Explaining poor UK productivity performance and some potential remedies

The question! - I was asked to write an 'essay' on this as part of a job interview process, which I subsequently pulled out of [I was promoted with current employer instead :-)]

My written response as follows - a halfway competent overview of productivity and possible policy responses etc (really just a lit review)

1. Numerous studies suggest that the UK lags behind other advanced economies in terms of productivity (measured as output per hour worked). Why is this? What policies would you advocate to improve the situation?

What is productivity?
In economics, productivity describes the amount of output created (in terms of goods produced or services rendered) per unit of input used. Inputs can include labour and capital. By measuring productivity, it is possible to understand how well an economy can use the resources it has available to produce a certain level of output.
The amount of output that people can create in work is termed labour productivity. The amount of output that machinery and equipment can create is termed capital productivity. Both labour and capital productivity do not operate in isolation. For example, a piece of equipment can increase the level of output that a worker can produce, thus influencing labour productivity. Alternatively, a complex piece of technical equipment needs a skilled person to operate it. So both labour and capital productivity are interrelated. When we consider their productivity in combination, we call this total factor productivity.
Increasing levels of productivity in a nation will lead to more outputs for the same levels of input, or the same levels of output with reduced inputs. So, productivity is considered as important in terms of the economic development, performance and growth of nations, localities or industrial sectors. Thus, productivity growth is of critical importance. High levels of productivity growth result in larger real changes in profits and wages in the long run. The total amount of economic output (often measured as Gross Domestic Product) will increase substantially from a small increase in productivity. For example, GDP would double in 25 years if productivity rose by 3 per cent per year.

Why is productivity of concern to UK policy-makers?
UK productivity has been lagging behind other advanced industrialised nations
It has been recognised over the past two decades, that UK productivity levels have lagged behind our major competitors or other industrialised nations, and that the rate of growth in UK productivity levels has also been lower than many other nations, especially the USA.
This is a significant problem. As discussed, higher productivity levels in the UK would enhance the growth prospects for the national economy in the long term. Achieving higher levels of economic growth is also more dependent on productivity gains in the UK, because the proportion of working age population in employment is already quite high. There is less scope to expand economic output significantly with current domestic labour availability.

Evidence tell us that the UK’s productivity performance has been lagging
The UK’s workers, as a whole, produce less per hour than many other industrialised nations
In 2001, out of the 30 OECD nations, the UK ranked 15th in terms of output per hour worked – behind other OECD nations such as France, Germany and the USA. A comparatively high employment rate, rather than higher productivity levels, sustains the UK’s level of economic output and growth.

UK growth rates in labour productivity have consistently lagged behind other industrialised nations. Since the early 1970s, average annual labour productivity growth has consistently lagged behind France, Germany and the USA.

UK businesses and organisations invest less in equipment, machinery, infrastructure and buildings compared to many other advanced industrialised nations. The amount of capital (equipment, premises, machinery) used per hour worked in the UK is lower than France, Germany and the USA. For example, UK capital use per hour worked is 50 per cent less than the ratio in Germany.

Workforce skills leads to lower productivity, but so does low skills utilisation. Compared to some other economies, such as Germany and Scandinavian countries, the UK has a large proportion of low- or un-skilled employees, and a lower proportion of employees with intermediate skills. This leads to lower labour productivity on aggregate, and explains a number of sectoral concentrations of low productivity (Futureskills Scotland, 2005).
Evidence indicates that there may be a lack of demand for skills and skills utilisation in the UK economy. Findings from national employer skills surveys (such as Futureskills Scotland, 2002 and 2004; and Learning and Skills Council, 2003) suggest that in the UK economy, problems of a lack of skilled workers to fill vacancies, and a lack of skills in employees in work, are both modest. This suggests that, on aggregate, neither the quantity of demand nor the quality of demand is stretching the UK labour pool unduly.

Innovation does not occur as much as in other advanced industrialised nations
Innovation and technical progress provide new ways of working and sources of efficiency gains. These enable workers to increase their productivity. The UK has also lagged behind other nations in terms of investment in research and development (R&D) and innovation:
According to Abramovsky et al (2004):

• In 2002, 2.2 per cent of the UK’s national output was invested in R&D. This is less than the USA (2.7 per cent) and Germany (2.5 per cent).
• In the 1980s, the UK’s share of national output spent on R&D was static. Business investment in R&D increased, whilst government investment in R&D decreased. Other G5 nations increased their share of national output spent on R&D.
• In the 1990s, the UK’s share of national output spent on R&D declined. This decline was largely due to a decrease in business expenditure on R&D.

