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Capital Shallowness: A Problem for New Zealand? - WP 05/05

1  Introduction

While indefinite growth in income cannot be sustained through input accumulation alone, capital deepening nevertheless has a direct impact on the level of output and productivity. Increasing the amount of capital directly influences labour productivity by increasing the quantity and quality of machinery, equipment and infrastructure available to each worker. However, evidence suggests that New Zealand is currently capital shallow compared with other OECD countries. That is, New Zealand appears to have a lower capital to labour ratio than many comparator OECD countries.

The Treasury Working paper by Black, Guy and McLellan (2003) was the catalyst for investigating the contribution of capital intensity to the labour productivity gap. Black et al found that New Zealand has had a lower rate of capital accumulation than Australia. In light of this paper Treasury (2004) took up this issue in Chapter II, laying down several hypotheses for why New Zealand’s rate of capital deepening may have lagged behind that in Australia in recent years. This paper is motivated by that discussion, and attempts to shed some light on these hypotheses.

The aim of this paper is to look at some possible explanations as to why New Zealand may have invested less in physical capital compared with other countries. We examine the rate of return to capital in New Zealand and comparator countries. High returns are an indication that investment within a country has been low and (perfectly functioning) international capital markets will begin to adjust by equalising marginal products across countries. The existence of high returns in one country for an extended period of time could be an indication that there are barriers to investing within that country.

While it is true that capital investment depends on the return it is expected to generate, firms will assess this return in relation to the return which may be made on other factors of production. Thus in section 6 we turn to the relative prices of labour and capital. We find that New Zealand appears to have a lower ratio of labour-to-capital prices, indicating that it has been cheaper for businesses in New Zealand to hire more workers rather than invest in physical capital. We then examine whether New Zealand also adjusts differently to changes in relative prices by estimating the elasticity of substitution in a CES production function.

The paper is structured as follows: Section 2 discusses the methodology employed to measure the capital stock, and issues surrounding the exclusion of land and inventories in the construction of capital stock measures. Section 3 examines the apparently conflicting evidence of New Zealand’s similar rate of investment and lower capital stock growth compared with other OECD countries. Section 4 presents evidence of New Zealand’s capital shallowness and its relation to New Zealand’s labour productivity growth. Section 5 discusses the impact of high rates of return to capital investment on capital stock growth. Section 6 then examines the effects of the relatively lower price of labour to capital in New Zealand, while the summary and conclusions follow in Section 7.

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