Case H6
Productivity Performance and
the UK Economy
Closing the gap with the rest of the world?
The Government's long-term goal is that Britain will achieve a faster rate of productivity growth
than its main competitors. In the modern global economy, faster productivity growth demands
new flexibility in product, capital and labour markets, with government, firms and individuals able
to respond quickly and adapt rapidly to change. Were the UK to join EMU, flexibility would be
even more important to ensure that economic shocks could be managed and economic strength
maintained.
UK Budget 2003 Economic and Fiscal Strategy Report, page 45
The current productivity gap between the UK and its main competitors is significant. Using
figures for labour productivity given by output per hour, the UK in 2004 was 12 per cent
behind Germany, 13 per cent behind the USA and 29 per cent behind France. But given the
longer hours worked in the UK than in France and Germany, the picture is much more
favourable when measured in output per worker (see Figure 2 below).
In many, but not all, of the key elements that are conducive to productivity growth, the
UK economy lags behind its main rivals.
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Low levels of investment since 1965 have left the UK with the lowest level of
capital stock per head among the G7 economies.
The proportion of workers with intermediate skills is barely half that in Germany.
The proportion with higher skills compares unfavourably with most other countries
including the USA.
Although the UK compares favourably in terms of business start-ups with elsewhere
in Europe, the rate of business start-up in the USA is twice that of the UK.
One area where the UK’s performance has fallen significantly since 1990 has been in
research and development. Even though the downward trend in R&D expenditure is
reflected in France and Germany, where R&D expenditure has fallen most
dramatically, the USA saw R&D expenditure rising after 1994.
So what must the UK government do if it wishes to close the productivity gap?
Before we consider the policy initiatives it has launched in the past few years, we will
first investigate (a) how productivity can be measured; (b) the UK’s recent productivity
performance; and (c) how the productivity gap might be accounted for.
Measuring productivity
Productivity reflects the efficiency with which an economy uses its resources. The more the
output from a given quantity of input, the more efficient, and hence productive, a business
becomes. Similarly, the greater the output of an economy from a given amount of resources,
the more productive is the economy.
Labour productivity refers to the efficiency of labour. It is common to measure labour
productivity by looking at either output per worker or output per hour worked.
Output per worker is the most straightforward measure of productivity to calculate, all
that is required is a measure of total output and employment. The advantage of calculating
productivity using output per hour worked is that it is not influenced by the number of hours
worked. So for an economy like the UK, with a very high percentage of part-time workers on
the one hand, and long average hours worked by full-time employees on the other, such a
measure would be more accurate in gauging worker efficiency.
In order to account for the productivity of capital we need to consider the growth in total
factor productivity (TFP). This measures output relative to the amount of factors used. The
result is a measure that shows how output per unit of factors has grown. It can be seen as an
indicator of technical progress.
Because of the difficulty in measuring the quantity of factors, and especially the capital
stock, and the relative ease of collecting data to measure labour productivity per worker,
labour productivity per worker has become the government’s favoured measure in assessing
the productivity gap.
The UK’s productivity performance
The level of output within the economy depends on (a) the number of people working, and (b)
how productive they are. The Treasury estimates that the UK economy can grow at about 2.5
per cent a year without causing inflationary pressure. To improve upon this, either more
people must be employed or productivity levels must be increased.
Employment growth in the UK has averaged 1.4 per cent since 1996. Only the USA has
experienced comparable rates of job creation. Concerning productivity, however, the UK has
done less well over a long historical period. Such poor productivity performance has
significantly constrained the trend growth rate of the UK economy. If the UK government
wants to raise the growth rate of the economy, then it must look to improve productivity
performance.
How far behind its main rivals is the UK’s productivity performance? How big is the
productivity gap that it must close?
The productivity gap
Looking at the available measures of productivity, the gap between the UK and its main rivals
is significant (see Figures 1 and 2). Although Germany and France have a lower output per
person of working age than the UK, this is largely due to the higher levels of unemployment
in these countries and a shorter working week. Both countries, however, have significantly
higher output per hour worked – a much better measure of productivity.
Source: 2005 Pre-Budget Report, page 37 (HM Treasury, 2005)
Source: Ibid, page 37
Figure 1 Output per worker gap with UK (1995–2004)
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Figure 2 Productivity gap with UK (2004)
How can we account for the gap between the UK and its rivals? Productivity growth within
an economy is largely determined by three factors: physical capital, human capital, and
innovation and technological progress.
