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Putting Productivity First - TPRP 08/01

Investment increases the stock of ideas and the productivity of labour

When Campbell Gower first invested in Phil and Ted’s Most Excellent Buggy Company, the operation was producing two or three buggies a week out of a house in Wellington. He made an initial investment in 1997 and bought ownership of the company a year later. This injection of funds, along with Campbell Gower’s vision for the company, paid for the research and product demonstrations and led to the redesign of the original buggy that has become the centrepiece of the business. New products have also been added to the range and Phil and Ted’s Most Excellent Buggy Company now sells in over 40 countries with exports accounting for 95 per cent of sales.

Investment impacts on productivity through capital accumulation and by boosting labour productivity

Investment does not just create returns to the individual; it impacts directly on productivity through capital accumulation. Increasing the amount of capital available to workers raises labour productivity, and investments in new knowledge and processes can spill over into other areas of the economy. Policies that help to create a business environment that provides access to finance and the incentives to invest will improve productivity.

New Zealand’s investment performance

Historical low levels of investment have led to low levels of capital per worker, inhibiting productivity

Investment as a share of GDP was low during the 1990s compared to previous decades. It is recovering, but is still below some of the higher-performing OECD economies. Since 1992, growth has been relatively stronger in residential and non-residential construction than other types of investment such as plant and machinery and transport equipment. The historically lower rate of investment has led to lower levels of capital per worker compared to international comparator countries and is a major contributor to the productivity gap with these countries.

Figure 5 - Gross Fixed Capital Formation: Share of GDP
Figure 5 - Gross Fixed Capital Formation: Share of GDP .
Source: Statistics New Zealand
Figure 6 - Capital Intensity: OECD Countries in 2002
Source: OECD National Accounts

Overall, New Zealand’s macroeconomic framework is sound and has delivered improvements in macroeconomic stability over the past 15 years, particularly in terms of output and inflation. This has supported New Zealand’s improved economic performance over the period. However, two intermediate macroeconomic variables may be impacting on investment patterns and levels: comparatively high real interest rates and large, real and nominal, exchange rate cycles.

Policy considerations

Greater levels of entrepreneurship, innovation and international connections increase the number of investment opportunities

Investment requires ideas and opportunities. To create more investment opportunities, firms and individuals need to engage in increased entrepreneurship, increase their involvement in innovative activities, leverage off innovation taking place elsewhere, and access new ideas and new markets abroad. Policies that affect the other drivers of productivity will also impact on the range of opportunities for potential investors. Investment relies on a quality macroeconomic and institutional environment that reduces the risks inherent in economic activity by maximising stability and certainty.

Low multifactor productivity is likely to be depressing incentives for investment, reducing the returns to capital and making investment less attractive. There is potentially a virtuous cycle arising from innovation, skill development and improvements in managing enterprises that will raise productivity and increase the incentives for investors to invest in more capital equipment.

A high cost of capital inhibits investment

Explanations for the high cost of capital suggest that the accumulation of net foreign liabilities is fundamental. These liabilities have arisen from a long period in which low national savings rates have been insufficient to provide for investment needs, leading to a reliance on foreign savings. Foreign savings do not substitute perfectly for domestic savings; a heavy reliance on foreign sources of capital has had a negative influence on the depth and breadth of New Zealand’s capital markets.

The depth and quality of financial intermediation can affect the cost of capital for firms. While the availability of finance for investment is generally good, underdeveloped financial markets mean that some types of firms may not be able to access finance or do so only at a premium rate. New Zealand has shallow equity and bond markets and firms have limited access to venture capital. Access to capital tends to be intermediated through banks and they may not lend to particular types of firms, for example start up firms and firms with assets focused on intellectual property rather than physical collateral. Overall, a lack of development in certain parts of New Zealand’s financial system is likely to be imposing a moderate constraint on the growth and performance of New Zealand firms.

Long exchange rate cycles deter investment

Whilst New Zealand’s macroeconomic institutions are sound, economic shocks appear to be amplified compared to other countries. Monetary policy in particular may need to work harder to stabilise the economy, with subsequent effects on the exchange rate. This amplification may be a function of economic structure, New Zealand’s size and geographical location, or other factors such as the tax treatment of housing, saving and migration.

Excessively long and large exchange rate cycles could potentially impact on investment. The evidence is unclear but it may be that foreign lenders require a higher currency risk premium because of the duration of this cycle. In addition, large exchange rate swings create uncertainty for entrepreneurs who might require a higher hurdle rate of return before investing.

Tax can impact on what, where and how much to invest

Tax rates can impact on the incentives to invest. International differences in tax rates can affect where firms invest, marginal tax rates can affect how much a firm invests, and differences in tax rates across assets can impact what a firm invests in. Whilst caution is required in interpreting empirical tax studies, the evidence is now broadly supportive of the view that tax systems can substantively distort or encourage investment choices and decisions, especially when major reforms take place. Tax regimes that promote the broad incentives to invest and avoid the favouring of specific types of investment are likely to improve New Zealand’s investment performance. This is an area where further work is required in order to understand the exact mechanisms through which tax can incentivise greater levels of investment.

Infrastructure investment

Public infrastructure is an important source of investment

It is not solely private-sector investment that creates returns and drives productivity; public sector investment in infrastructure can create considerable returns for the overall economy. Investment in infrastructure prevents bottlenecks occurring in networks, and can result in productivity spillovers into related industries. Investment in communications infrastructure, such as broadband and mobile networks, can enhance take-up of new technology, augment the diffusion of knowledge and create scope for new business models. Transport infrastructure facilitates agglomeration and helps firms connect more readily to markets. Energy infrastructure investment can improve the security of supply, reducing disruptions to economic activity and improving confidence in the environment for investment.

Spending on infrastructure has fallen

Spending on infrastructure in New Zealand as a percentage of GDP has trended downwards over recent decades and New Zealand is perceived to have lower quality infrastructure than other high-income countries. Part of this may reflect poor capital allocation decisions in the past. However, recent increases in the level of infrastructure spending have occurred, and an increase in public sector infrastructure investment has been a component of this.

The perception of overall infrastructure performance in New Zealand is relatively low. While some caution needs to be exercised in interpreting such subjective assessments, there is a risk that such perceptions could reduce the attractiveness of New Zealand as a place in invest and do business.

Figure 7 - Spending on infrastructure as a share of GDP
Figure 7 - Spending on infrastructure as a share of GDP.
Source: Statistics New Zealand

The quality of infrastructure investment matters and it is important to ensure that spending is directed to the most productive areas. Rapid increases in public infrastructure investment, particularly in land transport, could stretch industry’s capacity to successfully implement these projects. This suggests care needs to be exercised in terms of sequencing any further increases. Ensuring public infrastructure spending proposals are subject to cost-benefit analysis will be critical. This will ensure that funding is directed to the projects that offer the greatest benefits to the community.

Government policy also has a role to play in ensuring efficient use of infrastructure: implementation of appropriate charging structures will both raise revenue from those who benefit from the investment and ration the infrastructure to those who generate the highest value added from using it.

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