My aim today is to describe the policy direction we will need to take to lay the groundwork for a steady growth in our children's economic prosperity and wellbeing: not just for this electoral cycle, or even the next one, but for the decades to come.
The Intergenerational Report (IGR) provides a useful framework for thinking strategically about the medium to long-term challenges to continued good economic performance.
I will use the 40-year horizon and the modelling behind the Report1 to illustrate some of the slow but powerful forces at work on our economy.
So far most attention arising from the IGR has focussed on the cost pressure on expenditure over the forthcoming decades. Today I would like to turn to the other side: the growth of GDP over the next 40 years.
Gross Domestic Product (GDP) measures the production of goods and services in an economy. Countries with a larger population naturally produce more goods and services and have a larger GDP. This does not mean they have larger GDP per person. The common international measure of the wealth of a country is GDP per capita. This adjusts for population size.
As the size of GDP increases, on a fixed tax base, the level of resources for social services increases. Of course as population rises, the draw down on social services increases too. But on a fixed tax base, a higher GDP per capita yields a higher per capita revenue for better social services.
The higher the average GDP per capita in a society, the higher is the average living standard.
I am not going to address distributional questions in this speech, nor am I going to address the formation of social capital - a subject I have addressed on other occasions. Today I am going to focus on factors that promote economic growth.
The reason why countries around the world pursue higher GDP per capita is that they want better living standards for their people.
Far-sighted economic policies, enacted in good time, can make potent differences over decades, and dynamic and flexible economies can adjust very quickly to unforeseen shocks or other challenges.
I am going to frame the law of the 3 "Ps" for today's talk. These are the three factors that contribute to GDP growth. They are population - in particular, working age population; participation; and productivity.
Population
A larger population will produce a larger GDP. But even with a constant population, if a larger proportion of that population is of working age, all other things being equal, this will lead to a larger GDP because a larger part of the population is engaged in work.
What is more, a larger proportion of people of working age means the ratio of dependants to workers is lower, and GDP per capita is higher. Dependants can be either young (children not yet in the workforce) or old (those retired from the workforce).
This is the point that the IGR has recently focussed a lot of attention on. Over the next 40 years, the ratio of dependants to workers will rise as there will be more dependants in the retired bracket and a constant number of workers. Another way of expressing this point is the age dependancy ratio will increase. This means that population factors will detract from GDP per capita on average over the next 40 years.
Participation
Participation looks at the contribution of those of working age to GDP.
This first component, I have called the participation rate. This is the proportion [of those of working age] who want to work in the paid workforce.
The next component is the unemployment rate. Not all of those who want to work can find work. A high unemployment rate lowers participation in the workforce.
The next component is the average hours worked by those of working age, who want to work, and can find it. The higher the average hours, the higher the contribution to GDP.
Productivity
Productivity measures the output produced by an average hour of work. Working the same hours, a person can increase their output - that is, be more productive. This can come about through capital deepening (a man on a backhoe can dig more than a man with a shovel) or through other means - multifactor productivity.
Components of average annual GDP growth over the last 40 years
Over the last 40 years, Australia's annual average GDP growth was 3¾ per cent - 2 percentage points came from the two population factors, and 2 percentage points from productivity factors.
However, participation factors subtracted around ¼ percentage point from growth. This is the result of higher unemployment which has varied over the last 40 years but is still higher today than it was in the early 60s. Participation also subtracted from growth because on average today we work less hours than we did 40 years ago. Hours reduced from around 39 hours per week in the 1960s to around 34½ in the 1980s and are still around that mark today.
Productivity contributions were strong in the 1960s and in the latter part of the 1990s. These were two golden ages for productivity.
And the fiscal tax and structural reforms of the late 1990s have given us a strong base continuing into the 2000s.
Labor made some good reforms in the mid 80s which were supported by the Coalition which was then in Opposition. The difficulty for the future is that there is now no bipartisan commitment for productivity improvements - Labor has decided to adopt a populist and oppositionist approach since losing office.
This is a problem if Labor is successful in using the Senate to block productivity improvements. In the past, we had demographic developments working for us. Now they are working against us.
Population factors will detract from growth over the next 40 years. This is because the proportion of the population of working age will decline. The ratio of dependants to workers will rise. This is the consequence of lower fertility rates from the 1970s on. This is no new development. The fertility rate has been below replacement levels for 30 years. The damage has already been done.
Participation factors will also weaken GDP growth because, as more of the population moves into the upper sections of working age, they participate less in the workforce.
The Intergenerational Report assumed productivity growth would fall back to the 1¾ per cent average of the past 30 years, not the 2.2 per cent of the late 90s.
If the poor productivity growth of the 1980s (1.2 per cent) were repeated then IGR modelling suggests average annual GDP growth would be only 1¾ per cent, and growth in GDP per person would decline from 2¼ per cent to about 1 per cent.
Let me now turn to some policy issues that might influence, in a positive way, the three factors that determine GDP growth.
Population
There may be reasons to build population, such as defence or security reasons, but building population itself does not build GDP per capita.
Building a higher proportion of working age increases GDP per capita. A lot of attention has focussed recently on fertility rates as a way of rebuilding the working age population and decreasing the ratio of dependants to workers.
Let me make some brief points.
- Over the last 30-40 years fertility rates have fallen in all advanced industrial societies and none of them has had success at a major turnaround.
- Boosting fertility rates actually reduces the proportion of the population of working age at least for a generation. It increases the dependant to worker ratio with a higher number of children. It has a negative effect for around 30 years before you get the pay off.
