The productive capacity of the economy
The productive capacity of the economy can be thought of as the maximum level of production of goods and services that can be generated, given the economy's resource endowments, physical capital stock, population, labour force and technology, while maintaining reasonably stable inflation rates and wages growth.
Growth accounting frameworks for analysing productive capacity
It is important to have a framework that allows us to analyse the economy's productive capacity. While there is a range of such frameworks2, the framework employed by the Treasury disaggregates real economic output (GDP) into three components: population, participation and productivity (the '3Ps').
Each of the 3Ps can, in turn, be further disaggregated to reflect a range of demographic and economic factors. The demographic factors relate to fertility, mortality and migration, which affect the number of people of working age (population) as well as the composition of the population by age and gender. Because employment and hours worked differ substantially across age‑gender cohorts, changes in the composition of the population also significantly affect participation. In this decomposition, the labour productivity measure used is output per hour worked.
Employing the 3Ps, the Intergenerational Report 2007 highlighted the importance of demographic factors for Australia's future growth.3 Real annual GDP growth for the next 40 years was projected to average 2.4 per cent, down from an annual average of 3.5 per cent over the past 40 years. This primarily reflects projected lower growth in population. Australia's population growth was projected to fall from the annual average rate of 1.4 per cent over the past 40 years to 0.8 per cent over the next 40 years, reflecting falls in fertility rates starting in the 1970s. Real annual growth in GDP per capita was projected to fall from 2.1 per cent over the past 40 years to 1.6 per cent over the next 40 years, reflecting the impact of a projected decline in the share of the population of traditional working age (15‑64 years) on participation.
For this statement, it is useful to re‑arrange the 3Ps framework slightly to provide a greater focus on the role and importance of the capital stock — including public and private infrastructure — and skills, education and training to Australia's GDP growth. Australia's productive potential is largely driven by the interactions between and combined effects of the following:
- The rate at which the volume and quality of Australia's physical capital stock increases. This, in turn, will reflect trends in the size and economic efficiency of both the business or private capital stock, and public sector infrastructure.
- The rate at which the size and skill base of Australia's workforce increases, including the rate of overall population growth, the changing age structure of the population, the rate of active participation in the labour force across age groups and genders, and changing levels of education and training and attainment.
- The extent of 'pure' productivity, or multi‑factor productivity, growth.4 This represents improvements in allocative and dynamic efficiency that are not already captured in the elements discussed above.
This breakdown of the components of GDP growth highlights the role of particular factors that affect both productivity and participation. Well targeted investment in physical infrastructure can increase productivity by both increasing the capital stock and improving the efficiency of other factors of production. Sound investment in education and training results in a workforce with a better mix of skills leading to higher productivity, higher participation, lower unemployment and increased incomes and living standards.
Factors influencing expansion in productive capacity
Efficient investment in new capacity and the optimal utilisation of existing capacity are critical factors in raising an economy's productive capacity. A third factor, well‑functioning markets with effective price signals, is necessary to support the first two. These factors provide a conceptual framework for assessing the appropriate role of government in improving outcomes in infrastructure and skills markets.
Efficient investment
The expected return on investment is generally relied upon to guide commercial investment decisions, with respect to how much to invest and in which areas. Expected social rates of return can be used as a major guide in decision making with respect to public infrastructure projects, to help ensure that both the level and composition of public infrastructure investment are consistent with achieving maximum possible wellbeing. Only public infrastructure projects which at least meet a minimum benchmark social rate of return — determined through rigorous cost‑benefit analysis, including ex post evaluation and review — should be funded, and relative social rates of return above the minimum benchmark should be used to prioritise the funding of projects. While there are differences between the private and public components of the physical capital stock, there is a clear role for expected rates of return to drive investment decisions in both cases.
Expected rates of return on investment, both private and public, should also play a critical role in guiding investment decisions in the area of education and training. One challenge for policy is to ensure that expected private rates of return play an important role in guiding private decisions on whether to undertake higher education or training and in which areas. This requires appropriate price signals in the labour market and education and training institutions which are flexible and responsive to changing demands.
In some instances, however, private rates of return will not capture the full spectrum of benefits to investment in physical infrastructure or education and training. Infrastructure often involves 'network' effects, where one project has large effects (positive or negative) on other infrastructure. Problems may arise if these network effects are not recognised during the planning of infrastructure projects, and this may require coordination across a number of infrastructure providers.
There is also the potential for positive 'spillovers' stemming from education and training. Early childhood, primary and secondary school education play a critical role in increasing social cohesion in addition to their role in giving students the skills to enter the workforce. The possibility that the social returns to physical infrastructure and education and training potentially exceed the private returns has critical implications for assessing the appropriate level of, and allocation of, public funding for physical infrastructure and education.
Utilisation of existing capacity
Even with efficiently targeted investment, the long economic life of infrastructure assets means that it is also important for Australia to make the most efficient use of the existing stock of infrastructure at any point in time. Similarly, it is important to make efficient use of the skills of the workforce.
A number of reforms have improved efficiency across a range of areas of Australia's public infrastructure over the past two decades. The resulting increases in the productivity of Australia's stock of infrastructure, in turn, helped to raise Australia's potential level of output. Analysis by the Productivity Commission has highlighted that there are further gains to be made through additional infrastructure reforms.5 Similarly, the Productivity Commission (2005b, 2007, 2008) has noted the important role played by reforms designed to make more efficient use of the existing stock of skills in the workforce in meeting identified shortages in a range of areas.
Effective price signals
A key mechanism that guides investments in infrastructure and education and allocates existing labour and capital to different uses is a market determined set of relative prices and relative wages. Above average wage growth in recent years in the engineering, construction and energy sectors has reflected increased demand for skills in those areas. Such differential rates of wages growth across industries and occupations are a sign that market signals are working to address areas of shortage, both by helping to efficiently allocate existing workers and by providing incentives for new workers to train in those areas.
In practice, problems can arise that mean that price signals do not always operate effectively in infrastructure and skills markets. Ensuring that the Australian economy has the appropriate level of skills and infrastructure requires effective solutions to these problems.
2 See for example Solow (1956), Swan (1956), Barro and Sala-i-Martin (1995) and Mankiw (1995).
3 The Productivity Commission employed a similar approach in its study into the economic impacts of Australia's ageing population (PC2005a).
4 See for example: Banks (2002), Parham et al. (2001) and PC and ANU (1998).
5 The Productivity Commission (2006) estimated that improving productivity and efficiency in energy, transport, infrastructure and other activities could, after a period of adjustment, increase GDP by nearly 2 per cent.
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