24 Nov 2010

The Treasury has released a speech delivered by John Whitehead, Secretary to the Treasury, at Russell McVeagh, Auckland on 24 November 2010.

[Slides: spliftingecogrowth24nov10slides.pdf]

Thank you for that introduction. And thank you to Russell McVeagh for giving me the opportunity to talk about some of the ideas that the Treasury is working on to lift our rates of income growth.

It is always good to get in front of Auckland audiences and talk about critical economic issues. This city is, after all, by far New Zealand’s largest metropolitan area and New Zealand is not going to reach its potential unless Auckland is living up to its name as the super city.

I think we are all aware that these are fairly challenging economic times.

But we in New Zealand do have many things in our favour. We came through the global financial crisis in relatively good shape and that has again been underlined in recent days as we have read about the ongoing tribulations in the finances of some European governments.

I spoke at an Institute of Policy Studies seminar in Wellington last week, and the focus of my address was macroeconomic policy settings. In particular, I looked at why the Crown’s spending and revenue policy choices are, and will continue to be, such a critical part of any strategy that is aimed at permanently raising New Zealand’s per capita growth rate.

My conclusion last week, which I won’t dwell on too long today, was that we will need to ensure that fiscal policy settings are right to fully leverage the benefits available from adopting specific growth-enhancing policies.

Today I would like to spend some time talking not just about the challenges, but also the big opportunities that are in front of us right now.

Changes are obviously needed across a broad range of policy areas in order to allow the enterprise and innovation that will drive our growth, and to ensure that we emerge from these difficult times in a position for our economy to really thrive.

Because the list of possible policies is long, I want to confine myself today to four areas that I think are very important and require attention. I will summarise what they are before I examine them in greater detail.

The first is the need for New Zealand to have sound and stable macroeconomic policies. Without them it becomes very difficult to promote growth and employment, and to build the resilience we need for dealing with the next shock that will inevitably come along. We need to keep convincing markets that we’re serious on this stuff.

Second, I will talk about the importance of creating a business environment that attracts talent, and rewards enterprise, innovation and entrepreneurship. A competitive business environment requires policies and institutions that reward such behaviour.

The third area I will focus on is education and labour force participation. It should go without saying that a highly skilled labour force is critical for economic growth. Higher skills ensure that people have the opportunities to participate fully not just in the workforce, but in society, and that is a meaningful ambition for all of us.

And my fourth area of attention will be international connections. Our economy is small and distant, and our ability to grow depends on ensuring our firms are well connected with the rest of the world. Achieving this is about ensuring we open trade doors, have a prioritised strategy for engaging and integrating with countries in the Asia Pacific region, and that we have the sort of policy settings that enable us to attract, retain and enable the flow of the ideas, companies, people and capital that drive productivity.

Before I start to address these four areas, I do want to touch briefly on the position we are in now, and explain why faster growth really matters. The blunt truth is that our growth performance over a long period of time has been poor. In 1950 we had the third-highest GDP per capita ranking among OECD countries. Last year we were ranked 22. Tumbling down a league table tells us that our competitors are doing things smarter and better. Imagine the outcry if a sports team suffered such a decline? The figure here shows that, since 1950, our average rate of growth – at 1.3 per cent – has been the lowest in the OECD.

This next graph shows, however, that New Zealand performed better over the last two decades. Between 1992 and 2010, the annual average per capita growth rate was near 2 per cent. And, according to OECD projections New Zealand should expect a similar rate of growth over the next 15 years.

However, on the basis of these same OECD projections, New Zealand would need average per capita GDP growth of near 3 per cent over the next 15 years to reach the average GDP per capita level of OECD economies. And to catch Australia we need to crank the average rate up to over 4 per cent. That’s more than double New Zealand’s average rate since 1992 and more than triple the average rate since 1950. But this is the kind of target that I think New Zealand needs to be aiming for.

Why it matters that we do significantly better in the years ahead was outlined well, I thought, in a recent New Zealand Institute for Economic Research report that estimated that another 410,000 New Zealanders could emigrate to Australia between now and 2025 if our pace of per capita growth continues on its current track.

