Why not both? The effects of innovation and capital on productivity in New Zealand

New Zealand has not seen the same growth in productivity as comparable countries. Increased capital intensity and higher levels of innovation are pathways to greater productivity growth that are closely connected. Investment in more technologically sophisticated capital could contribute to productivity improvements along both pathways at once. New Zealand has relatively low capital intensity, with the high cost of capital a contributing factor. Though New Zealand’s investment rate has tracked with other advanced economies, it has not kept pace with rising labour utilisation, leaving the country capital shallow. Innovation increases an economy’s productivity by allowing for a more efficient mix of capital and labour. Improved technology is one route to greater innovation. Technology can be created anew or adopted from elsewhere. Neither creation nor adoption is unambiguously preferable from a productivity perspective. The optimal combination of creation and adoption in supporting productivity depends on context. We set out a number of reasons why adoption through capital investment may be an important path to innovation in New Zealand. New Zealand creates technology at a lower rate than comparable economies, in part because its Research and Development (R&D) expenditure is lower. New Zealand also struggles to convert R&D activity into outputs and broader productivity benefits. Although some business R&D appears an exception to this rule, New Zealand-specific evidence is limited, which makes it difficult to be definitive about the productivity benefits of R&D. Adopting and adapting new technologies, including through capital investments, typically costs less than creating them. Adopting new technologies is shown to have strong positive effects on productivity, and could potentially benefit a large share (up to 95%) of New Zealand firms. Given New Zealand’s struggle to create technology, greater adoption from overseas could form a crucial part of the country’s optimal approach to innovation. At the same time, a dynamic and, to some extent, complementary relationship may exist between creation and adoption – suggesting stronger adoption of new technology may enhance domestic scientific activity. Despite adopting some general-purpose digital technologies at a pace similar to comparable countries, there are signs that technology diffusion (the aggregate economy-wide rate of firm-level technology adoption) is low and slowing. To better understand opportunities for increasing diffusion, we capture in a framework the key factors that affect diffusion and their links to capital investment. We organise the framework around three firm-level factors: exposure and access to new technology, incentives to adopt new technology, and capacity to adopt new technology. We find there are four common channels that directly affect technology diffusion and capital intensity: importing, foreign investment, input costs, and access to finance. New Zealand appears, based on initial assessment, to be weaker than the OECD average across all four channels. Improvements on these channels and across framework settings (such as, competition), could boost productivity growth by lifting both capital intensity and innovation. The fundamental implication is that policy focussing exclusively on technology creation may miss a key pathway to greater innovation: diffusion through new capital investment. Equally, policies exclusively focussed on capital intensity may miss the role of investment in increasing innovation and lifting the technological sophistication of the capital stock.