of those receiving payments. An individual's return from working can depend on a complex mixture of interactions, including the rate at which income support is withdrawn, eligibility for other concessions such as rent assistance, and the marginal tax rate. If effective marginal tax rates are too high, they can affect work incentives.

Incentives to participate for some social security recipients have been improved through The New Tax System and the Australians Working Together packages. In addition, a review of working age income support payments is currently under way. A key objective is to ensure that the welfare system actively promotes participation in the labour force where that is an achievable goal for the individual. Retirement income policies should also not operate as a disincentive to participation.

The health of older workers is also an important factor in their labour force participation. Ill health plays a significant role in early retirement decisions. Maintaining and improving health will therefore become more important as the population ages.

Reducing the occurrence of avoidable diseases or injuries will mean that a higher proportion of the ageing population will be able to remain fully engaged in society, including maintaining some form of participation in the labour market if they so choose. Proper management of chronic diseases will be critical to ensuring this full and active participation in all aspects of society.

Product market reforms

Australian product market reforms over the past decade are internationally recognised as contributing to the improved performance of the Australian economy since the mid 1990s (OECD 2003c, pp. 75-84). These reforms intensified competition among both domestic and international suppliers. Intense competition has been shown to be particularly important in raising productivity in sectors where it trails the global frontier.

However, the starting point for these reforms was an economy that had comparatively restrictive product market regulation. Reforms have been implemented in the communications, energy and transport sectors, and by commercialising government businesses, removing anti-competitive regulation, and broadening the scope of competition. Broadly speaking, these reforms received bipartisan political support, and Australia now has a comparatively pro-competitive regulatory stance, as measured by a new OECD index of product market regulation.¹⁰

Many of these reforms were incorporated into National Competition Policy that was agreed by the Commonwealth and all States and Territories. The implementation of this agenda is now largely completed. However, Australia still lags behind world best practice in a number of areas. This includes acknowledged parts of an ongoing reform agenda encompassing energy, water and transport. There is also considerable scope for further reform in the communications sector.

It also will be helpful to participation and productivity outcomes to continue to lower barriers to trade.

A further helpful contributor to Australian productivity will come from foreign direct investment underpinned by the shift over the last two decades to a more liberal policy regime. Even in the United States and the United Kingdom, both often closer in many industry sectors to the global productivity frontier than Australia, foreign direct investment has clearly generated higher productivity levels and faster productivity growth in the sectors where it is prevalent through intensifying competition (Keller and Yeaple 2003; Griffith and Simpson 2003).

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6 The experience spans governments whose outlays as a share of GDP range from 23 per cent (Korea) to over 50 per cent (Sweden and France). The share of total government spending on education, transport and communications and R&D ranges from about 13 per cent (Germany) to 30 per cent (Korea). To finance total outlays, tax mixes also vary widely. For example taxes on incomes and profits as a percentage of GDP range from under 8 per cent (Korea) to almost 30 per cent (Denmark). See OECD (2003e), p. 69 and OECD (2002d).

7 These findings emerge after controlling for differences in other policies (such as competition and labour market policies, further discussed below) and country-specific circumstances (such as the size of national markets and the distance-related costs of their trading with other economies). However, this finding needs to be interpreted with caution, as the quality of individual tax and spending decisions will determine the impact of government on the economy.

8 Australian anecdotal evidence illustrates this point in the early and mid 1990s, when labour and product market reforms enabled firms to lift output without initially needing much, if any, new investment.

9 Data limitations have not permitted inclusion of Australia in this work. See Bartelsman, Scarpetta and Schivardi (2003).

10 The OECD index measures product market regulation for 21 of the 30 OECD members (including Australia) scaled from 0 (least restrictive) to 6 (most restrictive). The index shows the US, the UK, NZ, Australia and Ireland to be the least regulated group of economies. See Nicoletti and Scarpetta (2003).