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

7  Summary and Conclusions

This paper has addressed the level and growth of capital intensity in New Zealand. In particular the paper focuses on comparisons with Australia. Capital intensity is defined as the amount of capital per hour worked. The motivation for this arises from the observation that output per hour worked is lower in New Zealand than a number of other OECD countries. What explains this lower level of labour productivity? There are two proximate candidates: the amount of capital per hour worked (the capital intensity) and the overall level of efficiency of resource use as measured by multifactor productivity.

Over time the stock of capital per hour worked grows as the result of new investment (relative to the depreciation rate and growth in the labour supply). Each year some share of the total output of the economy is devoted to investment rather than current consumption. In New Zealand we find that that share (the ratio of investment to total output) has been comparable to the average for OECD countries over the last three decades. However, over the 1990s, starting from a relatively higher level of capital per unit of output, the rate of growth of the capital stock has been well below that for Australia and the USA, and on average 0.8 percent per annum below the average growth of capital in the OECD.

In the period 1990 to 2002, the amount of capital per hour worked grew very modestly in New Zealand; in contrast capital per hour worked rose by about 25 percent in Australia. In 1978, New Zealand and Australian workers had about the same amount of capital per hour worked. By 2002, capital intensity in Australia was over 50 percent greater than in New Zealand.

As a result it is not surprising that we find that between 1995 and 2002 some 70 percent of the difference in the growth of labour productivity is explained by a lower rate of growth of capital intensity in New Zealand. The remaining 30 percent is due to lower growth in multifactor productivity in New Zealand. In summary, our slower growth in labour productivity compared to Australia appears in recent years to have been associated with a slower growth in capital intensity. The net result is that the gap between the capital intensity in New Zealand and that of Australia has continued to widen for nearly three decades.

Why is the level of capital intensity lower in New Zealand and why has it grown more slowly? These are central questions addressed in the paper. One possible explanation for the lower capital intensity might be that returns on capital are lower in New Zealand which discourages new investment. However, we find in fact that the return on capital in New Zealand has been growing and by 2002 exceeded the level in the OECD and in Australia by some 15 to 20 percent. It is not immediately obvious why the rate of return in New Zealand should continue to exceed that in Australia given open capital markets. One possible source may lie in a higher risk premium in New Zealand, although the evidence for this is not overwhelming.

Firms select the mix of labour and capital in part based on the relative prices of these factors. If the capital intensity is observed to be low (as in New Zealand), it could be associated with a lower relative price of labour to capital. In a country where labour is relatively abundant and wages low while capital is scarce and commands a high return we would expect to observe a lower level of capital intensity. In New Zealand the price of labour relative to Australia was very comparable in the late 1980s. By 2002 it had fallen to about 60% of the level in Australia. With labour relatively cheaper in relation to capital than in Australia, it appears that New Zealand firms have opted for a lower level of capital intensity.

Even in a world where both countries faced the same relative factor prices, we might still observe differences in the capital intensity due to differences in the underlying production systems. We explored this by estimating the elasticity of substitution between labour and capital; this measure indicates the responsiveness of the capital- labour mix to changes in relative factor prices. As labour becomes more expensive relative to capital do firms tend to substitute more capital for labour?

The results confirm that in both Australia and New Zealand, this type of substitution does in fact occur. Our estimates are all significant and fall in the range of estimates from international studies: see for example Claro (2002) and Balistreri et al. (2002). Our initial results using the total capital stock (excluding land, inventories, and human capital) suggest that the long-run responsiveness of the capital-intensity to the relative price of labour to capital is very similar for the two economies. When we adjust the capital stock to exclude housing, the Australian long-run elasticity estimate becomes larger than New Zealand’s. However, a preliminary test suggests that the long-run elasticities in the two countries when housing is excluded are not statistically different. There is also no evidence that the long-run elasticities are different in the two countries when both the mining and agricultural sectors are excluded. However, when we adjust the capital stock to exclude only the mining sector, we find that the elasticity of substitution in New Zealand is on average less than one half of that in Australia. In other words for any given rise (fall) in the relative cost of labour, Australian firms which are not in the mining sector appear to make a much greater swing toward more (less) capital intensive forms of production. They alter their long run mix of inputs much more than do firms outside of the mining sector in New Zealand.

Has this degree of responsiveness been changing over time? It is possible that following the reforms there has been a period of learning and adjustment to a new economic environment. This would suggest that the rate at which the capital intensity responds to price signals might have increased over time. At the same time reforms create uncertainty and this could lead to a hesitation to make new investments until the future payoffs seemed more certain. This would tend to dampen any increase in responsiveness. To test the effect we allowed the response parameter to vary over time. However there was no evidence that the response is different between the two economies.

Three major limitations of the study should be noted. In the first place we have used data for either the whole economy or by excluding certain sectors for what we might call the “comparable core” sectors. It may be that there are differences in the responsiveness of the capital intensity to changes in relative factor prices across different industries within the core economy. The cross-country results for some 40 industries presented by Claro (2002) show a range from 0.6 to 2.1, whereas our aggregate long run estimates for New Zealand and Australia span a more limited range between 0.5 and 1.4.

Second, we have assumed that the relative prices of factors are given to the economy. In fact in the long run both the prices of the factors and the mix will be simultaneously determined. We tested for the direction of causation; do factor prices cause changes in the mix of capital and labour or is the direction of causation the other way around. The results were inconclusive.

Finally, it is evident that differences in the measurement of the capital stock are critical. Changes in the coverage and method of computing estimates of the capital stock do alter the conclusions. Whether New Zealand is really capital shallow relative to Australia may well hinge on whether land and inventories and human capital are adequately measured and incorporated in a more comprehensive concept of capital.

Two unanswered questions remain: why has the gap between the capital intensity in New Zealand and Australia continued to widen? At one level, the immediate answer to this question appears to be that the relative price gap has continued to widen. But this of course then merely raises the next question: why have relative prices moved in this way? Essentially these questions remain as topics for further research. Subtle differences in the regulatory environment, labour and capital markets, and taxation regimes may contribute but this remains to be further explored.

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