By Melissa Wilson, Senior Economist CEDA and James Brooks, Economist Ceda
Introduction
The construction sector is one of our largest industries and is vital to the functioning of our economy. It plays a critical role in meeting Australians’ housing needs, delivering the infrastructure pipeline and making the energy transition. These goals are important not only for Australians today, but also for generations to come. Our economic prosperity relies on our ability to get things built, but we are losing this ability. Without improvement in this sector we will not be able to deliver on a strong economy and a strong social compact.
Report highlights
Put simply, productivity means producing more of something (an output) with the same or fewer resources (inputs). It is about working smarter, not harder.
Labour productivity in construction (measured as output per hour worked) grew by just 17 per cent over the 29 years from 1994/95 to 2023/24. In contrast, labour productivity grew by 64 per cent in the ‘market-sector’ industries, and 58 per cent in manufacturing over the same period.
Multifactor productivity in construction has been broadly unchanged from 1994/95 to 2023/24. It grew by almost 20 per cent in market sector industries and 23 per cent in manufacturing over the same period.
Productivity has been particularly weak in the building of houses and apartments. Our analysis shows that dwellings built per construction worker have declined by roughly 50 per cent since the 1970s (Figure 3).
These measures do not account for changes in the size and quality of buildings, which have both improved over time. The Productivity Commission has found that, even when adjusting for size and quality improvements, construction labour productivity per hour worked has declined by around 12 per cent since 1994, and still significantly underperformed the wider economy, which experienced labour productivity growth of around 49 per cent over the same period.
Construction’s productivity performance has been one of the weakest of all sectors in the economy – it is one of only three market-sector industries to have subtracted from overall multifactor productivity growth in recent decades. Boosting productivity in construction will be vital to solving Australia’s housing crisis, rejuvenating weak business investment and supporting a strong economy.
Construction is now dominated by small firms
Construction is one of the least concentrated industries in Australia, made up mainly of small firms and individual subcontractors. Aside from the few very large or highly specialised firms, the number of firms in the industry is far greater than what is needed to deliver effective competition. Our analysis shows this is contributing to the productivity problem.
There are currently 410,602 construction firms in Australia, of which 98.5 per cent are small businesses with fewer than 20 employees. Ninety-one per cent of construction firms are microbusinesses with fewer than five employees, up significantly from 43 per cent in 1988/89. Construction has a much higher share of microbusinesses than comparable industries.
In Australia, firms with fewer than 20 employees account for 53 per cent of total construction sector revenue. Many of these small firms are “construction services” providers, which includes a diverse network of tradespeople and subcontractors. Their large share of construction revenue and employment, and high degree of interconnectedness with the rest of the sector, means that small construction firms are critical to the sector’s overall productivity.
Smaller construction firms are less productive
We analysed previously unreleased ABS data that looked at revenue per employee in construction firms ranging in size from zero to 200+ employees. While we are unable to measure firm-level productivity, revenue per employee acts as a reasonable proxy for labour productivity.
We found that Australian construction firms with 200 or more employees generate 86 per cent more revenue per worker than Australian construction firms with 5 to 19 employees (Figure 5).
If firms in the Australian construction industry matched the size distribution of firms in the manufacturing industry, the construction industry would produce 12 per cent, or $54 billion, more revenue per year without requiring any additional labour. This is equivalent to gaining an extra 150,000 construction workers. In a sector currently suffering from labour shortages that are holding back progress, this sort of increase
would make substantial inroads in the ability to deliver on critical infrastructure and housing works.
Smaller firms are less able to achieve economies of scale and scope. Consultation with CEDA members and other industry experts has confirmed that the construction industry tends to be fragmented, insular and lacking incentives to adopt new ways of doing things.
WHY ARE THERE SO MANY SMALL CONSTRUCTION FIRMS?
Construction firms have stayed small because the structure of the industry and regulations encourage them to remain so.
Construction is highly segmented and demand is highly cyclical. Downturns in demand can disadvantage businesses that invest in productivity-enhancing assets like machinery, equipment and new technologies. They are therefore more likely to maintain cost flexibility by relying on labour instead of capital inputs, and to favour subcontracting as a more flexible source of labour than direct employment.
As subcontracting fragments the industry, this has likely increased the time and effort spent on procurement, contract negotiations, supervision and regulation, and dispute resolution. Our consultation has identified reworks and disputes as a major source of inefficiency in the sector.
TAX SETTINGS AND REGULATIONS KEEP FIRMS SMALL
Tax incentives encourage construction firms to remain small
Being self-employed can result in paying less tax than a salaried employee earning the same pre-tax income. Self-employed businesses typically operate as a private company or sole trader.
Our analysis of HILDA income data for people working at least 30 hours per week shows around 8.5 per cent of independent contractors in the construction sector disclose income under the tax-free threshold of $18,200, and therefore pay no tax, compared with just 2 per cent of salaried construction workers (Figure 7). 2.2 per cent of the contractors disclose no income at all, compared with 0.44 per cent of salaried workers.
