Research Discussion Paper – RDP 2023-03 Doing Less, with Less: Capital Misallocation, Investment and the Productivity Slowdown in Australia

Productivity growth has slowed in Australia in recent decades. Previous research highlighted the roles of persistently weak non-mining investment and a pervasive decline in economic dynamism, including slower reallocation of labour from low- to high-productivity firms. While these facts have so far been considered separately, this paper attempts to connect them by documenting investment patterns for firms with different levels of productivity. We find that more productive firms are more likely to invest and expand their capital stock than less productive firms, but the extent to which this is true has declined over time. This has weighed on productivity, output and incomes through lower aggregate investment, and also through a less efficient allocation of that investment. We find evidence that capital reallocation slowed more in sectors that were more dependent on external finance, pointing to financing frictions as potentially playing a role. Declines have also been more pronounced in sectors with increasing mark-ups, suggesting that weaker competition may have blunted incentives for firms to expand and improve or exit.