Brian Fallow: Aussies play winning game off the field

You can put up with a lot of Aussie skiting about sport for an extra $175 a week in the hand.

The gap between Australian and New Zealand incomes is a standing challenge to the economy, especially in the context of a common labour market between the two countries.

One consequence is that the flow of permanent and long-term migrants between the two countries is in Australia's favour to the tune of just over 20,000 people a year.

Underlying the gap in incomes - about $9000 a year on average after tax - is a gap in labour productivity.

New Zealand workers' output per hour is only about 77 per cent of their Australian counterparts' and the gap is widening.

Research by Treasury economists Julia Hall and Grant Scobie shows that the gap largely reflects New Zealand's relative "capital shallowness" - on average each worker has less physical capital (plant and machinery) to work with.

Between 1990 to 2002 the amount of capital per hour worked grew very modestly in New Zealand, in contrast to Australia where it increased by about 25 per cent.

"In 1978 New Zealand and Australia had about the same amount of capital per hour worked. By 2002 capital intensity in Australia was about 50 per cent greater than in New Zealand."

Why the difference? Well it is not that returns on capital are lower here. Hall and Scobie found that the return on capital in New Zealand has been growing and by 2002 exceeded the level in the OECD generally and Australia in particular by 15 to 20 per cent.

Another way of putting that is that the cost of capital is higher, while the cost of labour is lower.

So New Zealand's lower capital-to-labour ratio looks like a matter of relative prices.

"In New Zealand the price of labour relative to Australia was very comparable in the late 1980s. By 2002 it had fallen to about 60 per cent of the level in Australia.

"With labour relatively cheaper in relation to capital than in Australia it appears New Zealand firms have opted for a lower level of capital intensity," Hall and Scobie say.

Since the passage of the Employment Contracts Act in 1991 New Zealand's labour market has been significantly more flexible than Australia's, delivering the job-rich growth that has seen the unemployment rate fall from over 11 per cent to under 4 per cent.

Australia's more rigid labour market, combined with a lower cost of capital, has encouraged employers, where it is possible to substitute capital for labour and its growth has been marked by higher levels of business investment, higher productivity, higher incomes - and a higher unemployment rate.

Our growth has been a matter of more hands to the pump. Theirs a matter of investing in a more efficient pump.

The problem with the New Zealand recipe for growth is that the key ingredient, labour, is in increasingly short supply. This shortage is not just acute it is chronic.

A cyclical economic slowdown has been under way for a year, but the unemployment rate at 3.9 per cent is still the second-lowest in the OECD after Korea's. Another couple of years of below-trend growth of 2 per cent or so is only expected to see the unemployment rate rise to something under 5 per cent.

On a medium or long-term view the underlying supply and demand picture for the labour market looks challenging.

Statistics New Zealand's projections for growth in the labour force show the supply of workers dwindling to zero over the next 20 years, as a modest net inflow of migrants makes little impression on the effects of an ageing population.

On the demand side, there is the prospect of more intense competition from Australia. Its unemployment rate has also fallen to 5 per cent, the lowest in nearly 30 years. With the Liberals controlling the Senate, further deregulation of the Australian labour market is expected.

And with their labour productivity nearly a third higher and growing about 1 per cent per annum faster than ours, the gap in incomes is unlikely to close any time soon. The implications of this seem clear.

The buyer's market in labour which existed in the 1990s, made possible by the spike in unemployment that followed the economic reforms, has given way to a seller's market.

Skilled labour shortages are not a temporary cyclical phenomenon, but are likely to be a permanent feature of the business landscape.

Relying on the ability to poach qualified staff is perilous. In-house training looks like a better strategy. There are no longer plenty more fish in the sea.

So far businesses seem to be responding as they should, by lifting their investment in plant and machinery.

Business investment increased by nearly 20 per cent last year.

The Institute of Economic Research's quarterly survey of business opinion, published on Tuesday, found that a majority of firms intend to invest more in plant and machinery over the year ahead than they did last year, despite a weakening economy and a squeeze on profitability.

The level of positive responses to that question, while down on the March and December surveys, remain high relative to the average over the past 10 years, suggesting the current strong investment cycle has still got some way to run.

Cycle. There's the rub.

How much of this surge in capital expenditure is just the cyclical response to the capacity contrasts and strong corporate balance sheets arising from three years of above average economic growth?

Will it, in short, peter out? Or are we seeing a step increase to a continuing higher more Australian level of capital intensity?

A crucial challenge for the next Government, whoever that may be, is to identify and remove impediments to capital formation, be it tax, the regulatory environment or infrastructure.

Otherwise those airport departure lounges are only going to get more crowded.