RDP 2023-03: Doing Less, with Less: Capital Misallocation, Investment and the Productivity Slowdown in Australia 1. Introduction

Labour productivity growth is the key driver of living standards over the medium term. However, growth in labour productivity has slowed markedly over recent decades in Australia and other advanced economies. If this slower rate of growth is maintained, it will have negative implications for living standards and the budget position. It will also make it harder to conduct monetary policy, as it will mean lower potential growth and real neutral interest rates, increasing the likelihood that nominal interest rates hit the effective lower bound.

While a range of explanations for weak productivity growth have been advanced, credible accounts of the Australian productivity slowdown capture two empirical regularities.^[1] First, non-mining investment was weaker than might have been expected based on economic fundamentals over much of the 2010s (e.g. Heads of Treasuries 2017; Debelle 2017; van der Merwe et al 2018; Hambur and Jenner 2019). This low level of non-mining investment occurred despite declines in interest rates and the end of the mining investment boom which likely freed up capital for non-mining investment. With less investment, the capital stock per worker grows more slowly, and so does output per worker and therefore productivity growth.

Second, there has been a pervasive decline in economic dynamism since the mid-2000s (e.g. e61 2022). Firms and product markets have become more stagnant: firms are less likely to enter and exit, the largest firms in industries have become more entrenched, and market concentration and mark-ups have increased. And labour markets have also become less fluid: job mobility and labour reallocation rates have declined, and labour has become less likely to flow to more productive firms.^[2]

The decline in dynamism has meant that scarce labour is increasingly ‘trapped’ in lower productivity firms, lowering both labour productivity (how productively the economy uses its labour) and likely multifactor productivity (MFP; how productively it uses all resources). For example, Andrews and Hansell (2021) found that the pace at which labour is reallocated from low- to high-productivity firms has slowed since 2012, and that this can account for a quarter of the slowdown in labour productivity growth from 2012 to 2016. This slowdown in reallocation was worse in industries where competitive pressures declined (Hambur forthcoming).

To date, studies have looked at these two facts – weak investment and declining dynamism – in isolation, but they could be linked. If the economy is growing more slowly due to slower productivity growth, productive firms may not feel the need to invest as much to keep up with demand and maintain market share. Similarly, if there are frictions that prevent productive firms from expanding their workforce, they could also cause them to invest less.

As such, this paper tries to bring these two observations together to gain a greater understanding of both. In particular, it explores three questions:

1. Could the same factors that are driving slower dynamism and reallocation also be driving weaker investment?
2. Has the reallocation of capital (financial or physical) from less to more productive firms (within industries) slowed, as has been evident with labour? If so, not only is investment weak, but it is being put to less productive uses.
3. By focusing on capital reallocation and investment, can we gain additional insights into slowing economic dynamism?

To preview the results, the answer to all three questions is yes. Declines in investment, while broad based, have been more notable for the more productive firms within each industry, suggesting that whatever is inhibiting productive firms from investing is also holding back aggregate investment. Consistent with this, the reallocation of capital from less to more productive firms in an industry has slowed moderately since the mid-2000s, meaning capital has increasingly been allocated to less productive uses. A simple counterfactual exercise suggests that, had the flow of labour and capital towards more productive firms not slowed over the period since the mid-2000s, and therefore had more productive firms been larger, by 2017 the economy would have been $13 billion (or ¾ per cent of GDP) larger, equating to around $550 per person or $1,000 per worker. And this only captures one channel through which weaker capital reallocation and dynamism are likely to have affected incomes, abstracting from any effects on the size of the capital stock, or on innovation and firm-level productivity. Thus, the story of Australian capital accumulation over the past decade or so is one of ‘doing less, with less’.

As to the causes, declining competitive pressures appear to have contributed to a slower flow of investment and capital from low- to high-productivity firms, and potentially weighed on aggregate investment. This is consistent with earlier work focusing on labour reallocation (Hambur forthcoming). There is also some tentative evidence that declining competitive pressures have held back aggregate investment, with firm-level average investment declining most in industries with the largest mark-up increases. But we also find evidence that access to debt finance may have played a role in supressing investment activity amongst productive firms. This is not evident when focusing on labour, which is not surprising given investment is more likely to be financed through debt than is labour (e.g. Spaliara 2009). Our finding highlights the benefits of extending the analysis to investment in trying to understand the causes of declining economic dynamism and productivity growth. And finally, simple tests suggest that the slowdown does not reflect increasing use of intangible capital, which is often poorly measured, though we can't rule out the possibility that this has played some role.

The remainder of the paper is structured as follows. First we provide further discussion of the economic context and existing literature. In Section 3 we describe the data before outlining the baseline model and results in Section 4. In Section 5 we dig into the potential causes for the slowdown in capital reallocation. Section 6 attempts to estimate the macroeconomic effects of the slowdown, before Section 7 concludes.

Footnotes

Other explanations or empirical patterns that have been noted include: slowing diffusion of adoption and technologies (Andrews et al 2022), low levels of R&D (Kido and Kothari 2021), potentially low or mismatched skills and human capital (e.g. Productivity Commission 2022), and low management capabilities (compared to the United States; Agarwal et al (2019)). [1]

While mobility has increased somewhat post-COVID-19, this may reflect a mix of ‘payback’ for low mobility during COVID-19, alongside cyclical strength in the labour market, rather than a structural improvement. [2]