Holding on and letting go: Opportunities and challenges for New Zealand's economic performance: A perspective from the Treasury

The art of walking upright here
Is the art of using both feet.
One is for holding on.
One is for letting go.

From ‘The trick of standing upright here’ by Glenn Colquhoun

Box 1: Drilling down into our productivity performance#

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We can gain a richer understanding of our labour productivity performance by drilling down below the aggregate numbers. For example, one of the reasons for differences in labour productivity across countries is the amount of capital (assets such as building and machinery) which people have to work with. Our labour productivity is two-thirds of Australia's - our lower levels of capital per worker account for almost 40% of that gap. However, the majority of the gap is down to the quality of our labour and capital and how well we use them (what economists call multi-factor productivity). In addition, there is a chicken-and-egg relationship between capital and productivity: our lower capital levels may hinder labour productivity but our lower productivity may also discourage investment in capital.

Another angle is to look at how the productivity of our industries stacks up. Do we have lower labour productivity than Australia because we happen to be in industries that inherently have lower levels of capital and, therefore, lower levels of labour productivity? Or is it because we are less productive than our Aussie counterparts in each industry? This type of comparison is challenging and the analysis is limited to what are still quite broad industries. In addition, a given industry in one country might have different linkages with other industries. While New Zealand's industry structure explains around 30% of the labour productivity gap with Australia, most of our economic gap is actually because Australia has a productivity lead across a wide range of industries (see Figure 3). We have to be careful about drawing specific implications from this type of analysis. As these industry classifications are broad, differences in productivity may reflect differences in composition. For example, forestry plays a relatively bigger role in New Zealand’s agriculture, forestry and fishing industry than in Australia, as does hydro generation in the electricity, gas and water industry.

However, it seems unlikely that the majority of our labour productivity difference with Australia is about composition.

Figure 3: New Zealand industry labour productivity as a percent of Australia's in 2009

Source:  Mason (2013)

If we switch from looking at productivity levels to recent productivity growth, we also find that most of our recent productivity growth performance can be explained by low productivity growth within sectors rather than by the growth of low productivity sectors. However, there has been some drag on productivity from relatively strong employment growth in some low productivity sectors (for example, Conway and Meehan, 2013).

We can drill down even deeper to look at firm-level productivity (New Zealand Productivity Commission, 2014a). For example, New Zealand, like many countries, has a wide dispersion in the level of productivity across firms within the same industry. The productivity of a firm in the 90th percentile (top 10%) can be several multiples of a firm in the 10th percentile (bottom 10%). However, there is uncertainty as to the role of competition and other factors (for example, entry, growth, and firm exit) in driving this dispersion and further research is underway (see Nolan, 2014).

Box 2: Māori Economic Development#

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Māori are playing an increasingly important role in New Zealand’s economy and society and the Treasury is committed to building its understanding of this role. The Māori economy contributes around 5.9% of total New Zealand GDP (BERL Economics, 2011), and we expect this to increase over the coming years. Māori will also represent an increasing share of the labour force over the next 20 years (Bascand, 2012). Increased Māori education and skills will be important to leverage off these assets and raise broader Māori living standards.

Māori enterprise is heavily represented in resource based industries, including significant holdings in fishing, forestry, dairy production, kiwifruit, and sheep and beef. Around 5% of total agriculture, forestry and fishing assets are held by Māori entities (see Figure 6).

Agri-business provides significant economic opportunity. There is about 1.5 million hectares of Māori freehold land. About 40% of this is estimated to be under-performing and 40% is estimated to be un-utilised (Ministry of Agriculture and Fisheries, 2011).

Māori entities are increasingly looking for opportunities to better utilise these assets and build connections with export markets, while also supporting the cultural and environmental objectives of Māori communities. While this provides a significant opportunity, there are also a number of issues including joint ownership of Māori land, the cultural commitment to ensure the retention of land for future generations, and uncertainty over property rights.

Māori entities are playing an increasingly important role across specific regions of the country and are also increasingly diversifying their assets into non-land based industries. Examples of diversification include property, tourism and cultural services and manufacturing (see Figure 6).

Figure 6: Māori assets by sector

Source:  BERL Economics (2011)

Box 3: Global value chains#

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Worldwide, firms are increasingly locating the various activities needed to produce final goods and services in different places, in order to exploit the gains from specialisation and economies of scale. Apple products such as the iPod, iPhone and iPad are classic examples - with design, production of component parts and assembly distributed across a number of countries.

The ‘participation index’ in Figure 11 measures the degree to which a country uses foreign inputs in its exports (backward participation) and the extent to which a country’s products are used by other countries as intermediate inputs in producing their exports (forward participation).

New Zealand's exports use only a relatively small proportion of foreign inputs and, therefore, have high domestic value added. The foreign content of New Zealand’s gross exports is around 18%. To compare with another small country, the foreign content of Denmark’s gross exports is around 32%. And many other small countries have even higher ratios.

However, our ‘forward participation' looks more consistent with other small countries. Around 16% of New Zealand's gross exports are used as intermediate inputs in other countries' exports, compared with around 19% of Danish gross exports.