Self-employed businesses operating as sole traders are taxed at the same marginal tax rates as employees. However, independent contractors must declare and assess their own tax obligations. Self-employed people are more responsive to changes in tax rates and are more likely to report their income just under thresholds where marginal tax rates increase, often called “bunching”.
These results are not unexpected given the structure of our taxation system. Employees or salaried workers typically make ongoing personal income tax contributions deducted from each salary payment with rising thresholds based on income. In contrast, private companies are taxed at a flat rate of 25 per cent for small and medium businesses (with revenue of less than $50 million) and 30 per cent for larger businesses.
Other tax settings also favour smaller construction firms. For example, the instant asset write-off currently allows businesses with turnover of less than $10 million to claim an immediate tax deduction on vehicles and other business assets. There are therefore significant incentives for construction workers to be self-employed under a private company arrangement to minimise their tax bill.
It’s not just individual tax settings that are discouraging scale. Taxes charged at different rates based on firm size can also discourage productive firms from growing, particularly payroll tax.
Australia’s land-use regulation is complex and decentralised
Australia has a complex combination of local, state and federal rules around land-use that often differ across local geographic areas. Australia has the most decentralised system of land-use planning in the OECD.
For example, the development application to build a three-storey block of apartments in Sydney in 1967 was 12 pages long. Today an equivalent building would require extensive structural, environmental, traffic and often heritage assessment, meaning applications are many hundreds if not thousands of pages long.
This can prevent new firms from entering the local market and prevent productive firms from growing. Where there is more regulation or it adds greater uncertainty to large housing projects, firms are more likely to prefer smaller projects that are better suited to smaller, less productive firms. This exacerbates geographic segmentation, makes it harder for firms to grow and reduces the incentive to invest in technology.
This area is ripe for reform. Our consultations revealed broad agreement that land-use regulation is a barrier to firm size in Australia.
In New Zealand, the Auckland Unitary Plan removed many different zoning restrictions, allowing for higher-density development across the city. The “up-zoning” of Auckland started in 2013 with the introduction of “Special Housing Areas”. It was implemented across three-quarters of Auckland in 2016, and more than tripled approvals for dwellings within six years. It coincided with a significant increase in multifactor productivity in NZ construction.
Other regulations
Other regulations may also be holding back firm size and productivity. This includes state-based occupational licensing, which sets legal requirements to practice an occupation such as being a plumber, painter or electrician. Construction licensing has become more stringent in recent years, which can be detrimental to productivity growth because it makes businesses less dynamic, reduces business entries and exits, and makes it harder for the most productive businesses to grow. The Federal Government’s new plan to introduce national licensing for electricians is a much-needed first step in the right direction.
CONCLUSION AND POLICY DIRECTION
Productivity in the construction industry has been stagnant for three decades. While many factors have contributed to this outcome, a critical driver is the dominance of small firms. Currently, 98.5 per cent of Australian construction firms have fewer than 20 employees. Smaller building companies are less productive than bigger firms because they can't achieve the same productivity gains from economies of scale and scope, innovation and investment.
Our analysis of previously unreleased ABS data shows Australian construction firms with 200 or more employees generate 86 per cent more revenue than those with 5 to 19 employees. If Australian construction firms matched the size distribution of firms in the manufacturing industry, construction would produce 12 per cent, or $54 billion, more revenue per year without requiring any additional labour. This is equivalent to gaining an extra 150,000 construction workers. The dominance of small firms is the result of the cyclical and segmented nature of the industry, combined with the shift to subcontracting that took place in the early 1980s and late 1990s.
Current regulatory settings are keeping builders small:
Tax incentives favour independent contractors, who are four times more likely to disclose income under the tax-free threshold than salaried construction workers. Other tax settings, such as the instant asset write-off and payroll tax thresholds, also favour smaller construction firms.
Australia has the most decentralised system of land-use regulation in the OECD, which exacerbates geographic segmentation and makes it harder for firms to expand into new areas.
Complex, and in some cases increasingly stringent, state-based occupational licensing rules also make it harder for the most productive businesses to expand interstate.
To encourage scale, governments should:
Make local and state government regulations more streamlined and consistent.
Help to smooth out variability in demand by creating a more consistent, predictable pipeline of construction work through their infrastructure and social housing programs.
Better align the relative tax rates for individuals and small and large businesses as part of broader reform of the entire tax system.
Australia has been slow to deliver on critical infrastructure projects and has not built enough homes to keep up with demand. Sydney is now the second most expensive housing market in the world, while Melbourne is seventh and Adelaide ninth.
To help us build smarter, not just harder, we must focus on policies to lift productivity in construction.
This article has been republished from CEDA under Creative Commons license. Read it here.