Why 2.5% Potential Growth is Wrong

Australia's potential GDP growth is closer to 2% than the 2.5% Treasury assumes. The difference matters for inflation, interest rates, and fiscal policy.

The Consensus is Split

Source	Potential Growth	Labour Productivity Assumption
RBA (SOMP August 2025)	Around 2.0% (down from 2.25%)	0.7%
Treasury (MYEFO 2025-26)	2.5%	1.2%
Treasury (IGR 2023)	2.2%	1.2%
Major Banks	2.0-2.25%	varies

The RBA revised its labour productivity assumption down to 0.7% in August 2025 - the 20-year average for non-farm labour productivity. Treasury still uses 1.2%. That 0.5pp gap in labour productivity assumptions explains most of the difference in potential growth estimates.

Potential Growth = Capital + Labour + Productivity

Potential GDP growth is the sustainable rate the economy can grow without generating inflation above the 2.5% target - it sets the speed limit for monetary and fiscal policy. The Cobb-Douglas production function decomposes potential growth:

  Potential Growth = α×(capital growth) + (1-α)×(labour force growth) + MFP growth
  

Where α is capital's share of income - not a fixed textbook value, but time-varying from national accounts data.

Capital's share has risen from ~0.25 in the 1970s to ~0.36 today. Long-run increases in the measured capital share in Australia reflect several structural accounting and economic forces:

• Rising imputed rents on owner-occupied housing - because these rents are classified as capital income, their growth mechanically lifts the capital share over time.
• Growth in financial sector profits post-deregulation - financial services' gross operating surplus has risen faster than labour compensation, contributing to a higher capital share.
• Cyclical effects from the mining sector - mining booms contribute to short-run surges in capital income, but they are less important to the persistent upward trend than the first two factors. 

Important distinction: Treasury and RBA quote labour productivity (output per hour), not MFP. The relationship:

  Labour productivity = MFP + capital deepening
  

Historical average: 1.6% labour productivity = 0.9% capital deepening + 0.7% MFP

But recent MFP has collapsed. From 2004-2018, market sector MFP averaged just 0.2%. In 2022-23, it fell 0.5%. Treasury's 1.2% labour productivity assumption implicitly requires MFP to recover to ~0.5% - a level not seen consistently for 15 years.

Current Inputs (ABS Data)

Using Henderson Moving Average (13-term) smoothed inputs from ABS data:

Component	Value
Capital share (α)	0.36
Capital growth	2.0%
Labour force growth	2.0%
MFP growth	0.0%

Cobb-Douglas calculation:

  0.36 × 2.0 + 0.64 × 2.0 + 0.0 = 0.72 + 1.28 = 2.00%
  

Model output: 1.97% (the small difference reflects stochastic innovations in the state-space model).

The Labour Force Growth Story

Something extraordinary happened to Australia's labour force in 2022-23. After COVID border closures, net overseas migration surged to record levels as the backlog cleared. Quarterly labour force growth spiked to nearly 1% - roughly double the long-run average.

Many forecasters extrapolated this forward. Their trend filters, trained on recent data, anchored to the surge. The HP filter currently reads 0.6% per quarter (~2.4% annualized).

But the surge was a catch-up, not a new normal.

By late 2024, net overseas migration had fallen sharply. Government policy shifted toward tighter visa settings. Raw quarterly labour force growth has fallen to 0.36% (~1.4% annualized). This isn't cyclical weakness - it's the end of a one-off adjustment.

The HP filter (blue) remains anchored at 0.6%/quarter while HMA(13) (red) has fallen to 0.5%/quarter and is still declining. The raw data (grey) shows the structural slowdown is real.

The HP Filter Problem

The Hodrick-Prescott filter has a known failure mode: severe endpoint bias. Feed it 2022-23 data showing ~1% quarterly labour force growth, and it concludes that's the trend.

This is a mechanical artifact, not an economic insight. The immigration surge was:

• Policy-driven: Border reopening after COVID, not structural labour market change
• Non-compounding: Visa backlogs clear once; they don't generate permanently higher flows
• Already reversed: 2024-25 data confirms the slowdown

A Henderson Moving Average (13-term) is more responsive to genuine structural shifts.

Filter	LF Growth (Q/Q)	Annualized
HP (λ=1600)	0.60%	~2.4%
HMA(13)	0.50%	~2.0%
Raw (latest)	0.36%	~1.4%

The same pattern applies to capital stock growth:

HP trend shows ~2.4%, but HMA(13) - which the model actually uses - shows ~2.0%. Using HP-inflated inputs systematically overstates potential.

