By Ross Gittins
AUSTRALIA'S economic growth is set to slow in coming years because of a sluggish increase in the population of working age.
So how much scope is there to counter this with faster productivity improvement?
Not as much as you might imagine. But Kevin Rudd's on the right track with his push for an education revolution.
That's the conclusion I draw from a study of our productivity prospects by two Treasury economists, Graeme Davis and Jyoti Rahman.
Productivity means output per unit of input. The productivity of labour is the quantity of goods and services produced during a period divided by the total hours of labour needed to do the producing. That is, gross domestic product per hour worked.
Improved productivity is the key driver of economic growth. It's the dominant reason our material standard of living is so much higher today than it was 20, 50 or 100 years ago.
So what's the fastest rate of productivity improvement we can reasonably aim to achieve?
Economists commonly attempt to answer such a question by focusing on the "global technological frontier". This is the economy that has the highest level of productivity in the world because each of its industries is at world's best practice with state-of-the-art technology.
Such a perfect economy doesn't exist, but the one that comes close is the United States. It's a big, rich economy with a lot of physical capital for its workers to use and a highly educated workforce. It invents much of the world's new technology and, what it doesn't, it quickly latches onto.
So, when you think about it, our productivity improvement can come from two sources: by closing any gap by which our level of productivity falls short of America's and then by adopting new American technology as quickly as possible - that is, by moving out with the technological frontier.
Australia's rate of improvement in productivity was weak in the 1980s, grew rapidly in the '90s but has fallen off again in the noughties. Davis and Rahman estimate this rate of improvement has left us with a level of productivity that's only 80 to 85 per cent of America's level.
The point is that although in the long term we can't expect to achieve faster productivity growth than that of the economy at the technological frontier, in the short to medium term we can improve our productivity at a faster rate than the Yanks while we catch up with them at the frontier.
And, since a lot of other developed economies have a much smaller productivity gap with the US than we do, the conventional wisdom among Australian economists is that we have plenty of scope for faster productivity growth than the Yanks.
But Davis and Rahman's study implies there's less scope for catch-up than widely assumed.
They seek to explain the size of our gap by looking at differences between us and the US in capital per worker, educational attainment, micro-economic policies and the "geographic and historical context in which the two economies operate".
It seems clear we have a lower ratio of capital to labour than the Americans - that is, our workers are given less equipment and other physical capital to work with, on average - which obviously limits our workers' productivity.
One study has estimated that this difference in capital per worker may account for about a quarter of the productivity gap.
It doesn't necessarily follow, however, that we could reduce the gap by a quarter merely by investing in a lot more physical capital.
Why not? Because the different nature of Australian production and conditions may mean Australian firms have good reasons for using production techniques that are less capital-intensive than their American counterparts.
Next is human capital - the skills and knowledge of our workers. This is very hard to measure, but one (imperfect) measure is the average years of schooling of the working-age population. Our average is about half a year lower than the Americans' and this is of long standing.
Among people born in the 1940s, five in six Americans have at least an upper secondary qualification compared with fewer than half Australians.
Thankfully, the gap is much narrower among people born in the '70s and '80s, so it's in the process of closing.
Had we started earlier, the productivity gap might now be about 2 percentage points narrower.
Next, the effect of government policies. Here, of course, we've already made many micro reforms - and seen the results reflected in the strong productivity growth of the 1990s, with a consequent narrowing of the productivity gap.
Along with Britain, Australia's regulation of the markets for particular products is the least restrictive among OECD countries. So further reforms would narrow the productivity gap by only a small amount.
America was judged in 2003 to have the least restrictive employment-protection legislation among 28 OECD countries. But, even then, we were the sixth least protective, so the sweeping measures in WorkChoices may not reduce the gap by much - say, by 1 to 2 percentage points.
But now we come to the role of geography and history in explaining the productivity gap. Research suggests that being an island or being remote limits a country's productivity and one study implies that, if we had land borders with some significant trading partners, our productivity gap could be nearly 6 percentage points narrower.
Our population is concentrated in a few large cities situated hundreds of kilometres apart, whereas US cities are much closer to each other. This reduces our benefit from economies of scale, intensity of competition and low transport costs.
According to another study (which shouldn't be added to the one I've just quoted) our remoteness can possibly explain more than two-fifths of our productivity gap.
The point is that we can't do much to change our geography or our history. So Davis and Rahman conclude that only about half our 15 to 20 percentage point productivity gap is capable of being reduced by such measures as better education of workers, continued vigour in competition policy and improvements in the functioning of the labour market.
They assume that US productivity will continue growing by 1.6 per cent a year, on average, so that if we were to aim for an average improvement of 1.75 per cent - as was assumed in the Intergenerational Report of 2002 - this implies a narrowing of the productivity gap of 5 percentage points by the mid-2040s.
Doesn't sound much, but it would require a fair bit of effort.