That is a very large potential exodus. But it’s understandable when you consider how much more Australians earn - $64,000 more for a family of four.[1] Higher income means that Australia can spend much more on material things, but also much more on things such as health, education and the environment.

I would like now to turn to the first of the four areas that I identified as being of significance to growth and deserving attention now. And that is macroeconomic policy. On Monday, New Zealanders were again reminded about the current heightened state of focus on country and government debt profiles when Standard & Poor’s announced that it had revised its outlook on the foreign currency sovereign credit ratings of the Crown and six Crown-owned entities to negative, from stable. The decision by S&P highlights that international ratings agencies, and financial market participants, seek re-assurance that New Zealand’s net external debt position will strengthen in the years ahead.

As this chart shows, our net foreign debt position, as a country, is one of the largest in the developed world, at nearly 90 per cent of GDP at last count. And the company we are keeping in this respect may ring some alarm bells.

Many countries with similar levels of external indebtedness to us are now experiencing severe fiscal and economic stress. While New Zealand’s low starting level of government debt appears to be an important differentiating feature, our government debt is rising. This trend, and the vulnerability to another external shock associated with our high national level of indebtedness, suggests that action is warranted.

Increased private sector saving – which has been historically very low – together with a turnaround in Government’s current fiscal deficit would help to reduce our vulnerability. Increased saving would also reduce inflationary pressure, which would help to reduce upward pressure on our interest and exchange rates. This would in turn help to boost business investment and, importantly in the context of our need to encourage a re-balancing in our economy, it would encourage a reorientation towards the tradable sector.

Treasury’s recent discussion paper for the Savings Working Group identified a number of policy areas that in our view need to be addressed. I will run through a couple of them for you. Policies to bring about growth are an obvious response, as income levels tend to determine how much people save. Another, as I’ve just mentioned, is to produce government savings by reducing some types of (non-productive) expenditure, focusing on growth-enhancing spending and lifting the productivity of the state sector. However, I don’t intend to dwell on state sector performance at any length today, as I will be speaking elsewhere about this subject over the coming months.

A further area that Treasury feels we should look at is the effects of government transfers, in particular student loans and New Zealand Superannuation, on shaping the incentives to save faced by households. And there is also the challenge of further reducing tax distortions where there are different forms of savings and investment being taxed at markedly different rates, as this graph shows. This warrants additional examination, and so too do the high rates of effective tax for savings over time due to the taxation of accumulated income from savings, which is accentuated by the effects of inflation.

More broadly, tax is one of a number of important policy areas – including the quality of regulation, natural resource management, and research and development - that affect the business environment, which is the second area I would like to focus on today. The Government introduced significant tax reforms in Budget 2010 focused on rebalancing the economy away from consumption and strengthening incentives to work, invest and save. This was primarily delivered through a GST-Income tax switch and lower company tax rates, to promote work, innovation and enterprise.

However, it is our view that more can be done to further improve the efficiency and fairness of New Zealand’s tax system to promote economic growth. New Zealand needs to compete internationally for capital and labour. Although the company tax rate was reduced to 28 per cent in the Budget, this is by no means low by international standards, as shown in this graph.

The Savings Working Group is looking at a range of options for reforming capital taxation as a means of promoting savings and investment. And, as you are probably already aware, the Treasury has previously explored the introduction of a capital gains tax as a means of removing significant distortions from the tax system.

The regulatory environment is another area where New Zealand must stay on top of its game. We have generally scored well in international measures of regulatory quality, but on some measures our relative position and advantage have slipped in recent times, as these graphs show. It would appear that other countries have improved the quality of their regulation, while we haven’t been making similar gains. When we are experiencing the sort of uncertainty that is prevalent at the moment, the quality of the regulatory environment takes on even greater importance.

Two particular pieces of regulation that Treasury sees as potentially inhibiting growth are the RMA and the HSNO, or the Hazardous Substances and New Organisms Act. It is not surprising that these both relate to our natural resource base, given its importance for the New Zealand’s economy. The Government is moving towards setting sustainable limits on the use of key natural resources. This means businesses, most notably in the primary sector, will need to innovate to maximise opportunities and productivity in an increasingly resource constrained world.