Figure 11: Participation in global value chains
Foreign inputs in our exports (backward participation) and domestically produced inputs used in other countries exports (forward participation) as a percent of gross exports

Source:  OECD Global Value Chain Indicators

Box 4: Innovation#

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Section 1 highlighted that our productivity performance is the underlying reason for our ‘economic gap' with the better performing OECD countries. We can increase output by increasing the quantity of inputs - capital and labour. But if we really want to narrow our economic gap, our businesses need to discover and apply new ways to produce more with the same quantity of inputs - or to produce higher value outputs. That is innovation - and it is at the heart of productivity performance.

Most of the big rise in living standards in the developed world over the past two centuries has come about through technological breakthroughs based on increased knowledge. A lot of this knowledge has been scientific but it has also been practical knowledge about production processes, and organisational, social, legal and marketing knowledge. Governments typically play some role in innovation because of its special characteristics. In particular, once an idea has been developed, others could use it at no extra cost and, indeed, for some forms of knowledge it can be difficult to exclude others from using it (see the Treasury, 2008 for more analysis and references). The complexity, cost and uncertainty of engaging in innovation is also very high (New Zealand Productivity Commission, 2014a).

Cross-country studies provide support to the importance of innovation to economic performance. For example, studies suggest that higher levels of research and development (R&D) spending are linked with higher economic growth. The available evidence indicates greater benefits from private than public R&D (see, for example, the Australia Productivity Commission, 2007).

Overall, New Zealand's performance as an innovative economy presents a mixed picture. On the positive side, New Zealand's science base delivers research outputs at a relatively high rate compared with the OECD average. We have a relatively large number of researchers, and our R&D has been growing at a fast rate relative to most other OECD countries.

The relative weakness in New Zealand's innovation system is in the successful commercial application of new knowledge. New Zealand's level of spending on R&D has been growing rapidly, but the total remains low by international standards and our level of patenting is also low. Most importantly, New Zealand has particularly low levels of business R&D. Given the significant proportion of R&D performed in public institutions, the relatively low levels of collaboration between business and some public institutions is a concern.

New Zealand faces some significant challenges in raising business R&D because we have a relatively low share of R&D intensive industries, our distance from markets creates risks for innovators, and we have few of the very large firms that dominate R&D around the world. New Zealand's small size and remoteness means we must strike a balance between enabling collaboration between firms to provide the scale often needed to support innovation versus ensuring there is sufficient competition to keep the pressure on firms to innovate.

Box 5: Economic performance and the state sector#

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New Zealand's state sector has a good reputation internationally, and is generally well-regarded domestically. But it needs to be at the leading edge if we are to overcome our geographical disadvantages and tackle our persistent social challenges.

The state sector impacts on economic performance and living standards through three main types of levers or interventions:

• Government expenditure and revenue. Central and local government spending add up to more than 40% of GDP. This spending funds a range of services and transfers that make an important contribution to economic performance and living standards. But New Zealanders must also ultimately pay for this spending through their taxes, which can discourage people from working, saving and investing. Therefore, it is important that public services are provided as effectively and efficiently as possible and that revenue is raised in the least damaging way (The Treasury, 2011). It will be important to maintain New Zealand's efficient broad base and low rate tax system as global competition for labour and capital intensifies, while maintaining its integrity and fairness.
  Over the medium to long-term, an ageing population will place increasing cost pressure on public expenditure and tend to shift expenditure away from areas that are typically seen as good for economic performance (for example, away from education and towards superannuation). There will be a number of choices around the mix and level of taxation and spending to meet the Government's objective to reduce net debt to 20% of GDP by 2020 and to manage expenditure pressures beyond 2020 (The Treasury, 2013d).
• Ownership: the government’s balance sheet. With over $240 billion in assets, $170 billion in liabilities and $70 billion in equity, the Crown’s balance sheet is large – assets alone are worth more than a full year of total output from the economy (The Treasury, 2014).
  Crown assets play a critical role in delivering public services. Therefore, it is important that public money is invested well and assets are managed effectively and efficiently. There are concerns about the age, utilisation and maintenance of the Crown's social assets. And there is scope to improve information and processes to support better management of the Crown assets (The Treasury, 2014).
  The Crown's balance sheet is also important for New Zealand's resilience to risk. Having low levels of public debt was crucial to New Zealand's ability to support New Zealanders during the financial crisis and deal with the costs of the Canterbury earthquake. Delivering the Government's fiscal strategy to reduce net public debt to 20% of GDP by 2020 will help rebuild our buffers against future crises, as well as position New Zealand to support an ageing population (see The Treasury, 2013d).
• Regulation. A certain and predictable regulatory system provides businesses and people with the confidence to innovate, invest in new capital, develop skills, and take risks. New Zealand’s regulatory quality is fairly high, and supportive of an entrepreneurial culture and dynamic economy. For example, New Zealand ranks eighth in the OECD’s measure of the restrictiveness of product markets (OECD, 2014). However, as a small and distant economy, we have to work hard to be at the cutting edge, particularly as other countries continue to improve the attractiveness of their business environment.
  A continued focus on strengthening the regulatory system also remains important. This means keeping a focus on the quality of both new and existing regulation, as well as recognising that the implementation and operation of regulatory regimes matters as much as the design of regulations. The Productivity Commission is currently undertaking an inquiry to identify where and how there may be scope for improvements in the quality and effectiveness of government regulatory institutions and practices (see New Zealand Productivity Commission, 2014b for their draft report).

