Following the summer budget, the government released a productivity plan aimed at dealing with a chronic issue facing the UK’s economy. Anna Valero and John Van Reenen review the plan, writing that overall the plan is broadly right, but that some gaps in policy remain.

The Chancellor’s productivity plan “Fixing the foundations: Creating a more prosperous nation” is long overdue. During the last parliament and especially in run up to the general election, economists were calling for more policy focus on our poor productivity performance. For many, this is the number one issue facing the UK economy since productivity growth is a pre-requisite for sustainable growth in living standards.

The Plan identifies the chronic problems which need to be addressed to get our productivity back on track, and sets out the government’s solutions. Overall, the analysis and priorities seem broadly right and there are a number of positive steps. For example, the emphasis on planning reforms (especially on housing), road infrastructure and vocational skills. However, much of the Plan simply places existing policies into eight drivers of productivity growth. Given the fact that UK output per hour is around 30 per cent lower than the US, France and Germany, is it really radical and coherent enough to yield the kind of growth we need to catch up with our peers?

The backdrop is challenging. Public investment is projected to remain relatively low as a share of GDP. Furthermore, some policies could actually have adverse effects on productivity such as funding for low income students and more generous inheritance tax rules.

Here we take a look at some key areas announced in the summer budget and embellished in the productivity plan.

Skills

The UK’s performance on higher education has been strong over recent decades, but gaps remain, especially in mid-level skills. To address this, the Plan describes a new apprenticeship levy on larger firms. In addition, there are plans to raise the prestige of vocational qualifications, making them a real alternative to university. These are steps in the right direction, but may be insufficient to deal with the “skills emergency” in some key sectors (engineering, science and high-tech). Furthermore, Business Secretary Sajid Javid has rejected calls from business groups and academics to relax the increasingly stringent visa restrictions on foreign graduates from UK universities.

There are also concerns that new policies around higher education could be problematic on both efficiency and equity grounds. Conversion of university maintenance grants into loans is likely to discourage poorer students from going to university, thereby preventing them from realising their full potential.

Investing for the long term

Further cuts to the corporate tax rate (to 18 per cent by 2020, from an already low 20 per cent) are likely to boost private investment, as are increases in the Annual Investment Allowance to £200,000. But there remains a problem of over-reliance on short-termism.

The government is sitting on fence in terms of policy in this area; leaving it to institutional investors and businesses to push for more long termism themselves. There is no appetite for an “allowance for corporate equity” (as recommended by the Mirrlees Review (2011) and LSE Growth Commission). This would reduce the debt bias in UK businesses and incentivise more equity finance, which is better suited to long term / risky investment.

A lack of competition the banking market is another obstacle for businesses to invest and grow. The Plan contains some policies for the Bank of England to promote competition, including the measurement of “finance for productive investment”, and the setting up of a new unit to help challenger banks enter the UK market. Measures to improve effective competition via easier consumer switching were taken in the last parliament (the 7-day switching service and MiData).

The Plan contains a commitment to capital spending on science. However, it does not promise any additional resources for the science budget. This has been falling in real terms (since it was protected only in cash terms by the coalition) and government spending on R&D as a share of GDP is below the UK’s international peers. This is a problem because research has shown that public R&D spills over to the private sector and leverages in private sector investment. Improving linkages between academia and business via the “Catapult” centres is likely to be fruitful for translating science into profits. One more Catapult (on energy) was announced in the March budget, and the Plan talks of further areas where this would be valuable (to be proposed in due course by Innovate UK).

Planning, housing and infrastructure

Problems in the planning system and NIMBYs (Not-In-My-Backyard) were identified as key bottlenecks for infrastructure and housing improvements by the LSE Growth Commission and this is echoed in the Plan. The UK currently has one of the most centralised fiscal systems in the developed world. Increased devolution to city regions may help overcome this as local policy makers are more likely to spend their political capital on pushing development if they can benefit from more of the “planning gain” through keeping local taxes. In this vein, the Plan promises devolution of planning powers to Greater Manchester and London, and the potential for similar arrangements with other city regions who elect a mayor.

There are also national policies to speed up development such as allowing automatic development of brownfield sites.

