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Economy-wide productivity

Labour productivity - the amount of output produced per hour of work - is the key long-run determinant of New Zealanders' incomes. Our projections assume that New Zealand's labour productivity performance evolves in line with the historical trend of 1.5% growth per year. This growth trajectory would see GDP per person, on an inflation-adjusted basis, increase by around 80% between now and 2050.

Lifting New Zealand's productivity performance, and hence reducing the gap in living standards between New Zealand and other OECD economies, is arguably New Zealand's biggest economic challenge. The most important benefit of greater productivity growth for the long-term fiscal position is in the expanded choices and opportunities it gives people. As will be discussed shortly, the long-term fiscal pressures create difficult trade-offs between government spending and tax. Faster productivity growth can help people adjust to policy change because increased incomes can offset the costs of reduced government spending or increased taxes.

Lifting national productivity performance will also help the fiscal position because the government's revenue base rests on New Zealanders' capacity to earn. Since productivity growth is the main determinant of real wage growth, higher productivity growth means more tax revenue.

Table 4.2 - The effect of an extra $1 of GDP from higher labour productivity on the fiscal position[5]

Additional GDP

 $1.00

  • Extra tax revenue

 $0.33

  •  Extra NZS cost

-$0.04

  •  Extra public sector wage cost

-$0.16

Fiscal dividend

 $0.13

Source: The Treasury

But higher labour productivity growth cannot be a solution in itself. This is because there are also links between economy-wide wage growth and government expenditure, both formally and informally. The formal link is to NZS, which current legislation links to the average wage. There is also an informal link in the case of public sector wages, which generally maintain relativity with the private sector because workers are mobile between sectors.

To demonstrate the effects of changing some of these assumptions, we consider a couple of scenarios. For example, taking more favourable, but still plausible, assumptions about some of these variables - annual economy-wide productivity growth of 2% instead of 1.5% in the baseline, aggregate labour force participation rate around 3 percentage points higher than in the baseline and net migration numbers rising to 15,000 - results in net debt in the historic trends scenario increasing to 146% of GDP instead of the 223% in the baseline. Even so, this is still an unsustainable fiscal position, with debt projected to be about 40 percentage points higher relative to GDP than it was in the 2006 Statement.

Figure 4.2 - Net debt
Figure 4.2 - Net debt
Source: The Treasury

However, it is just as easy to come up with less favourable plausible assumptions - annual economy-wide productivity growth of 1.0%, aggregate labour force participation rate being around 3 percentage points lower and net migration numbers falling to 5,000 - that result in a materially worse long-term fiscal position, with net debt increasing to 324%.

This emphasises that economic growth and income from tax are only one side of the fiscal equation. No matter what level of income a government receives, the fiscal position will deteriorate if spending is higher than taxes.

Fiscal policy and growth

Just as different growth scenarios affect the fiscal position, fiscal policy settings also impact on the economy's productivity growth. Such feedbacks (from policy to economic growth) are not incorporated into our main projections, because their precise nature is too uncertain.

Maintaining a sustainable fiscal position is a key contributor to a stable macroeconomic environment, which supports growth. Government deficits put pressure on interest rates, divert investment flows away from the private sector and can lead to a more vulnerable economy with larger current account deficits. In addition, ensuring the government's balance sheet is resilient to shocks supports the ability of the government to have smooth tax and spending paths over the economic cycle, creating a degree of certainty for those looking to invest. This is one reason for the 2009 Fiscal Strategy Report objective of government net debt of 20% of GDP in the long term.

The level and structure of tax and spending affect growth through their effects on people's incentives to innovate, work and invest. Over coming decades, there may be opportunities for structural reform that supports growth. Elsewhere in this Statement we discuss how the tax system could be made more growth-friendly; for example, by taxing land and consumption more heavily, and reducing the tax burden on income. Nevertheless, higher aggregate tax is likely to result in lower income growth overall. Government expenditure may also need to be targeted to areas that are conducive to economic growth, such as infrastructure and education policies that underpin a more highly skilled workforce. Globalisation and the increased mobility of people and capital create added impetus for New Zealand's policy settings to be internationally competitive.

The Government has recently announced a desire to close New Zealand's income gap with Australia by 2025. Based on Australia's historical growth performance, closing the income gap would likely require labour productivity growth in New Zealand of around 3.3% every year for the next 15 years. If this were achieved, it would significantly improve the long-term fiscal position, resulting in net debt being around 100% of GDP in 2050. Achieving sustained labour productivity growth rates at this level would require a strong commitment by governments to significantly reform many aspects of New Zealand's tax and regulatory frameworks.

Notes

  • [5]The fiscal dividend is defined as the change in government revenue minus the change in automatic adjustments to expenditure. The automatic spending adjustments result from the assumption that labour productivity growth is linked to expenditure on NZS and public sector wages. The calculation was done using policy settings for the first year of the projection period (2013/14). It is assumed that nominal tax scales are unchanged (ie, there is fiscal drag). This accounts for the additional tax revenue being 33% of the additional GDP, higher than the overall average tax rate (which is 29% of GDP).
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