3  Moving towards exports and investment#

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The previous section set out our first strategic issue - supporting economic growth that is oriented toward high-value-added activities, which are likely to require innovation, scale, investment, and exporting to new markets. This is likely to be associated with a shift in the balance of economic activity toward exports and investment. This section is about the management of short-term demand pressures to help facilitate this shift, as well as more medium-term issues around reducing supply-side constraints on economic activity.

That was then...this is now?

Have we been here before?#

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The New Zealand economy has emerged from recession, and the short-term economic outlook is good. New Zealand’s GDP per capita recovered in March 2013 to its pre-recession level. And economic growth appears to be gathering momentum, strengthening from 2.8% in the year to December 2013 to nearly 4% in the year to March 2015.

However, growth is dominated by domestic consumption and the Canterbury rebuild. A strong rebound in residential investment is also expected as a consequence of the rebuild and the growing mismatch between housing supply and demand in Auckland. The combination of the Canterbury rebuild with a cyclical rebound in housing demand in other parts of the country is likely to lift construction activity to the high levels seen in the early 2000s.

Some of the drivers of the current economic upturn were also present during New Zealand's last economic expansion from 1998 to 2007 – which was long and large by the country’s post-war standards, with average annual GDP growth of 3.6% (Hall and McDermott, 2013) and strong employment growth. The unemployment rate fell from 8% in 1998 to around 4% by 2007.

From 1998 to 2007, strong domestic demand was underpinned by a large increase in net migration, booming house prices, and a lift in key export commodity prices (Chetwin, 2012). There was strong growth in public and private consumption, as well as housing construction. The capacity of the economy to absorb this strong demand was limited by some supply-side constraints. In particular, underlying labour productivity growth appears to have slowed from around 2000.[11]

The last economic upturn was also associated with a range of emerging domestic and external imbalances: average house prices grew faster than rents and incomes, domestic credit growth was rapid, the current account deficit widened and the exchange rate appreciated above its long-term average.

As a consequence, New Zealand saw strong growth in non-tradable GDP (those industries that are less exposed to international competition), while tradable GDP was broadly flat. Box 6 discusses some of the conceptual and measurement issues around tradable and non-tradable GDP.

Figure 12: Breaking down tradable and non-tradable activity

Source:  Statistics New Zealand and the Treasury

While the tradable sector in aggregate saw only limited growth, this measure is masking differences in output growth across industries. Figure 12 shows that a sub-group of industries within the tradable sector has enjoyed relatively strong growth, albeit less robust than the non-tradable sector. These ‘booming’ or resource-based tradable industries have been buoyed by strong international demand, particularly for our dairy products. However, other trade-exposed parts of the economy (the ‘lagging’ tradables’), such as non-food processing manufacturing and exports of services, have seen little growth. This may be a concern if high commodity prices are transitory or if it reinforces our dependence on sectors with less scope for productivity growth.

The role of the exchange rate#

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The impact of the exchange rate in driving this difference in performance across the tradable and non-tradable sectors has been widely debated.[12] The nominal exchange rate is a measure of how much our currency is worth relative to our trading partners. When the currency is strong, New Zealanders can afford more goods and services on world markets, as any international traveller will understand. A strong dollar also reduces the costs of imports used by businesses, including capital goods. However, a strong New Zealand dollar can also make life harder for firms in the tradable sector - making our exports more expensive in world markets and imports more competitive in the New Zealand market. On the other hand, the greater pressure to be cost competitive may incentivise New Zealand firms to improve their productivity.

The exchange rate is very cyclical. The cycles that occur with a floating nominal exchange rate reflect a range of factors, including New Zealand’s economic performance relative to other countries and whether the exchange rate is acting to offset external shocks, as was the case in the global financial crisis.

While the exchange rate is cyclical, there has been an upward trend over the past 15 years in New Zealand's nominal exchange rate. Moreover, what matters for competitiveness, especially in non-primary exports, is the real exchange rate. The real exchange rate is the nominal rate adjusted for changes in domestic prices or labour costs relative to foreign prices or labour costs. If the appreciation in the nominal exchange rate had been offset by an equivalent decline in our unit labour costs relative to our trading partners, for example from improving labour productivity, then our competitiveness would not have deteriorated. However, this has not happened and we have seen an appreciation of our real exchange rate (see Figure 13), which may have worked against export growth and the productivity benefits it brings (see Section 2). And while interest rates may currently be at a cyclical low, they have been persistently higher than in other advanced countries.

There is no single compelling explanation for New Zealand's combination of a high real exchange rate and a high real interest rate – indeed it is likely to reflect a range of factors. One factor is the persistently strong domestic demand in the New Zealand economy, which is linked to low levels of national saving relative to domestic investment. Other explanations point to the existence of a country risk premium, perhaps owing to New Zealand’s persistently high net foreign liability position or currency volatility. The historically high value of the real exchange rate over the past 10 years also partly reflects New Zealand’s buoyant terms of trade, which helps to explain the variation in performance between the agricultural and other parts of the tradable sector. However, the extent of real exchange rate overvaluation is subject to uncertainty, and there is no simple answer to how exchange rate movements affect the real economy (Cassino and Oxley, 2013).