Dealing with the supply side is needed to tackle the “housing affordability crisis”, which as the Plan rightly points out is a barrier to growth. It is unclear that the package of reforms are radical enough to remove supply constraints in housing such as allowing building on parts of the Green Belt.

In this environment, it is all the more important to get the demand side right. The reduction in tax relief on mortgage interest for buy-to-let investors will dampen incentives in this area, but it likely to have a marginal impact as long as capital gains and rents on properties continue to rise. On the other hand, policies such as Help to Buy and Right to Buy are likely to stimulate demand and make problems of affordability worse. The adjustment to inheritance tax also serves to make property investment an even more attractive choice and is likely to increase wealth inequality (see The Economist analysis of the summer budget)

There is discussion around the importance of all areas of our infrastructure in the Plan (transport, energy and telecommunications). The main area is roads which will be paid for by increases in vehicle excise duties. By contrast there has been postponement of much rail investment and the decision on a third runway at Heathrow is not expected until the end of the year. Given the commitment to achieve budget surplus by 2019-20, we should not expect substantial increases in infrastructure investment in the near term. The LSE Growth Commission suggested a new institutional architecture so that infrastructure decisions can take a longer term view and to mitigate political cycles. Although there are a plethora of reviews announced in the Plan, there is not a systemic approach to dealing with policy uncertainty due to prevarication and reversals.

Management

Research at the CEP has shown that poor management is one of the reasons that firms in the UK are less productive than international counterparts. The latest research is cited on p.62 of the Plan, and two new, potentially valuable measures, are announced to improve the quality of our managers: employer-designed degree apprenticeship in Leadership and Management and new income contingent loans to contribute to the costs of an MBA.

Living wage

The Chancellor pulled a “rabbit from the Summer Budget hat” by promising an increase of £7.20 (from £6.50) next year to the minimum wage for those over 25 years or older. A number of concerns have been raised with respect to this National Living Wage. In particular, it is unlikely to help worse off workers, given the cuts to welfare which accompany it. Any impact on productivity would be likely to be a composition effect, as firms will lay off some less productive workers. The lower employment rates of unskilled workers has been cited as one of the reasons for higher productivity in France than the UK. But it would be better for us to emulate our Continental neighbours for other reasons – such as higher levels of capital or R&D per worker, so that future rises in productivity are driven by all employees working more productively rather than the exclusion of some employees from work.

Trade and exports

The Plan talks of the need to stimulate trade and exports, and promises a major push across government in this area, remodelling delivery, requiring the British Business Bank to review the obstacles faced by SMEs seeking to export, and a focus on markets with growth potential. However, the largest risk to UK trade stems from the forthcoming EU referendum. Analysis at the CEP has shown that Brexit would reduce GDP by between 1.1 per cent and 3.1 per cent due to lower trade alone. These losses would probably double due to dynamic effects on innovation and loss of easy access to future trade agreements, dampening productivity growth.

Summary

It is good to see productivity considerations at the heart of policy. The framework for thinking about the issues is broadly in line with the conclusions in the LSE Growth Commission.

Although there are many individually sensible policies, it is difficult to discern a clear growth strategy emerging from the Plan. Without such a vision, it is likely that shorter term considerations will come to dominate, especially as the parliamentary term wears on. For example, the coalition government had set out what was meant to be a long-term industrial strategy, but there is no mention of building on this in the Plan. Given the need for continued savings across government, it seems wasteful to neglect an existing (seemingly sound) framework and the body of work that it would have entailed.

Bearing down on skilled migration with an arbitrary cap on net migration remains a problem, as does the continued exposure of infrastructure decisions to huge policy uncertainty. Moreover, the over-riding of independent recommendations of the Low Pay Commission and Pay Review Bodies is not a welcome precedent.

Nevertheless, the government is focusing on the right area – how to get productivity back up so we can have sustainable income increases once more.

About the Authors

Anna Valero is in her fourth year of the LSE MRes/PhD in Economics, and works on the Productivity and Innovation programme. Her work is focused on firm organisation and workforce skills, and their effects on productivity and innovation.

John Van Reenen is Director of the Centre for Economic Performance at the London School of Economics.