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The link between Business R&D, Productivity, Inflation and Interest Rates

Australia and its global peers have experienced a rapid rise in interests rates over the past 12 months to combat high and persistent inflation.

In recent months, Australia’s RBA Governor and Treasurer have begun to mention the importance of improving Australia’s productivity as a means of addressing the inflation issues. The Australian and AFR newspapers today have noted that:

• A 4.6 per cent plunge in ­labour productivity in the year to March came as figures released by the Australian Bureau of Statistics showed economic growth slowed sharply to 0.2 per cent in the first three months of the year;

• The fastest drop in Australia’s productivity on record and accelerating wages growth threatens to push the cash rate towards 5 per cent, up from the current rate of 4.1%;
• Treasurer Jim Chalmers noted that “a big part of our economic agenda is investing in productivity; not by trying to make people work longer for less, but by investing in their skills and their capacity to adopt and adapt technology and to get the energy mix right in our economy,”
• Output per hour worked, a proxy for labour productivity, fell 0.3 per cent in March and by 4.5 per cent over the past year, which was the largest annual decline since at least 1979, when records began;

• Falling productivity leads to higher unit labour costs, which are passed through to higher prices, and prevents the economy from expanding at a decent pace without generating inflation.

What is not often explained in simple terms is the link between productivity, inflation and interest rates, but then also the impact that Business Investment in R&D can have upon productivity, inflation and interest rates.

In simplistic terms:

• A moderate level of inflation (generally 2-3%) is considered healthy in a growing modern economy, however some developed economies have experienced inflation of up to 11 to 12% since the pandemic;
• High inflation is bad since it:
  • Erodes the value of accumulated monetary assets, which then have reduced purchasing power;
  • Harms the most vulnerable in society by increasing the cost of living.

• Interest rates (being the cost of money) generally have an inverse effect on growth and activity, since higher rates increase the cost of capital and reduce economic activity;
• The role of central banks is to set a country’s interest rates to keep inflation within a target zone (generally 2-3%) to ensure economies are productive, yet don’t overheat leading to high inflation. When confronted with recent high inflation, central banks have had to significantly increase interest rates;
• Productivity growth, as per the standard statistical agency definition, is the ratio of output growth to input growth, that is, the amount of growth in output that cannot be explained by the growth in measured inputs. Labour productivity is based solely on labour inputs (e.g., hours worked to produce the outputs), whereas multifactor productivity (MFP) takes into account the multiple inputs used in production (e.g., labour, capital and land);
• Where Labour or process inputs are unproductive or inefficient, it requires more inputs to produce a given output;
• Where more inputs are required to produce a given output, it increases the cost of that output (including food and basic living essentials);
• Where growth in the cost of producing output (including food and basic living essentials) accelerates, it leads to high inflation, then higher interest rates;
• Innovation and R&D Activity (including development of more efficient processes or more efficient to produce goods) is recognised as being key to increasing productivity in the economy. Productivity has been shown to be positively correlated with innovation performance across multiple documented academic studies;
• Companies who are associated with Innovation and R&D Activity may be more productive and capable of producing goods more efficiently or at lower cost. This then presents them with the option to:
  • Offer products at the same cost as their peers, but with increased profit margins; or
  • Offer products at lower cost to their peers, to increase their market share.

Therefore, Business Investment in R&D should be a key focus of our leaders in helping Australia through the current economic challenges confronting us.

Policy makers should ensure that suitable settings are in place (including business access to resources and the maintenance of a stable, generous R&D Tax Incentive) to assist business in playing their role in increasing Australia’s productivity and reducing inflation.

Please get in touch with our office if you would like to speak to someone about a potential  R&D claim, or check out our website for more information.