There are choices about the overall monetary and exchange rate regime. As discussed in Box 7, New Zealand has operated a floating exchange rate for nearly three decades. Thechoice of regime will affect how the economy adjusts to changing domestic and external circumstances, but it is unlikely to make a sustained difference to the level of the real exchange rate. For example, strong non-tradable demand, or low levels of saving, will result in an appreciation of the real exchange rate under any regime - either via a nominal exchange rate appreciation under a floating regime or through domestic inflation under a pegged or fixed exchange rate (Grimes, 2014).[13] At the margin, monetary policy and foreign exchange rate intervention can perhaps take out the worst of the peaks and the troughs of the cycle in exchange rates (McDermott, 2013).

Figure 13: Nominal and real exchange rate
Relative unit labour cost measure

Note: The Unit Labour Cost based real exchange rate adjusts the nominal exchange rate for changes in the labour cost (per unit of output) for a group of 49 (trade-weighted) countries. An increase in the index indicates a real exchange rate appreciation and a corresponding deterioration in New Zealand's competitiveness.
Source:  OECD

Overall, this tells us that enduring solutions to imbalances or weak tradable sector performance lie not with monetary policy but in other policy areas. It is about showing restraint as economic activity picks up and also using the opportunity to lift productivity by easing some of the underlying constraints on the supply side of the economy. The following sub-sections look at each of these options in turn.

Showing restraint as the economy hits a new gear#

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There are lessons to be learnt from the previous economic expansion and the global financial crisis. The global financial crisis highlighted the dangers of booms and busts in asset prices, and recent changes to New Zealand’s monetary policy recognise this (see Box 8). While New Zealand’s low public debt helped in coping with the crisis, in hindsight our fiscal policy settings may have been too loose before the crisis. While strong revenue growth kept the government’s books in the black, growing public spending was putting upward pressure on inflation. This meant that monetary policy had to be tighter – and interest and exchange rates higher – than they otherwise would have been. This experience highlights that distinguishing the cycle from the trend during an economic upswing is always subject to uncertainty.

Fiscal policy can help with managing domestic demand. Even though public finances are likely to improve as the economy picks up, there will be little scope to increase expenditure or reduce taxes without putting upward pressure on interest and exchange rates. This implies a continued pursuit of efficiencies in public spending, including tightly managing the Crown’s investments in the Christchurch rebuild. It may also potentially mean further tightening of government spending if household spending is higher than expected.

There are also more formal approaches to help fiscal policy lean against the economic cycle. Recent changes to New Zealand’s public finance legislation require governments to report on how they are co-ordinating fiscal policy with the economic cycle (The Treasury, 2012b and Brook, 2013b). The Government's fiscal strategy emphasises the need to use fiscal surpluses over the current economic upturn to repay debt and build up assets. Looking further ahead, another possible tool is the use of a fiscal stabilisation fund. Under this approach, government revenues would be ‘banked' in good economic times and used to support higher government spending or tax cuts in downturns (Brook, 2013b). For example, Chile used a stabilisation fund to bank some of the large fiscal surpluses it enjoyed off the back of high commodity prices. It was then able to increase public spending to support economic activity and living standards during the global financial crisis.

The aftermath of the global financial crisis has also led to consideration of other tools to support macroeconomic objectives. Many of these instruments, such as higher capital adequacy standards for banks, are primarily about reducing the risks of future financial crises. However, some of these also have the potential to help smooth cyclical fluctuations in economic activity. For example, during the mid-2000s the Treasury and Reserve Bank assessed a range of alternative instruments to manage demand in the economy. One of these, Loan to Value Ratio limits (LVRs), was implemented in late 2013 to address the financial stability risks associated with rapidly rising house prices and residential mortgage lending. There are also other potential instruments that are more directly aimed at easing demand in an upturn, which can be reversed as economic activity weakens. However, there is much uncertainty about whether the costs of microeconomic distortions induced by such instruments would outweigh any benefits for cyclical demand management.

A number of potential demand management tools have a housing focus, reflecting the importance of housing in the New Zealand economy. High house price growth is signalling strong housing demand in both Christchurch and Auckland. Increasing housing supply to match that demand will be a key driver of domestic demand and economic growth over the next few years. Reducing constraints on housing supply will be important to help moderate the demand pressure on house prices and improve affordability – making an important contribution to wider living standards. The responsiveness of housing supply to price changes in New Zealand is estimated to be about average in the OECD, but it is about half as responsive as in some of the better-performing OECD economies (New Zealand Productivity Commission, 2012). Improving supply responsiveness would require either increasing the productivity of the construction sector or increasing land supply.

The relationship between housing markets and macroeconomic demand pressures are complex. There are two offsetting impacts on domestic demand from increasing housing supply and it is difficult to know which will dominate:

• Increasing housing supply implies at least a temporary increase in construction activity which adds to domestic demand and inflationary pressure, although this would be mitigated if the increase in supply is driven by improved productivity in the construction sector. More construction activity could drive interest rates up above where they would otherwise be, which, among other things, may push up the exchange rate and make life harder for exporters.
• On the other hand, increasing housing supply may moderate increases in house prices. This would lessen ‘wealth effects’ from increasing house prices, which can make people feel wealthier and so spend more and save less, exacerbating demand pressures. More responsive supply would reduce the risks of a boom-and-bust cycle with house prices increasing too far and too fast, and a subsequent drop when supply eventually catches up. Therefore, less volatile house supply would moderate risks to financial stability, which has wider consequences for economic activity.

