Next UK government must make productivity its top priority

Creon Butler

London: The upcoming general election may lead to a far-reaching shift in the UK government’s underlying economic philosophy and policies. Comparisons are already being made with the game changing elections of 2010, 1997 and 1979.

However, in many respects the situation today is unlike any other. The UK is not struggling to emerge from the world’s worst ever financial crisis, as it was in 2010. The international environment is much less benign than in 1997, which came in the middle of the ‘Great Moderation’ – a twenty-year period of low inflation and stable economic growth in the US.

The UK…currently faces an unenviable combination of weak GDP growth, falling living standards, high public debt, a large current account deficit, historically high taxes and weakened public services

The election of 1979 has some parallels to today’s conditions, taking place when the UK economy was mired in long-term structural weaknesses, including dismal labour relations, high inflation and large public deficits. But growth averaged 2.7 per cent over the 1970s and living standards rose significantly.

Like other advanced economies the UK economy has been through the cumulative shocks of the 2008-9 global financial crisis, the pandemic and the 2021-23 inflation surge triggered by Russia’s invasion of Ukraine. However, it is taking longer to recover from these shocks than other advanced economies.

It currently faces an unenviable combination of weak GDP growth, falling living standards, high public debt, a large current account deficit, historically high taxes and weakened public services, particularly the National Health Service (NHS), where more than 6 million people are waiting for hospital treatment, contributing to a recent sharp rise in labour inactivity.

Indeed, some commentators have described this as the worst economic legacy facing any incoming government since the Second World War.

Brexit certainly has not helped – estimates suggest a cumulative 2-3 per cent of GDP has been forgone three years after the UK left the EU. But at the heart of the current problems is a long-term decline in productivity growth that pre-dates Brexit.

Between the 1990s and early 2000s UK productivity gradually gained ground on the US, France and Germany. But since the mid-2000s it has been in relative decline. As a result, the gap between UK productivity (measured as an index of GDP per hour worked) and the average of France, Germany and the US increased from 9 per cent in 2008 to 18 per cent in 2022.

This has occurred despite some evident UK economic strengths, including a strong research base, some highly competitive economic sectors (from business services to creative services and pharmaceuticals), high employment rates and strong economic institutions.

Until recently the UK was relatively successful in attracting foreign direct investment, but performance…has weakened sharply since Brexit.

Views differ on the potential causes – for instance on the role of high migration, or the UK’s internationally focused financial sector, and the overall macroeconomic policy framework. But there is a strong consensus that one of the most important drivers is low total investment sustained over a long period of time.

Underlying this is low domestic savings. Until recently the UK was relatively successful in attracting foreign direct investment, but performance in this respect has also weakened sharply since Brexit.

The next UK government will need to make tackling low productivity growth its top political and economic priority. This means putting it first in decisions on public spending, tax policy, regulation and international economic policy. And doing the minimum necessary on other issues that compete for resources despite the strong case for them.

There is a simple reason for this. Without a sustained increase in productivity performance, the UK will continue to find it impossible to meet public expectations for rising prosperity and quality of life – or its international security, environmental and development responsibilities.

To address the productivity challenge, the next government will need the maximum freedom of action in three critical areas.

High and sustained public investment will be critical to raising productivity. In theory, the government can pay for this at least in part through higher debt, as it will also raise the growth rate and future tax revenues with which the debt can be repaid.

Avoiding…spending commitments which don’t contribute to productivity is important too, as is maintaining the freedom to raise tax rates if this proves necessary.

But it is uncertain how much additional debt the markets will tolerate, even if the spending is clearly used for investment. Therefore avoiding other spending commitments which don’t contribute to productivity is important too, as is maintaining the freedom to raise tax rates if this proves necessary. This is not just because the government might need the revenue, but also to minimize distortions in the tax system.

A further option (proposed by Labour) is to set up a publicly capitalized energy company which will be able to raise private sector funds for investment in the energy system. This is intended to leverage private sector finance while ensuring that the funds raised are used for long-term public benefit. But to succeed it will be critical to structure the new entity with a sufficient degree of independence to avoid its balance sheet being consolidated with the government’s.

Another critical decision will be over the way money for investment is spent. We know, for example, that investment in high quality transport and energy infrastructure, public education and skills, and university research and development has a good prospect of boosting productivity.

Poorly conceived or implemented regulation could also cause enormous damage.

It’s much less clear that the same is true of sectoral industrial subsidies, such as those being mooted to compete with China in EVs, batteries and solar power. In their statements on economic security, the Conservatives have emphasized keeping interventions to the minimum necessary for national security while Labour has been more ready to embrace intervention as a means of boosting strategic competitiveness.

The second, key area for government policy is domestic regulation. This can be used to mandate or incentivize increased private investment in critical sectors, as seen with National Grid’s commitment to invest over £30 billion in UK energy networks over five years.

But poorly conceived or implemented regulation could also cause enormous damage. The parlous state of the UK’s water utilities where private investors have extracted dividends, while failing to invest and ignoring critical health standards, illustrates this well.

Planning reform, competition policy, broader Net Zero delivery, environmental protection and tech industry oversight (particularly on AI) are further areas where effective regulation can make an enormous positive difference to both investment and productivity.

But managing the interactions between different policy areas and achieving the right balance between protection, freedom to innovate and policy certainty will be far from straightforward.

Improving the political relationship with the EU and working pragmatically on cooperation could deliver some economic benefits, but these are likely to be limited given the decision of both major parties to remain outside the single market and customs area.

The US is keen for the G7 to have a common strategy on economic ties with China linked to a common analysis of the economic security threats. But the UK’s interests, for example, on which sectors to protect from Chinese competition and by how much, will likely differ from both the US and the EU, and future government policy will need to address this.

The UK will also need to decide how much effort to put into sustaining and reforming the WTO (and in particular pushing for a new plurilateral negotiation mechanism) or whether it is better to prioritise CPTPP as the most practical way to promote free trade and investment flows outside the three major economic blocks.

The next UK government will have many difficult decisions to make. But being honest with the public about the challenge the UK faces and the need to prioritize productivity will make the task ahead easier.