Physical capital.
Investment in physical capital is necessary to support labour productivity. If such investment
in capital stock does not take place at a sufficiently fast rate, relative labour productivity will
steadily fall. The UK’s poor investment record over many years is argued to be a major
contributing factor to its poor productivity performance.
Estimates of capital intensity, that is the amount of capital per worker, show that the
USA today has 25 per cent more capital stock per worker than the UK, France 40 per cent
more, and Germany 60 per cent more. Figure 3 looks at the gap in 1970 and 1999. Only with
the USA has the gap narrowed; with France, the gap has widened.
Source: Productivity in the UK: The Evidence and the Government’s Approach, page 9 (Pre-Budget Report, HM Treasury, 2000)
Figure 3 Relative Capital intensity: 1970 and 1999
A study by Oulton (2000) found that foreign owned firms in the UK operated with 50 per cent
more capital per worker than comparable domestically owned firms.
Human capital
Figure 4 shows the contribution of labour to growth, and assesses how far such a contribution
is influenced by improvements in skills or the number of hours worked. In the UK,
improvements in labour quality have contributed most to growth, whereas in the USA, with a
comparable change in labour input, most change has come from worker hours.
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Source: Productivity in the UK: The Evidence and the Government’s Approach, page 11 (Pre-Budget Report, HM Treasury, 2000)
Figure 4 Changes in labour input by hours and quality: 1986–98
When assessing skills, as mentioned previously, the UK lags behind Germany in intermediate
skills but leads it in higher level skills. Compared to the USA and Japan, the UK has a higher
percentage of intermediate skilled workers but a lower percentage of workers with higher
skills (see Figure 5).
Percentage of adults (25-64)
100%
24
80%
38
38
28
24
37
41
35
36
UK
France
60%
59
40%
49
47
20%
13
16
17
USA
Japan
Germany
0%
Low
Intermediate
High
Source: Skills in the UK: the long-term challenge: Interim report, Chart 3 (based on data in Education at a glance, OECD, 2005)
Figure 5 International comaprisons of qualifications profiles
In the UK in 2004, 43 per cent of 18–30 year olds went into higher education, and the UK had
the highest first degree graduation rate in the EU.
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Innovation and technology
The development and use of new technology and new working processes is crucial to
maintaining productivity improvements and potential. Measuring technical progress is,
however, very imprecise, and most measures do not fully capture the diversity and complexity
of developing and using technology. Although limited, a widely-used indicator of technical
progress is the level of R&D that is conducted within the economy. The UK’s share of GDP
devoted to R&D has fallen since 1990, and relative to its main rivals its position has
deteriorated (see Figure 6).
3.2
Japan
3.0
2.8
% of GDP.
USA
2.6
Germany
2.4
2.2
France
2.0
UK
1.8
1.6
1990
1992
1994
1996
1998
2000
2002
2004
Source: Source: based on data in Main Science and Technology Indicators (OECD)
Figure 6 Gross expenditure on R&D as a share of GDP: 1990–2004
Accounting for the productivity gap
Using a process known as ‘growth accounting’ (see Economics (6th edition), section 13.5), it
is possible to identify and calculate how much each of the above factors has contributed to the
productivity gap between the UK and its main rivals. Using 1999 data, Crafts and O’Mahony
(2000) found that, compared to the USA, 31 per cent of the productivity difference was
attributable to physical capital. More significant was innovation, which accounted for 69 per
cent. With Germany, capital stock differences accounted for 55 per cent of the difference,
and, while innovation was important, 14 per cent of the difference with the UK was attributed
to having a better skills base.
Table 1 Decomposition of the productivity1 gap, 1999 (%)
Physical capital
TFP
(of which:
Innovation
Skills
Other)
Total productivity gap
USA
Germany
31
69
(65)
(0)
(4)
100
55
45
(17)
(14)
(14)
100
1
Labour productivity measured as output per hour worked
Source: Crafts and O’Mahony (2000)
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Closing the gap
The UK government’s focus on the productivity gap has been a consistent policy theme since
1997. It has identified what it calls the ‘five drivers of productivity growth’, and policy has
been based around enhancing these.