Another policy area that can, to some extent, be co-ordinated with the economic cycle is migration. The evidence points to a small positive impact of immigration on New Zealand’s productivity and economic growth by, for example, bringing new skills and ideas. However, immigration may also contribute to demand pressures, including in the housing market. While there is debate about the empirical evidence, some commentators have argued that it may have put upward pressure on New Zealand’s exchange and interest rates (Reddell, 2013 and Fry, 2014).

Where possible, policy should not exacerbate cyclical pressures by loosening immigration flows as the economic cycle gathers pace. However, there is a limit to which government can control net migration as flows of New Zealand and Australian residents play a large role. In our current economic upturn, net migration is already picking up as more New Zealanders stay home in the face of a slowing Australian economy. In the medium-term, a well-designed migration policy needs to be supported by increases in the capacity of the economy to absorb population increases, particularly through more responsive housing supply.

Using the opportunity to lift productivity#

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While short-term choices about how we manage the cycle are important, the real prize is long-term economic and productivity performance. Removing constraints to New Zealand’s economic and productivity performance enables the economy to sustain higher levels of domestic demand without putting pressure on interest and exchange rates. For example, improving the poor productivity performance of the construction sector would reduce the extent to which an expansion in housing demand and supply diverts resources from the tradable sector.

Lifting New Zealand's rate of national saving has a role to play. While New Zealand has low levels of government debt, it has one of the largest net international investment liabilities in the OECD (see Figure 14). Over time, higher national saving would make the economy more resilient by reducing our high net external debt and vulnerability to external shocks. Any reduction in vulnerability may also be reflected in a reduced risk premium on our long-term interest rates.

As New Zealand's public saving rates are - on average - relatively high by international standards, a substantial increase in national saving will require an increase in our relatively low private saving rates. However, the linkages between policy settings and private saving are complex. The saving rates of households and businesses are influenced by a range of factors, including: the age structure of the population – people tend to save more in their working years and draw on those savings in retirement; the taxation of income from different sources; the provision of government transfers and services; and the saving rate of the government itself.

Figure 14: Net international investment position and gross government debt
Percent of GDP in 2012

Note: The net international investment position is foreign assets less foreign liabilities.
Source:  IMF, WEO, Statistics New Zealand, the Treasury

Higher saving rates should in principle enable greater investment and, therefore, also higher economic growth. Empirical evidence struggles to find any simple and consistent relationship between national saving and economic performance across countries. Perhaps this is to be expected because investment is not constrained by domestic saving but can be financed from abroad. However, there does seem to be some ‘home bias' to investment, so that domestic investment levels may partly depend on domestic savings. Although New Zealand has an open financial system, its small size and its large distance from major international markets could make it particularly susceptible to ‘home bias', for example from a lack of understanding of New Zealand opportunities amongst foreign investors. These problems are more likely to be evident for equity than debt, with young and small firms seeking equity finance most likely to be adversely affected (Cameron, Chapple, Davis, Kousis and Lewis, 2007).

Despite limitations in the evidence, there are a number of reasons why higher national saving is likely to improve economic performance. In particular, higher savings would reduce demand pressures, permitting the Reserve Bank to keep interest rates lower than otherwise. To the extent that lower short-term interest rates are also reflected in lower longer-term interest rates, the reduced cost of capital would provide greater incentives for firms to invest (NZIER, 2011). As new capital also brings with it new technology, higher investment may increase the productivity of both labour and capital. Lower interest rates would also reduce upward pressure on the exchange rate over the business cycle, supporting export growth and the productivity benefits it brings (see Section 2). That may also support an increased share of investment in the tradable sector, particularly if accompanied by changes in tax and regulation settings to reduce differential impacts on investment incentives across sectors.

Sufficient and well-designed infrastructure is also important for productivity growth. The state sector typically undertakes benefit cost assessments to measure the potential impact of infrastructure projects on economic performance and living standards. At very low levels of infrastructure, new investments are likely to make a significant contribution to productivity and economic performance and so have high benefit-cost ratios. However, as the quantity and quality of infrastructure increases, new investment will contribute less to economic performance and living standards – and so will have lower benefit-cost ratios. This has been the experience of New Zealand’s roading investment over the past five years or so. Reflecting past under-investment, new projects had fairly high benefit-cost ratios five or so years ago (see Figure 15). However, the average return from new projects has declined over time as the Government has significantly increased investment in roads. Figure 15 suggests that the need for further investment is reduced but that further investment will still bring net benefits.

Figure 15: Benefit-cost ratios for approved state highway projects

Source:  Ministry of Transport, derived from New Zealand Transport Authority data

Investments in education and skills are also critical to reducing constraints on the capacity of the economy to support high levels of domestic demand. The next section turns to some of the challenges in equipping New Zealanders to succeed in an increasingly global economy.

4 Helping all New Zealanders play their part#

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Last, but not least, our third strategic challenge is about enabling all New Zealanders to reach their potential and play a meaningful role in the economy and society. The state sector has an important role to play in helping all New Zealanders to play their part in New Zealand’s future: access to quality government services can have a lasting impact on people’s economic and social outcomes.

Quality public services have long-lasting impacts on living standards

A focus on economic and social participation#

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The Treasury's focus is on enabling people to participate - or find their role in - the economy and society. While the distribution of income at a point in time does matter, low income is most likely to lead to poor outcomes if it is persistent and associated with material deprivation. Employment and educational opportunities, as well as access to quality public services, are what really matter to peoples’ long-term outcomes.