- Boosting fertility rates may well reduce participation rates because mothers stay out of the workforce if only for a time. What this means is that in the near term there are two factors likely to reduce GDP before the pay-off after a generation.
- If boosting the fertility rate is done by additional expenditures, it could have a negative effect if it required higher tax rates, or crowded out better alternative uses of public expenditures.
Whilst the IGR has kicked off a great deal of interest in fertility rates, with maternity leave, divorce rates, abortion law changes, tax incentives to opt out of no-fault divorce all being raised, I would like to focus the debate on something that might actually have an achievable and practical effect. A positive development would be to encourage greater workforce participation by Australians in the 55-65 year old age bracket. I will come to this later.
Migration has a positive effect on the population factors, if it is skilled migration focussed on those of working age.
To attract skilled migrants, keep skilled Australians, and encourage internationally skilled Australians to return to Australia at some point, we need to make this an attractive place to work and live, including a competitive tax structure. This is where new expenditures designed to increase population factors could actually become counter-productive if they make our tax structure less competitive.
Increasing participation
Participation factors are vital.
Importantly for tomorrow's policy choices, participation factors can be more readily influenced by governments and private sector employers than fertility rates. Any increases in participation contribute directly to increasing GDP per person.
Over the last 40 years, Australia's participation performance detracted from our GDP growth and living standards. By contrast, these factors added around ½ percent a year to GDP growth in the United States. Unlike Australia, American unemployment did not increase and average hours did not decline. If Australia had had US participation trends over the last 40 years, we could have been around one third again better off today in per capita GDP, and would have moved from the ranks of the OECD's second richest group of economies into the richest group.
Of course, Australians might reasonably choose to work less than, and differently from, the Americans. And Australians may prefer to trade off income for better quality of life.
However, if participation decisions are unintentionally distorted, we have cause for concern.
For example, I believe several factors other than individual choices about participation have tended to hold participation rates undesirably low, such as rigid labour market and management practices that restricted flexible work; excessively high unemployment brought on by recession; high marginal tax rates that discouraged effort; insufficient incentive to move off welfare payments into work; and insufficient rewards in the wage structure for education and training.
I would tend to favour those policies which maximise workplace flexibility and individual and family choice, while avoiding unnecessary government spending and taxing.
Better participation in the older brackets
The decline in participation projected in the IGR is also driven by the fact that many Australians seem to stop work shortly after they turn 55.
Males aged 45-55 have a participation rate of around 87 per cent, between 55-60 it is 70 per cent, and for males aged 60-65 it is 47 per cent. As our population ages, an increasing proportion of those of working age are going to be in lower participation cohorts.
Higher participation among the over 55s will have a much more immediate and direct impact than rising fertility rates. More flexible working arrangements, training and re-training, and raising the preservation age for superannuation would all be positive moves to address this issue.
...And the vital role of productivity growth
Productivity factors are also vital.
As with participation factors, we can significantly influence our future productivity performance.
Lifting productivity growth requires continuing attention to fiscal policy, low and stable inflation and low interest rates, which facilitate investment and the roll-out of new technologies.
It also requires flexible, efficient goods and labour markets and strong competition, which encourage management and workers to find better ways to work, not only with the flow of new investment, but also with the much larger stock of existing investment.
High productivity growth requires good education and training, and programs to encourage innovation such as Backing Australia's Ability.
It requires not just higher productivity within existing companies, but also the movement of resources away from less productive and profitable firms to more productive and profitable firms.
This resource re-allocation occurs through strong competition. But in addition it demands good corporate governance, so that shareholders can make their investment decisions on the basis of valid information - not management misinformation, poor accounting or inadequate auditing.
- Accountability of management, transparency of financial and other information and the protection of shareholders' rights are the fundamental pillars of the Australian corporate governance framework.
- It is possible to place too much reliance on prescriptive black letter law to solve corporate governance problems. Black letter `tick a box' approaches have limited use when addressing very complex issues. It is not possible to draft rules that will apply sensibly in every conceivable situation.
- The law needs to be enforced by the regulator ASIC, but backed up by the hierarchy of those responsible in a company in this order: Executives, Directors, Auditors, Investors - particularly Fund Managers.
Effective regulation is - and should be seen as - a plus for business. If you want investors to enter the waters, you had better make sure there are some good shark-proof fences to protect them.
The purpose of a corporation is to engage in an economic enterprise. It does this best in an environment that engenders confidence with clear rules of accountability and enforcement when they are contravened. Regulation does not exist for its own sake but as a necessary precondition for the economic enterprise. This is why we have named our programme in this area the Corporate Law Economic Reform Programme (CLERP).
The shakeout on world markets arising from poor corporate governance at present illustrates how poor governance has an immediate effect on companies and can feed back into the wider economy through confidence effects, effects on net wealth and consumer spending, and business investment.
Because Australia avoided the worst of the excesses, and the worst of the irrational exuberance, our corrections have been less severe. We have not been immune from our own corporate failures but they are nothing of the dimension of those on Wall Street at present.
World markets are in for a rocky ride. Australia, as one of the strongest growing economies in the developed world, will go into this period better placed than most others. And our regulatory systems, while not perfect, are better than most others.
But we have positioned the economy well on the basis of past reform that has boosted productivity. I have tried to show today that with population factors not working our way in the future (a feature that is common to the rest of the developed world) productivity improvements are more important now than ever. And we cannot retire from the important work of economic reform.