Productivity performance is not uniform across sectors. Research by Griffith et al (2003) on comparing the USA and UK’s productivity performance by industrial sector is revealing:

• Low productivity across all sectors accounts for most of the UK-USA productivity gap
• There is considerable variation in productivity between different industries. Over half the productivity gap with the USA is from three industry groups: wholesale and retail; financial intermediation; and machinery and equipment
• The UK has increased employment in the lower productivity sectors of hotels and restaurants and wholesale and retail.

Productivity performance is highly variable between individual businesses. Barnes and Haskel (2000) found that within industries, there can be individual businesses with productivity levels that are comparable with the best levels found anywhere else in the world. However, behind the leading firms, there is a “long tail” of firms that are much less productive.

What might the UK government do to improve UK productivity performance?

Selecting and advocating policies

There are a significant number of potential policy options, some of which are described below and are short-listed as policies that the author would advocate in the first instance.
Particular policies are advocated over others for the following reasons:

Where they can positively influence business performance. Productivity is related to overall business performance. Evidence shows that to achieve significant productivity gains, businesses and organisations have to improve many factors at once such as skills, technology, capital investment, business planning, product quality and management for example. A classic example is that investing in IT equipment without investing in staff skills to operate it would not be effective in increasing productivity. This is a challenge for government in prescribing policy.

Policy options with higher efficiency, effectiveness and net positive impacts. Not all policy options are equal in cost, effectiveness or impacts. Policy options must be evaluated and prioritised according to:

• Their efficiency - the impact they will make versus their cost
• Their ability to work with the market – helping the market work better for the desired outcome
• Potential for lower levels of displacement – they will have less potential to distorting markets negatively than other options

Demand side solutions are needed. Supplying factors of production and government expenditure aren’t enough, on their own to stimulate productivity gains in the UK economy. The demand side must be addressed. Incentives and conditions must be provided to stimulate businesses and organisations to utilise factors of production better to stimulate productivity. To address productivity, enterprises must have a real demand more highly skilled workers, more productive technology, and must seek to be more competitive in markets. This essentially involves attempting to influence and incentivise the organisational and managerial decision making behaviour of businesses and institutions.

Policy recommendations

Enhance capital availability for investment in equipment, land and premises. The UK has a history of low capital investment amongst businesses in the past 30 years. There is some evidence to suggest that some businesses invest at sub optimal levels. Labour and Total Factor Productivity might be increased if businesses can realise their optimum investment requirements.

Recommended policies:

• Ensuring macroeconomic stability - to keep the costs of capital and levels of perceived risk at reasonable levels so as not to disincentivise the demand for, and supply of, capital.
• Addressing market failures in financial markets for businesses by incentivising market provision, or giving better market information and guidance to increase transaction levels.
  Other policy options
• Addressing market failures in financial markets for businesses by providing public loan funds or loan guarantees.

Increasing capital investment. There are certain types of capital expenditure, such as IT expenditure, which have significant impacts on productivity and also require upgraded skills for operation.

Recommended policies:

• Promotion and marketing of benefits of greater investment in IT and other technologies to businesses
• Fiscal incentives to investment in more advanced technology and capital equipment
• Public investment in capital and infrastructure.
• Regulation of credit to finance capital equipment to ensure market rates of interest are applied

Other policy options

• Grants to businesses for IT, technology and capital equipment
• Price controls on IT, technology and capital equipment

Ensuring competitive markets. Evidence demonstrates that rates of innovation and productivity growth are higher in competitive markets, where there are many actors in each sector and market places.

Recommended policies

• Regulatory government activities: to limit monopoly behaviour and to ensure market competition; reduction of information asymmetries in markets.
• Controlling the regulatory burden on markets: so that market entry and transactions are not disincentivised.
• Privatisations of state enterprises: creating more competitive markets, breaking public monopolies
• Promotion of entrepreneurship and business start ups: to increase market entrants and competition in markets

Better understand the problem and potential solutions. The need to improve research and understanding on productivity, the UK economy and comparator economies cannot be understated. It is very challenging to disentangle the multiple causal factors involved in determining productivity performance. Although the UK experiences from generally lower productivity throughout most sections of the economy, certain sectors and activities have a more negative influence than others on productivity levels and growth.

Recommended policies:

• Better use of existing research funding to inform the productivity question

Other policy options

• Promoting collective public, private and university coordination and actions
• Increase levels of in-government research
• Establish internationally collaborative research

Increasing research, development and innovation expenditure and activity. Higher levels of innovation and the development of more sophisticated and efficient modes of production and service delivery will enhance productivity.