The Treasury supports a primary focus of policy on removing the barriers and increasing the opportunities for people, especially for people experiencing hardship. In particular, it implies a focus on work, education, and supportive social services, as well as income protection:

• New Zealand needs a labour market and welfare system that helps people move between jobs, occupations and sectors to take up opportunities in new and growing firms and sectors.
• The education system is the key opportunity for young people and in providing the strong general skills that equip people for a changing job market.
• But it is also important to maintain an adequate safety net that provides support for people who are temporarily between jobs or are unable to work for extended periods.
• Other social services, such as health and housing, also have a critical role to play in improving living standards and supporting economic and social participation.

Employment is a key opportunity for adults#

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The New Zealand people and labour market have become more resilient. New Zealand's labour market has delivered a relatively low unemployment rate since the mid-1990s. It has provided jobs for an increasing number of New Zealanders wanting to work. And it has been able to adapt to a number of global changes, such as changing markets for our exports and imports, changing consumer demand, technological changes and increasing competition from emerging economies. For example, while these was a gradual decline in manufacturing employment between 1989 and 2012, overall employment continued to grow as new jobs were created in other sectors (Carroll, 2013). The increased resilience of the labour market is important in preventing people getting stuck between jobs and becoming disconnected from the labour market.

While New Zealand's overall employment rates are high, some groups are still under-represented in employment. These include those with no or low qualifications, Māori, the disabled and solo parents. New Zealand is particularly unusual in terms of the high proportion of our children in sole parent households and our low employment rates for solo mothers. In many OECD countries solo mothers have similar or higher employment rates than partnered mothers. However, solo mothers have significantly lower employment rates than partnered mothers in New Zealand (see Figure 16).

These employment patterns matter because paid work is an important route out of poverty and low incomes. Unsurprisingly, around two in three (63%) of the children in low income households are in households where the main source of income is a welfare payment (Perry, 2014). These families often face multiple barriers to moving into work, including low parental education, health and housing issues. However, overcoming these barriers can bring wider personal and social benefits to the parents, their children and the community. These include the long-term economic, social and fiscal costs from the related impacts of joblessness, like crime or anti-social behaviour, and poor housing, health, and educational achievement.

Figure 16: Employment rates for different groups of mothers

Source:  Statistics New Zealand (2006 census)

As the pace of economic change continues to intensify, there will be even more pressure on the state sector to support people to cope with change. This will be particularly the case as the combining forces of globalisation and technology continue to increase the pace of change in our economy. There is a debate about the degree to which employment protection, minimum wages and support for some industries and sectors are levers that should be used to try and insulate people from these changes. However, given that employment opportunities will continue to evolve in an increasingly dynamic economy, our focus is more on supporting people to be adaptable, flexible and resilient.

Therefore, the Treasury supports the increasing focus of the welfare system towards investing in those people who, without support, are most likely to be on benefits long-term. Policies that assist people to move out of long-term dependence on welfare and participate in the labour market are likely to improve outcomes for the most disadvantaged, including the most disadvantaged children, as well as enhance economic growth (The Treasury, 2013c and The Treasury, 2013e).

Education is critical to lifelong outcomes#

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An education system that supports children to overcome disadvantage and enables all students to achieve is the best way to improve long-term outcomes across generations. Individuals with higher levels of education tend to have higher incomes, a lower risk of unemployment (see Figure 17), and do better on a range of health and other outcomes.

Figure 17: Educational attainment and unemployment rate
Average over 2013

Source:  Statistics New Zealand (Household Labour Force Survey)

Educational achievement is also linked to higher levels of economic growth. This is partly because higher income countries can afford to spend more on education. However, there is also reasonably strong evidence that higher levels of education support economic performance (see, for example, OECD, 2010).

A child's educational achievement is driven by many factors beyond the education system. This includes their own ability; the family environment, including attitudes to education and the provision of learning opportunities, such as reading at home; and the community environment. Indeed one of the most important influences on a child’s education achievement appears to be their parents’ education level (The Treasury, 2012c).

However, the educational system does matter for learning outcomes. New Zealand’s universal education system, with national curriculum, provides access to high-quality education for most New Zealanders. But while New Zealand’s educational system performs well overall relative to other OECD countries, there remain challenges across all its levels.

There has been significant recent academic and policy focus on the importance of the early years in preparing children for school. Literacy and numeracy at entry to school are strong predictors of later outcomes because they provide the foundation for school achievement. Prolonged material and social disadvantage in the early years has a critical impact on children’s early development and school readiness, which can have ongoing and long-term negative effects that extend into adulthood. The children who are most at risk of the worst outcomes come from backgrounds with a range of disadvantages, such as families with lower incomes, less education, lower employment and increased levels of stress and anxiety.

Intensive and high quality early childhood education for the most disadvantaged children can significantly improve educational outcomes, particularly when combined with support for positive parenting approaches. In New Zealand, participation rates are lower for children from families with lower socioeconomic status (see Figure 18), and the quality of services is mixed. There is significant evidence that increasing the participation of children from low socio-economic backgrounds in high-quality early childhood education will help to improve educational outcomes for this group who tend to perform less well at school (The Treasury, 2013c).