The HSNO legislation is crucial because of the implications for innovation and primary sector productivity. As the graph here illustrates, the number of genetically modified organism trials and outdoor developments spiked significantly just before HSNO came into effect, and has diminished following its introduction. These trials and outdoor developments are critical for innovation in biotechnology, a rapidly developing field where New Zealand has significant expertise. However our regulations under HSNO are more restrictive than a number of other countries. And it may be time now to review the Act to test whether or not it is striking an appropriate balance between economic opportunities and protection of the environment and public health.

The last point I want to make in respect of improvements to the business environment is around investment in research and development. As a nation, we don’t have a particularly compelling story to tell in this area.

Our business expenditure on R&D, as a ratio of GDP, is among the lowest in the world. At 0.5 per cent of GDP, our rate of spending is only one-third of the OECD average. There is scope to make changes that will help raise our levels of innovation.

One approach is to get science and business much better connected. The CRI Taskforce recommendations, which encouraged CRIs to develop stronger long-term partnerships with businesses in this country, are part of the way to do this. We should also consider increased government financial support for business R&D, providing that this is within the bounds of our fiscal constraints.

I want to move now to the third area of significance, which is education and labour force participation.

Getting the boost that we want in innovation means we have to do something about building our skills base. It is fashionable to knock our education system, but the reality is that much of it performs very well. For example, participation in early childhood and tertiary education is relatively high compared with other OECD countries. And the performance of New Zealand’s 15 year old students in international tests is among the best in the world, both in terms of the average and the proportion of students scoring at the highest levels. However, having said that, there are some failings which are limiting our potential. Nearly half of the working age population have what are judged to be low literacy and numeracy skills. Just over one-quarter of secondary students leave school with no upper secondary qualifications. Nearly half of tertiary education entrants end up leaving without completing tertiary qualifications. While this may be explained by our open access system, and therefore higher rates of part-time participation and older students, we need to understand this better.

Another concerning statistic is that one in ten of 15 to 19 year olds are not in education, training or employment.

Our judgement is that urgent steps are needed to address these shortcomings. We need to lift teacher quality in order to raise the performance of students across the whole school system. We need to ensure that tertiary education settings prioritise participation and completion of studies by young people. Another way forward is to target resources better to those most at risk of poor education outcomes. As I commented earlier, higher skills ensure that people have the opportunities to participate fully in both the workforce and society. Educational failure imposes a high cost on all of society, and that is something we must strive to avoid.

As well as the high portion of youth not in education, training or employment, more broadly there is a large and growing proportion of the working age population on benefits – particularly the DPB, Sickness and Invalid benefits. This has huge fiscal and social costs and it is important to address this growth, as indicated in Treasury’s report to the welfare working group.

An ageing population is another key issue for New Zealand, as it is for many other developed economies. The proportion of over 65s relative to the population will roughly double over next 40 years, from 13 per cent to 25 per cent. The effects of this are illustrated by the graph here displaying the number of 15-64 year olds relative to the number of people over 65. This ratio is projected to decrease from just over five workers per person over 65 in 2009 to two and a third by 2061. Even though we expect an increasing proportion of people to work past 65, population aging will still reduce labour force growth and create considerable fiscal pressure. Both issues suggest current New Zealand Super settings may need to be revisited – for example, in relation to its size, age of eligibility or other dimensions of its coverage. Consideration should be given to providing greater incentives for those aged over 65 to participate in the labour force and to protecting the fiscal position of the Crown, while still ensuring that our elderly are well looked after. Let me be clear that we are not suggesting that there is a fundamental problem with the scheme itself, rather that its settings are a valid matter to look at from time to time.

That brings me to the fourth and final area that I signposted earlier, which is that of international connections. I cannot stress enough how important the international environment is for our economic well-being. Our connections to the world ensure we get access to key economic resources, and they allow our firms to specialise and achieve economies of scale by expanding into larger markets. They are of particular importance in our efforts to attract skills and capital, and to improve our trade access and sharing of ideas.