Recommended policies:

• Establish and regulate property rights to research and innovations. The government can establish a legal framework to protect the ownership of research and innovations through systems such as patenting or copyright. This means that individuals and companies developing new innovations and research can be satisfied that they have the sole rights to exploit these commercially.
• Incentivise the commercial consideration of research, development and innovation in business management and planning so to integrate these processes in the normal course of running a business.
• Increase and incentivise research and innovation activity and expenditure in businesses. Various mechanisms include grants, tax credits, tax relief, subsidised consultancy, specific loan funds with favourable terms.

Other policy options:

• Fund research: the government can fund research that has commercial applicability. The research can be undertaken by research institutes or private companies
• Increase commercialisation of research: so that research performed in government institutions or higher education institutions is applied to commercial situations for commercial benefit and exploitation
• Promotion of enterprise creation and development to increase the entry of new business models, technologies, innovations, services and products.

Increasing employer’s use and development of skills. There is much evidence to suggest that the level of demand for skilled employees is low in UK businesses and workplaces.

Recommended policies

• Ensure labour market flexibility and mobility so that employers can access the skills they need
• Make education and skills providers tailor provision more closely to employers, and involve employers in designing provision

Other policy options:

• Assist businesses to be more effective human resource managers and planners
• Assist businesses to engage in more skills development and use

Increasing skill levels of the workforce. Several policy options exist to increase the overall levels of skill available in the workforce.

Recommended policies:

• Public provision of education and skills: through schools, colleges and universities
• Immigration – policies to encourage the immigration of workers to provide higher levels of skill in the labour market, or to fill vacancies that require skills that cannot be sourced in the domestic labour market

Other policy options

• Funding of skills development in the workplace: through grants, incentives and regulations for employer based skills development
• Incentives to employers to train: fiscal or tax incentives, grants, funds.

Remove capacity constraints to businesses and increase returns to scale. It may be the case in some businesses or industries that there are certain barriers to them achieving the most efficient returns to scale from business operations.

Recommended policies

• Revise planning legislation to allow for better returns to scale in industries that can achieve higher productivity, or significantly lag in productivity

Encourage coordinated solutions to productivity enhancement. Actions to address the ‘long tail’ of low productivity businesses within certain industries.

Recommended policies:

• Ensure there are no significant barriers to business acquisition – i.e. so high productivity businesses can buy and improve low productivity ones
• Ensure competitive labour market that enables worker mobility

Other policy options:

• Encourage greater transfer of technology, know-how and productivity enhancing techniques and practices
• Encourage greater collaboration between businesses
• Institutionalise productivity related development – for example, establishing centres of excellence linked to industry and university specialisms

Import businesses with high productivity levels. It is an option to seek to attract new foreign corporate investment and activity from corporations which have high levels of productivity, so as capture their high productivity in the domestic economy, as well as the potential for spillovers and transfer of technology and skills to domestic enterprises.

Recommended policie:

• Marketing and incentives for foreign direct investment

Enhancing public sector productivity. Public spending and employment accounts for a large proportion of the UK economy.

Recommended policies:

• Establishing new business models
• Organisational restructuring
• Service level agreement contracts with productivity clauses
• Contracting out delivery to more efficient service providers

References

Abramovsky L, Harrison R, Simpson H (2004) Increasing Innovative Activity in the UK? Where Now For Government Support For Innovation and Technology Transfer?, IFS: London.

Barnes M, Haskel J (2000) Productivity in the 1990s: Evidence from British Plants.

Competition Commission (2000) Supermarkets: A report on the supply of groceries from multiple stores in the United Kingdom

Futureskills Scotland (2002) Skills in Scotland: results from the Scottish Employer Skills Survey 2002, Futureskills Scotland: Glasgow.

Futureskills Scotland (2004) Skills in Scotland: results from the Scottish Employer Skills Survey 2003, Futureskills Scotland: Glasgow.

Futureskills Scotland (2005) International Comparisons of Labour Market and Skills Performance, Futureskills Scotland: Glasgow.

Griffith R and Harrison R (2002) Understanding the UK’s Poor Technological Performance, IFS: London.

Griffith R, Harrison R, Haskel J, and Sako M (2003) The UK Productivity Gap & The Importance Of The Services Sectors, AIM: London.

HM Treasury (2001) Productivity in the UK: The Evidence and the Government’s Approach, London.

HM Treasury (2004) Benchmarking UK Productivity Performance, London.

Learning and Skills Council (2003) National Employers Skill Survey 2003, LSC: Coventry.

Skiczylas L and Tissot B (2005) Revisiting recent productivity developments across OECD countries, Bank for International Settlements: Basel.