Spring budget: How will the chancellor tackle productivity?

The reason why fiscal firepower has eroded over the past 25 years has been a commensurate drop in Britain’s GDP growth, which economists blame on weak productivity improvements. Recent higher interest rates haven’t helped, either.

Jeremy Hunt is set to be bound by this dynamic next month, with analysts expecting the chancellor to have about £13 billion to use, probably enough to cut income taxes by 1p and leave some cash in reserve.

How bad is the productivity and investment slump?

In productivity terms at least, Britain looked like a relative land of plenty in the decade before the 2008 financial crisis. In the ten years to 2007, productivity contributed an average of 1.7 percentage points to GDP growth per year. Over that time, the economy grew at an average annual rate of 3 per cent.

Since then, however, productivity’s contribution has dropped to 0.1 percentage points, while average growth has slipped to 1.1 per cent. And since 1997 investment’s share of total output in the UK has been weak, reaching a historic low of only 15 per cent in 2009.

Productivity growth can be a panacea for an economy. Improving output per worker means that a country can produce the same amount of goods and services with fewer inputs, freeing up resources to be used on industries that will shape production in the future.

For living standards, productivity growth is as close to a free lunch as it gets. It reduces the cost of production for companies, allowing them to raise wages or to generate larger profits. It is no
coincidence that real wages in the UK have undergone the worst downturn on record alongside declining worker efficiency.

Similarly, productivity growth alleviates inflationary pressures by increasing the potential supply of resources and by creating space for pay to increase without putting upward pressure on prices.

Government finances receive a boost, too. Taxes tend to rise as a country with strong productivity growth seizes upon new frontiers of production and wages strengthen while the cost of providing public services falls.

It is no surprise that both the Conservatives and Labour have put making the workforce more productive at the centre of their economic pitch to voters before an expected autumn election. Both parties know they cannot deliver a meaningful change to living standards without reversing the nation’s turgid recent productivity history.

Consensus is another rare commodity in economics, but one has emerged. There is agreement that the source of the UK’s economic ills has been stagnant productivity growth, producing damaging consequences for its prosperity over the past 14 years.

Why have investment and productivity slowed since the 2008 financial crisis?

When productivity rates slow in an economy, the risk of making unprofitable investments rises. This often leads to a self-fulfilling prophecy, where businesses cut capital spending, further
undermining productivity growth, a dynamic that has played out in Britain since 2008 and that accelerated after the 2016 Brexit vote.

In a situation where private sector investment is insufficient, public sector investment should step in to reanimate the economy. Austerity measures launched by David Cameron and George Osborne in the 2010s prevented this from happening, leaving the Bank of England to pick up the slack by slashing interest rates and keeping them at record lows. Some argue that the long period of low interest rates that came after the financial crisis has exacerbated the productivity problem.

Greg Thwaites, research director at the Resolution Foundation, a think tank, blames the productivity slowdown on “how efficiently we use the resources in the economy”. After the financial crisis, there was, he says, “a broad-based fall in dynamism across the economy. Workers changed jobs less often, resources flowed more slowly to the most efficient firms and our best-performing sectors did not grow faster than our lower-productivity sectors.”

Brexit also has erected trade barriers and has complicated the UK’s position in the global trade network.

Yael Selfin, chief economist at KPMG UK, argues that the UK’s “ageing population and a shift to a more services-based economy have given less productive sectors a larger share of the economy”.

In short, there is no one cause for the slump. A combination of negative factors has steered Britain away from relatively healthy productivity growth.

Policy remedies to reanimate the economy

Things that are valuable are often costly to achieve. If it were an easy feat, policymakers in developed economies would have solved the productivity paradox long ago.

However, there are some simple steps that Britain can take, starting with reducing the frequency with which policies are chopped and changed.

In September 2022, Liz Truss and Kwasi Kwarteng delivered their calamitous mini-budget. It included £45 billion of tax cuts. Jeremy Hunt reversed these and then some, amounting to a swing in fiscal policy of about £100 billion in a matter of months.

Such policy instability is ruinous for business confidence and investment, according to Selfin, who believes that “improving skill formation in the areas where shortages hamper productivity” also should be prioritised.

For Thwaites, it is more about more evenly distributing investment to raise productivity rates across the country, and that raising spending on “connectivity, infrastructure, housing and people in Birmingham and Manchester will help to narrow the gap with London”.

The National Institute of Economic and Social Research, Britain’s oldest economic think tank, argues that Hunt immediately should raise public investment by about £15 billion annually to 3 per cent of GDP. This would “not just boost economic growth and productivity but also help to unlock more business investment on which shared prosperity and well-being depend”.

The UK “lacks a cohesive, joined-up set of policies, and the means for implementing them, aimed at boosting productivity across central and local government”, Bart van Ark, managing director of the
Productivity Institute, says.

In 2017, Theresa May’s government published the last UK industrial strategy. Since then, the Conservatives have launched two growth plans, one in 2021 under Boris Johnson, a blueprint for his “levelling up agenda”, and another by Hunt in January last year to focus on the clean energy, life sciences, aerospace and automotive sectors.

Labour has set out its plans to deliver “prosperity through partnership” between government and private enterprise in its industrial strategy, although its recent pulling back from increasing green
investment by £20 billion makes this ambition tougher to achieve.

“Without a longer-term strategy, growth will remain in a slump,” van Ark warns.

London’s productivity slowdown has been among the worst of all big cities in the world and within the UK.

In an analysis of Office for National Statistics data, the Centre for Cities estimated that the rate of growth in output per job in London had dropped to only 0.2 per cent a year between 2010 and 2019.

Between 1998 and 2007, workers in London on average would produce an additional 3.1 per cent of output per year. New York, Paris and Stockholm all have stronger growth than London, the think tank said.

The findings echo a similar study by the National Institute of Economic and Social Research, which claimed that the capital had suffered the second-worst rate of productivity improvement in Britain between 2010 and 2021.

Rapidly falling output per worker in the financial services sector has driven London’s overall decline, with the pace of improvement in productivity per job in the City falling sharply from an average annual increase of 5.9 per cent between 2000 and 2008 to -1.1 per cent in the decade after the global financial crisis in 2008.

The institute said in a report last autumn: “Despite being higher than in other UK regions, London’s productivity has been growing much more slowly. This is undermining the city’s global competitiveness.”