The Productivity Problem

MFP makes the picture worse, not better.

Australia's multi-factor productivity has been flat to negative since the GFC. The mining boom dragged it down as capital-intensive resource extraction delivered lower measured productivity. COVID disrupted measurement. The hoped-for rebound hasn't materialised - trend MFP is currently negative and floored at zero in the model.

Treasury's 1.2% labour productivity assumption requires ~0.5% MFP growth (given ~0.7% capital deepening). The RBA's 0.7% assumption is consistent with MFP near zero - which is what we actually observe.

This is not a claim that productivity cannot recover - only that policy must be set on observed trend capacity, not hoped-for reversion that has failed to appear for more than a decade.

Possible reasons why Treasury's estimate stays high

Fiscal arithmetic looks better

• Higher potential growth → higher projected nominal GDP → higher projected tax revenue
• Medium-term budget projections show smaller deficits (or larger surpluses) without announcing any policy changes
• The "return to surplus" date gets pulled forward

The structural balance is flattered

• If potential is 2.5% but actual growth is 2%, you conclude there's a negative output gap (slack)
• A negative output gap means part of the current deficit is "cyclical" - it will close automatically when growth returns to trend
• Less of the deficit looks structural, so less corrective action appears necessary
• At 2% potential, the same deficit is mostly structural - requiring actual policy decisions

More room for discretionary spending

• A negative output gap implies the economy can absorb more demand without inflation
• This gives cover for fiscal expansion ("we're closing the gap") rather than consolidation
• Stimulus looks responsible rather than reckless

Avoids hard conversations

• Admitting potential has fallen to 2% implies living standards will grow more slowly than voters expect
• It implies the tax base won't grow as fast as spending commitments
• It implies structural reform is needed, not just cyclical patience
• Politically toxic - easier to assume productivity will bounce back

Any reckoning gets deferred

• If potential really is 2%, revenue will persistently undershoot projections
• But that's next year's problem, and the year after that

To be clear: this isn't a claim about bad faith. Treasury may genuinely believe productivity will recover. But institutional incentives don't require intent to operate. Optimistic potential estimates make fiscal arithmetic easier, output gaps larger, and hard policy conversations avoidable. When forecasters face uncertainty, these pressures create drag against downward revisions.

Why This Matters

The gap between 2.0% and 2.5% potential growth sounds small. It isn't.

For inflation: If actual GDP grows at 2.5% and potential is only 2.0%, the economy runs 0.5pp hot every year. That's persistent inflationary pressure that monetary policy must offset.

For interest rates: A central bank estimating 2.5% potential when true potential is 2.0% will consistently run policy too loose. They'll face inflation surprises, then be forced into larger corrections.

For fiscal policy: Budget projections built on 2.5% potential will systematically overstate future revenues. The structural deficit is larger than reported. The fiscal space politicians think they have doesn't exist.

What Would Change My Mind

Three things would shift me toward 2.5%:

1. Sustained NOM above 300,000: If net overseas migration stabilises well above long-run averages despite tighter visa policy.
2. MFP inflection: If productivity growth turns decisively positive for 2-3 years - not measurement noise, but genuine sustained improvement.
3. Evidence the RBA is wrong on productivity: If the 0.7% assumption proves too pessimistic and labour productivity returns to 1.2%+.

None of these are currently evident. All are possible.

Conclusion

The RBA's 2.0% estimate reflects reality:

• Labour force growth has structurally slowed as the post-COVID catch-up ends
• MFP remains near zero with no clear catalyst for recovery
• Labour productivity of 0.7% (RBA) is more defensible than 1.2% (Treasury)
• Cobb-Douglas arithmetic with current data gives exactly 2.0%

Treasury's 2.5% requires both HP-inflated input growth AND productivity recovery that hasn't materialized. It's not wrong to hope these improve. It is wrong to build hope into baseline forecasts and policy settings.

Potential growth of 2.0% isn't pessimism. It's what the data says.

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Sources: MYEFO 2025-26, IGR 2023, RBA SMP August 2025. Cobb-Douglas estimates use ABS national accounts (5206, 1364, 6202). Inputs smoothed via Henderson Moving Average (13-term). MFP calculated as Solow residual, HP-filtered and floored at zero.