Productivity and the wage gap

Why are people in Australia paid more than people in New Zealand? The traditional answer from the right is that the former are taxed less, and therefore we should cut taxes on the rich to allow our living standards to catch up (this ignores the facts that there's no proven link between tax rates and economic growth, and Australians are actually taxed more at the top end anyway). The traditional answer from the left has been that it is a wage issue, not a tax issue, and that it is ultimately rooted in poorer comparative productivity growth due to low capital investment.

The latest report [PDF] from the Centre for Independent Studies - a right-wing think-tank whose usual job is to provide props for further demands for tax cuts - shows that the left have won the argument. According to the CIS,

The big difference between the countries is labour productivity. Australian workers produce a third more wealth for every hour worked, largely because they have more capital (machinery and technology) to work with.

But while they've finally recognised the key problem, the CIS loses it when looking for explanations:

New Zealand firms have invested less in capital than their Australian counterparts, but not because of a lack of savings or finance. Instead, the major challenge for New Zealand seems to be a lack of profitable investment opportunities.

Government policy has a major role to play in creating a healthy environment for growth and investment. International surveys show little difference between the two countries in terms of red tape and regulation, but the direction of policy is just as important as the static picture. Ad hoc government interference in areas such as energy, telecommunications, and asset sales has greatly increased investor uncertainty in New Zealand.

Tax is a major area of difference between the two countries. Australia is a much lower taxing country, especially in terms of income tax. This affects incentives to work, save, and invest.

If that all seems a bit random, it's because it is. Their answer in the Herald is just as unilluminating:

"There's obviously something there, some anomaly that's holding back investment," Centre for Independent Studies policy analyst Phil Rennie said yesterday.

"I've tried to find evidence for other reasons, but the strongest case for me still seems to be Government policy."

So, it's the Evil Gummint. They're not sure how or why, but it must be them, because they are the source of all problems - which can be cured with the usual "solution" of tax cuts, tax cuts, and tax cuts. If I had paid for this report, I'd be wanting my money back.

Perhaps some empirical data will enlighten the situation. The graph below shows one measure of our labour productivity (real GDP divided by FTE workers, which is roughly hours worked, indexed to 1978):

(Source: Paul Dalziel, "New Zealand’s Economic Reforms: an assessment", Review of Political Economy, 14, 31 - 46)

As can be seen, the productivity gap long predates the current Labour government, whose policy direction so exercises the CIS (in fact, the graph doesn't even extend to cover their first year in power). In fact, while there were ups and downs, the gap really only opened up during the "reforms" (which the CIS wants us to return to), during which our productivity stagnated. So what's the explanation?

Simple: labour costs. The decision on whether to invest in productivity improvements is determined by the relative costs of capital and labour. Employers will only invest in productivity improvements if the resulting increase in output is cheaper than hiring more warm bodies. And in 1991 - when the gap opened up - the government drove the price of labour down significantly by passing the Employment Contracts Act. So, a centrepiece of the Revolution has caused our current problem. I can see why the CIS wouldn't want to think in that direction.

As for policy to narrow the gap, the obvious one is to raise the cost of labour, by engineering a labour shortage, rebalancing employment law to allow unions to push for wage increases, and hiking the minimum wage to create pressure from below. Which is exactly what the government has done.