6.2 Modelling framework for public services expenditure (continued)

6.2.2  Input price growth

Our modelling framework requires growth rates for input prices to be specified. These growth rates are decomposed into nominal and real components (π_t and w_t ).

It is assumed that all input prices rise by at least CPI inflation. It is also assumed that there is some real input price growth, largely associated with the labour cost component. Theory would suggest that wage growth should be in line with labour productivity growth over time, although the relationship may not be strong in the short term. Empirical measurement in New Zealand over the 20th century shows periods of divergence between wage and labour productivity growth which may be partially explained by poor quality data on wages (Briggs, 2003) and also episodes of structural change in the economy (such as those discussed in Parham and Roberts, 2004).

We also assume that wage growth across public services is driven by economy-wide labour productivity. That is, there is equalisation of growth rates across public and private sectors. This relationship is likely to hold broadly because workers are relatively mobile between sectors. Although there could be a wage discount (or premium) for working in the public sector (eg, a discount because of higher job security and/or satisfaction), there is no reason to model a differential in the growth rates. Recent New Zealand data show public sector wages growing slightly faster than the private sector (see Figure 6.1). Also consistent with the theory, no evidence was found for a wage growth differential between high productivity and low productivity sectors in a US study which looked at data from the past 50 years (Nordhaus, 2006).

Figure 6.1 - Labour cost growth in public and private sectors

Source: Statistics New Zealand

Since not all inputs are driven by labour costs, we do not equate the real input price growth factor to be exactly equal to the assumed rate of real wage growth (itself set to economy-wide labour productivity growth). Instead we apply a scalar of 0.8, so that where g_t is the rate of economy-wide labour productivity growth. In the two main scenarios, the assumed rate of economy-wide labour productivity growth is 1.5%, applying the scalar gives a real input price growth of 1.2%.

The choice of 0.8 as the scalar is a judgement which reflects the high share of input costs driven by wage growth in public services. A higher scalar means a higher input cost. Labour shares in the production of public services are higher than in many other parts of the economy and likely to be in the range of 60% to 80% (including labour costs incurred outside the formal employment of the State). The scalar applied is at the upper end of plausible values based on labour costs and reflects a judgement that there are likely to be non-labour inputs which exhibit above-inflation price growth, such as costs associated with the introduction of new technologies in the health sector.

6.2.3  Public sector productivity

Public sector productivity is modelled to be an explicit cost driver, with cost and productivity being inversely related (with the parameter a_t). The intuition is that a higher level of public sector productivity means that the government could deliver the same level of public services for a lower cost, holding all else equal (ie, still matching private sector wage growth but using fewer labour inputs).[14] A key purpose for introducing the parameter into the modelling is to decompose expenditure into price and quantity components. It also enables, through sensitivity analysis, the quantification of potential impacts of increases or decreases in the productivity of public services.

Our assumption is that there are small long-run productivity gains in public services, with two main scenarios including an assumption of annual growth of 0.3% (ie, a_t = 0.3%). This is a judgement based on available evidence, as discussed below. A higher value for a_t would mean a lower cost of public services. This is a much lower growth rate than the economy-wide productivity assumption (1.5%). Unbalanced productivity growth can have important dynamic implications, stemming from an increasing relative price of the output produced in the low productivity sector.[15] The effect is known by economists as “Baumol's cost disease.” William Baumol's hypothesis was that the service sector (or some parts of the service sector) had less potential for productivity growth because of the high labour content needed in the production of services. Baumol characterised services as the “stagnant” sector compared with the “progressive” manufacturing sector which could make productivity gains through automation (Baumol, 1967). There is continued debate about this hypothesis.

Empirical measurement of productivity in public services is scarce, and New Zealand does not have well-measured productivity statistics for the public sector (Douglas, 2006). However, the available empirical work suggests a plausible range in annual growth of between -0.3% to 0.7%. This is discussed below in more detail.

The United Kingdom's Office of National Statistics (ONS) measures productivity for the majority of the public services, although caveats are placed on the results due to measurement issues. The ONS found that public services productivity averaged -0.3% over 1997 to 2007 (ONS, 2009). This negative result was during a period of significant increases in both inputs and outputs, but with input growth outpacing output growth.

Studies of health care that take a macroeconomic approach to estimating productivity generally find modest gains over the long run. For example, Pomp and Vujic (2008) found that labour productivity gains across the OECD in health care to be approximately one-fifth as high as labour productivity as economy-wide gains, although the extent to which health care is publicly-funded varies across the OECD. Triplett and Bosworth (2003) found that labour productivity in health services in the United States rose by 0.7% per year in the period 1995 to 2000, or at a rate of 0.27 times that of economy-wide labour productivity over that period. The nature of health care partly reflects public services in general, in that it contains a mix of both publicly and privately-provided services, including services with potential for productivity gains (eg, hospitals) and services with apparently low scope for productivity gains (eg, residential care facilities). These issues are discussed in greater depth in Section 7 on modelling health expenditure.

In the private sector, there have been some signs of increasing service sector productivity. Tripplett and Bosworth (2003), for example, found average labour productivity growth in services industries accelerated in line with economy-wide labour productivity growth in the United States over 1995 to 2000. This suggests that significant productivity gains in labour intensive service-based industries are possible where there is scope for introducing new business models or the widespread application of new technologies such as information and communication technology. New Zealand’s market sector service industries (eg, retail) showed labour productivity growth from 1995 to 2006 averaging 0.6% per annum – slightly less than half the economy-wide rate of labour productivity growth (OECD, 2008).

Focusing on New Zealand's public services, the main areas of government expenditure are labour-intensive services, many of which are likely to have relatively little scope for significant labour-to-capital substitution in the foreseeable future. Moreover, the public sector is less exposed to competitive market forces which would be expected to spur greater productivity growth, all else equal. These observations support claims that public sector productivity growth is likely to be lower than economy-wide growth rates.

Our judgement is that over thelong run there will be the introduction of new technologies and practices which mean that productivity should increase, albeit at a slower rate than in other parts of the economy. The estimate of 0.3% annual growth should be interpreted as a plausible estimate within a wide range of plausible values. It is also not an estimate of historical performance in any particular time period. Indeed, productivity growth in public services may have been negative over the last decade, as found in the United Kingdom. Although we apply a uniform rate across all sectors delivering public services, it should be considered an average – some sectors will perform better than others.

Combining input price and public sector productivity assumptions, we can derive an implicit price deflator for nominal public services expenditure. In the base case, and in steady state, this deflator is equal to CPI + 0.9% (since w_t - a_t = 1.2% - 0.3% = 0.9%).