Figure 18: Prior participation in early childhood education of children starting school
Average of participation rate over 2013

Note: This chart shows the proportion of children who regularly attended early childhood education in the six months prior to starting school.
Source:  www.educationcounts.govt.nz/statistics/ece2/participation

Effective early childhood interventions need to be followed and reinforced by an effective schooling system, with an emphasis on high quality teaching. On the whole, New Zealand children and young people perform relatively well in international tests of literacy and numeracy skills, although New Zealand has recently lost some ground in international rankings (OECD, 2013c).

While the system works well for many New Zealanders - it does not work for everyone. More than one in five young people have not achieved NCEA 2 by the time they are 18 years old (see Figure 19). In particular, around 40% of young Māori and around 30% of young Pacific people do not achieve NCEA 2. These ethnic disparities are interlinked with poorer educational achievement of lower socio-economic groups. A higher percentage of the variation in student performance in New Zealand appears to be explained by parents’ socioeconomic status than for the OECD as a whole (The Treasury, 2013e).

A wide range of factors can contribute to student under-achievement, but there is strong evidence that the quality of teaching is key to unlocking student potential (The Treasury, 2012c). This implies a focus on ensuring consistently high quality teaching in all classrooms; use of formative assessment for early identification of children who are falling behind; and effective interventions to address learning and other needs. While lifting teacher quality can improve education for all, we need a particular focus on the most disadvantaged schools and students.

Figure 19: Percent of 18-year-olds achieving NCEA Level 2 or higher by ethnicity in 2012

Source: 

While the compulsory education system provides a critical foundation for participation in the workforce and economy, the tertiary system provides individuals with occupational, industry-specific, and more advanced qualifications. The tertiary education system is a supplier of the skills the economy needs. People with tertiary qualifications are more likely to be employed and more likely to have higher earnings.

There have been significant increases in the proportion of the workforce with post-school qualifications (including university and vocational qualifications), from around 40% in the mid-1980s to around 60% now. In addition, the proportion of Māori with a bachelors or higher qualification has increased from 4.5% in 2002 to 7.9% in 2012 (Ministry of Education, 2013), with many more highly-skilled Māori entering the labour force each year. This will bring greater diversity to key New Zealand institutions and in turn help strengthen those institutions.

However, New Zealand returns from education vary widely by level, subject, provider, and student group. They also appear low by international standards (see Figure 20). In addition, a number of employers cite soft skills (such as job readiness) and technical skills as issues for recruitment or with existing staff (Stevens, 2012). Going forward the tertiary education system must be equipped to invest in high-value areas.

Figure 20: Earnings from tertiary qualifications
Difference in earnings for someone with a sub-degree and degree or higher qualification relative to an upper secondary education

Source:  OECD (2013d)

The skills system will also need to respond to longer-term trends. Big changes in the global and domestic economy are radically changing the nature of work. The ‘great doubling’ of global labour supply from an emerging Asia, combined with technological change, is continuing to reduce low-skilled job opportunities while increasing opportunities for those with high skills. In the face of these long-term trends, New Zealand will increasingly rely on skilled people to ensure our economy is productive, competitive and innovative. This makes education all the more important.

A safety net to catch New Zealanders in need#

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There will always be some people for whom work and education are not appropriate goals, including the seriously ill and the severely disabled. A well-designed safety net is the most-targeted approach to ensure these people have adequate incomes. Welfare payments can reduce the incentives on others to seek work or education, so it is important that it is complemented by support and encouragement for people to move into and sustain paid work.

Social welfare payments are only part of the total support the government provides. For many households, ‘in-kind’ services (such as schools and hospitals) are a significant part of this support. Over the past decade, the level of total government support has risen for all households (primarily as a result of increased expenditure on education, health and superannuation). Because this increase was relatively untargeted, the overall effect was that social services provided to households in the top half of the income distribution rose almost 20% more than for those in the bottom half (see Figure 21).

Figure 21: Average cost of social services (education, health, social welfare) by household

Source:  The Treasury, Statistics New Zealand

Social services that New Zealanders value#

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The state sector provides a number of services that New Zealanders value. This section explores issues in health and housing, given that they are both important for living standards and can support or hinder economic and social participation.

Health services have a significant impact on living standards and wellbeing. Studies suggest that substantive or persistent health problems have more than twice the negative impact on peoples’ life satisfication than halving their income would. Health can also impact on economic and social participation, such as whether and how much people work, and on productivity (Holt, 2010).

New Zealand performs reasonably well compared with other developed economies in terms of the value for money and efficiency of its health system. New Zealand spends less on health per person than the OECD average, although we do spend more as a percentage of GDP, reflecting New Zealand’s lower per capita income. Despite relatively low per-person spending, New Zealanders enjoy health outcomes comparable with those of other developed economies. For example, potential years of life lost measures deaths that should have been preventable given effective and timely healthcare.[14] New Zealand has seen similar significant falls in this measure of preventable deaths as other OECD countries over the past 50 years (see Figure 22).

Figure 22: Potential years of life lost
Per 100,000 population aged 0-69 years

Source:  OECD Health Data 2013

However, there are some areas where New Zealand's health system performs less well. For example, rates of some infectious disease are high in New Zealand compared with other developed countries and seem to be increasing. There is also evidence of disparities in health between ethnic groups and that unmet need is higher for those on low incomes. The demands on the system are also changing, with chronic and long-term conditions increasingly important as a source of morbidity.