The chart I showed you earlier highlighted just how highly dependent New Zealand is on foreign capital to fund our shortfall in national savings. Foreign direct investment in New Zealand, in particular, is also one of the key ways in which we can get access to international relationships, expertise, technology and ideas. As the Prime Minister has recently highlighted, New Zealand’s wine industry is one example of the enormous benefits that FDI can bring. Our top wines are among the best in the world and total wine exports now exceed one billion dollars each year, roughly 25 times more than only 15 years ago. This remarkable development of our wine industry – from a small, family-based sector into a capital-intensive and technologically-advanced industry with real global connections - has largely happened because of overseas investment. However, New Zealand does not score well on international measures of openness to foreign direct investment. There are a number of reasons for this, including foreign ownership restrictions in some sectors and investment screening for purchases of significant business assets or sensitive land.

There are changes that could be put on the table to increase our attractiveness as an destination for foreigners to invest the finance, ideas and skills that we need from them. The most obvious one is to improve our domestic policy settings in areas like tax and regulatory settings. Another is to reduce other costs and distortions associated with capital inflows, particularly in relation to tax treatment, which can be advanced through double-tax agreements.

In the area of trade, we still have some barriers when it comes to doing international business. I can put these barriers into two sets: the first set is about getting the door opened to our exporters; the second set is about making sure it is as easy as possible for our exporters to do business in a country once the door has been opened. In terms of the first set, an ongoing difficulty for New Zealand is that we face relatively high barriers to international market access. And tariffs faced by New Zealand exporters, a cornerstone of growth, are particularly high for agricultural products, an area in which many countries have been reluctant to liberalise. There are steps that we can take in terms of addressing trade barriers, such as improving market access through trade agreements. These agreements are also expected to reduce New Zealand’s import tariffs, which should be reduced to zero over time.

Of equal importance to improving access is working towards reducing behind-the-border barriers such as regulatory settings. Internationally, our strategy is to push for greater regional economic integration. Achieving a single economic market with Australia is naturally a first area of focus. But given we are also fortunate to be near Asia, the current engine room for global economic growth, that region should also be a priority. Domestically, lowering international transport and communication costs, ensuring efficiently functioning and integrated infrastructure networks and improving the effectiveness of New Zealand’s offshore presence, would also benefit our cause. To illustrate where improvements are possible, the OECD and World Bank have looked at the ease of trading across borders in New Zealand. They find it takes roughly twice as long to import or export compared to OECD best practice, and it requires over twice as many documents and costs almost twice as much.[2]

The final aspect of international connections that I’d like to mention is people flows - both inwards and outwards. People flows matter a lot to growth and vice versa. Immigrants comprise a substantial proportion of our labour force, and they play a key role in the exchange of ideas and innovation. We need to be doing all we can to utilise migrants’ skills effectively, and to manage the infrastructure and housing requirements associated with immigration.

A lot has been written about how we lose our best and brightest, with survey measures showing that job opportunities are a key motivator for those going abroad. The influence of economic growth on the decision to leave New Zealand is illustrated by this graph, which shows a striking correlation between net migration to Australia and the size of the trans-Tasman difference in GDP per capita.

The New Zealand skilled diaspora has grown to be the largest in the OECD, with more than half of emigrants classed as highly skilled. Around one quarter of skilled New Zealanders are now living abroad - I am sure it is safe to say that everyone in this room knows someone in that category. Increasing our rate of economic growth is crucial to ensuring that we can provide attractive, well-paying jobs for our best and brightest, so they need not go elsewhere to fulfil their career ambitions. Making the policy changes that I have discussed today will not be easy, but I’m convinced that achieving much higher economic growth is vital for providing an environment where talented New Zealanders want to be.

So in closing, I would like to encourage you all to join the process of debating these issues. I have given you some of Treasury’s thinking around four areas that we think are important and need to be addressed if we are to progress our growth prospects. But there is no magic formula, and we don’t profess to have a monopoly on ideas.

What I do know is that it’s really important for the future well-being of New Zealanders that we get our country on a stronger growth path, and it’s critical that everyone who has got something to contribute to that discussion, gets a chance to say it.

Thank you, and I’d be happy to take your questions.

Notes

[1]As reported in the 2025 Taskforce’s 2009 report.
[2]For example, see (Guillemette, 2009): “Structural Policies to Overcome Geographic Barriers and Create Prosperity in New Zealand”.

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