NZ is failing: we need fast, focused action to solve low productivity

New Zealand is being undermined by its poor productivity.

The population and participation levers that we have relied on for economic growth in the last 50 years, as an alternative to productivity growth, are now less effective.

On our current trajectory, it is impossible to reconcile how improved government services, budget surpluses, reduced government debt, social justice and tax cuts can all be achieved. 

Productivity growth is the only way we can match our beer incomes to our champagne tastes. However, the productivity can has been kicked down the road for so long that it's unrecognisable.

NZ is a small, remote, concession-based “endowment economy”, where our endowment comes from what our land, sea and climate allow us to produce.  

Some 80% of our exports are endowment based and comprise just 20% of our GDP. Over 160 years of democracy, we have built an economy based on concessions – special rights and obligations for firms and industries – that govern the use of our endowment.

We do the Organisation for Economic Co-operation and Development and International Monetary Fund-advised stuff – but underperform anyway. NZ’s productivity conundrum is the result of mistakenly assuming our economy is similar to other small, developed economies.

Like all economies, technology adoption, innovation, creative destruction and international connectivity are the only pathways to productivity growth. 

In our case, these pathways are most effective when applied to our endowment and the concessions governing its use. These concessions are of widely varying quality.

Groundhog Day

At the heart of NZ’s productivity conundrum lies a political conundrum. What is politically achievable that also makes a material difference? In the lifetime of most New Zealanders, neither National nor Labour have solved this conundrum.

We just get a productivity Groundhog Day.

There are many things about our economy that need reform. But in an environment where there is limited political stomach for reform, the main game must be doing two or three things well. Fiddling with the smaller stuff will not be effective and wastes political capital. 

The focus must be on actions that have the biggest impact on technology adoption, innovation, creative destruction and international connectivity. Those actions also need to be achievable immediately after an election. 

Accordingly, tax, credit allocation and concessions policy are the levers to pull.

Changes to tax and credit allocation are required to drive down our cost of capital and encourage entrepreneurship and investment. Removing harmful concessions will make our economy more competitive and resilient. 

Access to capital

Over 60% of employees work for the 160,000 businesses that have fewer than 100 employees. SMEs provide most of the employment growth in NZ and are at the core of our tradeable sector, which is substantially more productive than our moribund non-tradeable and public sectors. 

Lower cost of capital and better access to credit will drive more investment, entrepreneurship and competition.

Tax reform

The old political trope that NZ has a broad-based tax system is just politicians looking the other way. To attract talent and capital, a switch away from income tax is required. 

High rates of income tax drive very mobile talent and capital away from NZ and contribute to a vicious poverty trap that discourages work. 

An Auckland solo mum working 30 hours a week on the minimum wage and receiving a sole parent benefit for two kids, Working for Families and the Accommodation Supplement has an effective marginal tax rate of nearly 90%. In other words, she earns less than $20 in the hand for working an extra five hours.

The last independent tax review, the 2009 Victoria University Tax Working Group, supported a low-rate land tax. 

Capital gains tax is stupidly complex, non-neutral and ineffective as a revenue-raising and equity instrument. A switch away from income tax to land tax using councils’ rating systems (which this year will raise about $7 billion for them) is simple, neutral and effective in revenue-raising. 

It also maintains the progressive nature of our tax system.  

The credit allocation death zone 

There is a credit allocation death zone in NZ for businesses with enterprise values between about $2 million to $50m. This is because banks are concerned about difficulties that may arise when any of these businesses is recapitalising or being sold.  

The SME recapitalisation problem is difficult to solve, with no sensible material government intervention available.  

However, governments can make a sensible intervention on credit allocation itself. Credit allocation is heavily influenced by bank sector characteristics – in particular, the oligopoly of Australian banks and the Reserve Bank of NZ’s (RBNZ) risk weightings in its bank prudential management.  

The result is pro-cyclical credit allocation that offers little bank product innovation, low rates of technology adoption and declining lending to SMEs when measured against GDP.  

The RBNZ's prudential management lies at the heart of these problems. Its incentives are dominated by system stability rather than efficiency and competition. 

It also suffers from hubris and confirmation bias. Its relative risk weightings between, say, residential mortgage lending and SME lending, which determine capital requirements and therefore credit pricing and availability, don’t reflect credit experience. 

Its risk weightings are also responsible in part for a desperate lack of innovation in housing tenure – an area in which the RBNZ has shown wilful ignorance. 

The consequence of the relative risk weightings and the banks’ uncontested commercial judgements about operating leverage and innovation is their strong preference to only lend when residential property is the security.  

This drives their residential lending (including re-badged residential property-secured SME lending) and starves the high-performing SME sector of credit. Check the RBNZ’s bank lending data series S32 and S35 – they are alarming.

Parliament can intervene in the harmful RBNZ biases and risk weightings by splitting out the central bank’s prudential management, as occurs in many other jurisdictions, implementing bias safeguards and independently reviewing the risk weightings.  

Foreign direct investment should also be less restrictive because it brings innovation, technology and international linkages, which are the only reliable way for our firms to achieve even a modicum of scale. It may also help to ameliorate the business credit allocation death zone.

Dealing to privilege

What to do about the harmful concessions in both our private and public sectors that have tipped parts of these sectors away from being politically and economically inclusive to becoming extractive and exclusive? 

Here are some observations:

First, we have vibrant economies in bureaucracy, corporate welfare, dubious infrastructure planning, vetoing activity, avoiding externalities, grievance, patronage, privilege, regulation, risk-washing, risk socialisation and waste – the rules for which are becoming unclear. 

Second, fixing harmful concessions in an orderly way while satisfying the political test of “only winners” is much more complicated than quantum mechanics (which is very complicated). 

Third, politicians deny the benefits of allowing devolved community decision-making as a proxy for markets and a bulwark against the grabbing hand of the state. 

Fourth, even when a theoretical case exists for state intervention, in practice net benefits often don’t accrue. State intervention is poorly implemented, and the state regularly demonstrates its diseconomies of scale. 

Fifth, MMP has discouraged opposition parties from presenting carefully thought-out plans as manifestos because they make coalition formation harder. It is acceptable to loosely define some problems and not to present any concrete solutions, which in turn undermines the timing of their management and legislative agenda in government.

Shake up the public service

There are no orderly routes to reshape our harmful concessions. 

Instead, we should rip the band-aid off these problems, starting with a shakeup of leadership in the public sector. 

While the public sector congratulates itself on its independent leadership, in practice that independence has had its day. 

No surprises, faltering Official Information Act (OIA) compliance, gradually rising patronage and corruption, overworked and under-resourced parliamentary select committees, crowded legislative agendas and a small labour market for leadership in Wellington mean that public service leadership is inevitably politicised, with a self-preserving bias to inaction. 

Let’s face that reality and make chief executive positions within the core public sector political appointments by the government of the day. Wrap a fit-for-purpose OIA and anti-corruption system around that. 

At least this way we get more accountable politicians, mitigate wide capability differences among ministers, access to a wider bureaucratic talent pool and achieve more transparency about motivations. 

An overtly politically-minded cadre of public service leaders might get some stuff done, including removing nasty concessions.

We are getting what we vote for – economic failure, diminishing social justice and our best and brightest leaving our beautiful country.

We are failing ourselves.