Health will also become an increasing share of government spending as an ageing population, rising incomes and improved technology push up demand for health care (see Figure 23). In light of these pressures it is critical to continue to look at ways to drive improved productivity and value for money in health service delivery, while maintaining and improving the quality of care provided.

The health system is only one factor driving health outcomes. One example is the inter-linkages between health and housing. In particular, well-maintained housing can improve health outcomes by reducing accidents in the home and some types of illnesses, particularly respiratory illnesses in children (Weinmayr, Gehring, Genuneit, Büchele, Kleiner, Siebers, Wickens, Crane, Brunekreef and Strachan, 2013).

Figure 23: Projected public healthcare spending Percent of GDP

Source:  The Treasury

Well-maintained housing can also contribute to better educational and other outcomes. For example, a warm and quiet place to do homework is important to a child’s ability to concentrate (James and Saville-Smith, 2010). And the provision of adequate housing in the right places is key to enabling people to access employment opportunities. Suitable and well-maintained properties can also help to maintain community cohesion and commitment to continued care for the local physical and natural environment (Department of Internal Affairs, 2011).

Housing affordability is also important for New Zealanders' living standards, given the New Zealand aspiration to own our own home. Rising house prices challenge this aspiration for home ownership as increasing amounts of income are spent on servicing property costs. New Zealanders spend the highest proportion of their income on housing costs after Greece in the OECD (OECD, 2013a).

As well as the provision of financial assistance for housing costs, provision of government-supported housing is essential for some households who face multiple disadvantages in the housing market. The state currently houses 69,000 households in state housing, including some of the most disadvantaged groups in society. However, housing need is usually a symptom of a larger problem facing a household, such as health or employment challenges. Focusing on housing alone can miss the opportunity to tackle the bigger underlying challenges facing individuals. Joining up public services could have significant benefits for tenants, with evidence from the United States pointing to particular benefits for drug and alcohol treatment (United States Department of Human and Health Services, 2005).

The state sector is learning to work differently#

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Given that long-term economic and social outcomes are increasingly inter-connected, the state sector is learning to work more effectively across agencies and sectors. The public sector reforms of the 1980s were bold and world leading. They allowed the public sector to work in new ways that improved efficiency and service. The public sector needs to hold onto these gains but also focus more directly on results or outcomes. The state sector needs to prioritise, concentrate on the right outcomes and work collectively to use resources better and deliver results.

Delivering results is about making sure the state sector is focusing on the right things that will make a difference to New Zealanders' living standards. It is important that the policy advice that informs government’s decisions and priorities is backed up by solid evidence and quality analysis. And once a transfer, service, investment, or regulation is put in place, our job is not done. The state sector needs to be more systematically evaluating whether a policy is having the impact we thought it would on economic, social and environmental outcomes, as well as whether it is delivering value for money. This focus on long-term outcomes and evaluation are key principles behind the increasing focus of the welfare system on investing in people to support them into work. While it is likely to be applied in different ways, the basic principles of this approach have significant potential for improving outcomes across a number of policy areas and population groups (see Box 9).

It is also about continually looking for new - more innovative - ways of working or delivering services. State sector leadership is becoming much more oriented to the need to deliver improvements in living standards over the medium-term, and to encourage more innovation and collaboration to address underlying causes. For example, the Department of Corrections has partnered with Housing New Zealand to refurbish a minimum of 150 houses over the next five years which will also provide offenders with skills to contribute to the Canterbury rebuild. And the Ministry of Education has been working with the New Zealand Rugby League to promote and champion participation in early childhood education.

Diversity of ideas and contestability of advice is also vital to facilitating innovation. We need to harness all the passion and creativity of the public, private and voluntary sectors to find better ways of delivering on the results that matter most to New Zealanders. As an important example, there are opportunities to work differently with Māori organisations to deliver across education, employment, whānau and health outcomes. Māori organisations are increasingly looking to partner with government to deliver services and this provides an opportunity for greater innovation and improved outcomes. While this is particularly important for hard to reach groups, there are also opportunities for public services more generally.

Lifting performance matters as the state sector has an important role to play in helping New Zealanders to achieve their potential. The education and other social services it provides are an important part of this challenge, including supporting the most disadvantaged New Zealanders to participate in the economy and society. However, its contribution to tackling our first two challenges is closely inter-linked. As well as access to government services, a well-performing economy and strong employment rates have long-lasting impacts on New Zealanders’ living standards.

Concluding message#

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This paper is a reflection of how the Treasury's strategic thinking on economic performance is evolving to include the wider elements of living standards. Unquestionably, growth and income matter for economic performance. But they are not the only things that matter. Instead, in this paper we have explored economic performance from the dimensions of prosperity, sustainability and inclusiveness.

Our analysis has identified a key strategic challenge in each of these dimensions:

• For increasing our prosperity, it is connecting internationally.
• For improving sustainability, it is moving towards export and investment-led growth.
• For ensuring inclusive economic performance, it is enabling all New Zealanders to participate in the economy and society.

We recognise that these challenges are not necessarily new, and that they are not short term. We also recognise the considerable progress made, both past and present, to address these challenges. We recognise, too, that as much as these are challenges, they also represent opportunities for Aotearoa New Zealand to lift its medium-term economic performance and living standards.

Ma tini ma mano ka rapa te whai.

By many, by thousands, the work will be accomplished.

Gabriel Makhlouf
Secretary to the Treasury

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