Productivity Performance And

Productivity Performance and

the UK Economy

Closing the gap with the rest of the world?

1

The government’s long-term economic ambition for the next decade is that Britain will have a faster rise in productivity than its main competitors as it closes the productivity gap.

UK Budget 2000 Red Book, Chapter 3

The current productivity gap between the UK and its main competitors is significant. Using figures for labour productivity given by output per worker, the UK is 36 per cent behind the USA, 25 per cent behind France and 15 per cent behind Germany.

In many, but not all, of the key elements that are conducive to productivity growth, the UK economy lags behind its main rivals.

• 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 has seen R&D expenditure rising since 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 and France have 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).

Source: HM Treasury (2000), page 6Source: Ibid, page 8

Figure 1 Productivity gap (1999) Figure 2 Total factor productivity gap (1999)

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: Ibid, page 9

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.

Source: Ibid, page 11

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 in higher level skills. Compared to the USA, the UK has a higher number of intermediate skilled workers but a lower quantity of workers with higher skills (see Figure 5).

Source: Ibid, page 12

Figure 5 Employees by skill level: 1978/9 – 1998

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).

Source: Ibid, page 15

Figure 5 Gross expenditure on R&D as a share of GDP: 1980–99

Accounting for the productivity gap

Using a process known as ‘growth accounting’, 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 (%)

USA / Germany
Physical capital / 31 / 55
TFP / 69 / 45
(of which: Innovation / (65) / (17)
Skills / (0) / (14)
Other) / (4) / (14)
Total productivity gap / 100 / 100

1Labour productivity measured as output per hour worked

Source: Crafts and O’Mahony (2000)

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.

• 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.

Business investment as a share of GDP has been rising since 1994, and since 1996 has been at a higher level than the USA, France and Germany. 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 30 per cent, and established a new 10 per cent rate for small business.

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 plans that between 2000/1 and 2003/4 real spending will rise by 5.4 per cent a year.

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 medium-sized 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, 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.

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 do you think R&D is a poor measure of technological progress?

Sources

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)

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)