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investment in physical capital
improving skills and human capital
greater innovation
competition
enterprise
Investment in physical capital
The best way to stimulate investment is by creating a stable business environment in which
risk and uncertainty are minimised. Since 1997, the UK has gone through a period of
sustained growth and stable inflation. Both fiscal and monetary policy are now based on clear
rules and targets.
Investment (gross fixed capital formation) as a proportion of GDP, however, remains at
lower levels than those in the USA, France, Germany and the average of the EU15 countries.
This is shown in Table 2.
Table 2 Gross fixed capital formation as a percentage of GDP: 1960–2005
Year (average)
UK
Germany
Japan
EU(15)
USA
1960–67
17.7
25.2
31.0
22.8
18.2
1968–73
18.9
24.5
34.6
23.6
19.2
1974–80
19.2
21.0
31.8
22.2
18.9
1981–85
16.5
20.4
28.7
19.8
18.9
1986–90
18.9
19.9
29.8
20.1
18.3
1991–94
16.6
22.4
30.0
19.8
16.6
1995–00
16.8
21.7
27.4
19.8
18.9
2001–05
16.7
18.5
24.2
19.5
18.4
Source: European Economy (commission of the European Communities)
In addition to the stable business environment, the government has initiated a series of
tax reforms seeking to encourage investment. They have, for example, reduced the marginal
rate of corporation tax to 19 per cent for small businesses – those with profits up to £300 000
(in 2006/7). Above that level, the rate rises gradually to reach 30 per cent for companies with
profits over £1.5 million.
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Skills and human capital
Between 1978/9 and 1996/7, spending on education rose by only 1.5 per cent in real terms.
To improve upon this, the government planned that between 2000/1 and 2004/5 real spending
on education would rise by 5.4 per cent a year. As it turned out, real expenditure rose by 8.1
per cent over this period and by 5.5 in 2005/6.
The government has set education targets and hopes to be able to offer 50 per cent of
those aged 18 to 30 the opportunity to enter higher education by 2010.
Innovation and technology
In April 2000 the government launched the new R&D tax credit. Here small and mediumsized enterprises can claim 150 per cent tax relief on R&D spending.
The DTI’s Science and Innovation White Paper (2000) set up a new £1 billion
programme with the Wellcome Trust, and launched a £250 billion programme to promote key
areas of research within the economy.
Competition
A number of studies have revealed that with increasing market share business productivity
growth slows. As a result, government policy has sought to strengthen competition policy.
The Competition Act 1998, which came into force in March 2000, and the Enterprise Act of
2002 (see Economics (6th edition) pages 351–4), enhanced the powers of the Office of Fair
Trading in respect to dealing with anti-competitive practices. It now has the ability to impose
large fines on firms which have been found guilty of exploiting a dominant market position.
Enterprise
The creation of an enterprise culture is seen as a crucial factor not only to encourage
innovation but also to stimulate technological progress. The government launched the Small
Business Service in April 2000. It role is to co-ordinate small-business policy within
government and liase with business, providing advice and information. The UK is currently
rated by the OECD as having the lowest barriers to entrepreneurship of any major economy.
Conclusions
The first step on the road to dealing with the productivity gap between the UK and its main
rivals is the recognition that the gap exists. Governments in the UK, have for many years
failed to appreciate the significance of the productivity gap, and as such have failed to
develop the coherent and wide-ranging series of initiatives necessary to deal with the
problems that have led to its creation.
In this respect the UK has made progress. It now appears to recognise that if the economy
is to be successful, the productivity gap must be closed. It also appears to recognise that the
policies necessary to achieve this are long term. There is no quick fix.
There is also a recognition that the productivity problem is a multi-faceted one, and that
to deal with it requires policy initiatives on a broad front: initiatives that encompass
institutional changes as well as adjustments in policy.
Question
Why is R&D a limited measure of technological progress?
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Sources
HM Treasury (2004, 2005 and 2006), Economic and Fiscal Strategy Report, Chapter 3
HM Treasury (2005), Pre-Budget Report
HM Treasury (2000), Productivity in the UK: The Evidence and the Government’s Approach
Crafts and O’Mahony, ‘A Perspective on UK Productivity Performance’, (Mimeo, July 2000)
HM Treasury (2005) Leitch Review of Skills Skills in the UK: the long-term challenge: Interim
report
Oulton, Nicholas, ‘Why do foreign-owned firms in the UK have higher labour productivity?’, Inward
Investment, Technological Change and Growth, ed. Nigel Pain, (Macmillan, 2000)
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