Published on 28 January 2022
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Productivity growth continues to reinforce regional imbalances

With recent data showing negative private sector productivity growth, and a pattern of worsening regional imbalances, the government needs to expand its arsenal of policies if it is to succeed in levelling up, says Thomas Aubrey.

The government’s stated vision for the United Kingdom (UK) outside of the European Union (EU) is a high wage, high skill, high productivity economy. In the Autumn Budget and Spending Review 2021, the government set out its plans to invest in innovation, infrastructure and skills with the aim of delivering on this vision through higher productivity growth. Driving up productivity growth is a key policy lever for ‘levelling up’ the UK’s persistent regional imbalances. Unfortunately for the government, UK private sector productivity growth since the pandemic has been negative. Furthermore, the sectors that are performing well have a bias towards the Southeast, while those such as manufacturing, predominantly located in the Midlands and the North, continue to decline.

So how does the government plan to tackle the productivity problem? On innovation, it is set to increase public Research & Development (R&D) investment to £20bn per annum by 2024-25, which is to be welcomed. In addition, public sector net investment, a proxy for infrastructure spending, is expected to rise to an average of 2.7% of GDP (Gross Domestic Product) per annum. This will certainly go some way to rectifying the UK’s infrastructure deficit. On skills, while adult education and skills funding has been boosted, it will still be 15% below 2009-10 levels, with further education and Sixth Form spending still 10% below 2010-11 levels.

The government therefore faces a number of significant challenges if it wishes to see faster productivity growth. Many studies indicate that the main driver of productivity growth is the ability of an education system to improve human capital to make the most of new technology (eg. Goldin & Katz 2009). So with skills funding still significantly down on 2010 levels, this seems unlikely to happen.

Moreover, there is no magic formula where more investment in innovation and infrastructure automatically leads to higher productivity growth. Productivity growth takes place in firms, but it is a by-product of innovation-driven profitable growth. Managers are not paid to increase productivity, they are paid to increase profits. Innovation is hard to get right, hence managers may prefer to look at alternative routes to drive up profits without having to innovate.

Hence a key omission from the government’s plans to support higher productivity growth is to enforce competition through more trade in conjunction with a robust competition policy. The problem for the UK is that it has just exited from the European single market which helped achieve this. Furthermore, additional red tape now the UK is a third country, has reduced the competitiveness of UK exporters and importers resulting in a negative productivity shock.

The government’s idea that it might counteract this loss of competitiveness through regulatory divergence may make the situation worse. For example, if the Medicines and Healthcare products Regulatory Agency (MHRA) is to set up an entirely new set of rules and regulations for medical device manufacturers, firms are less likely to set up shop in the UK. Any new regulatory regime will increase costs for UK based firms and do little to help them to export to the two major healthcare markets: the US and the EU.

As the UK economy emerges from the Covid-19 pandemic, assessing if sectors are experiencing rising or falling productivity growth will provide the government with an indication of whether their strategy is proving successful. The early indicators compared to the pre-pandemic base of 2019 are not particularly positive.

While headline productivity growth between Q3 2019 to Q3 2021 was positive at 1.7% (excluding real estate activities), this was largely driven by more jobs being allocated to higher-paid public sector roles (labelled ‘between’ effect in the table). The private sector experienced a -0.6% fall in labour productivity. And although Q2 2019 to Q2 2021 was positive, the private sector still only managed 0.2% growth over the two years.

Table 1: Productivity contribution by sector Q3 2019 – Q3 2021[1]

Table 1 Productivity Contribution by sector

There are some positive signs in a few sectors. The steady increase in R&D investment will continue to boost productivity in Scientific Research & Development – part of the Professional & Scientific sector. This sector has also been boosted by a rising employment share for legal & accounting activities.

The financial services sector, having experienced a significant decline in productivity since the financial crisis, appears to be on an upward trend once more. One potential driver here is the acceleration of digitization since the pandemic. Digitization can also be observed in the Wholesale & Retail sector which has experienced a large increase in its value-added per hour since the pandemic (labelled ‘within effect’). The pandemic has also boosted Postal & Courier Activities which is part of Transportation & Storage, although the rest of this sector which includes aviation, has not surprisingly seen a marked decline due to the pandemic.

The Transportation & Storage, the Arts Recreation & Other Services and Administrative & Support Services (which includes travel agencies) are still being impacted by the pandemic. However, there are good reasons to think that these sectors might at least stabilize in the next few quarters as the effects of the pandemic recede.

Manufacturing, however, remains on a negative trajectory and has been particularly impacted by the UK’s exit from the single market. The challenge for the government’s strategy is that manufacturing is a high value-added activity and is largely concentrated outside the Southeast of the country. Hence further declines in manufacturing productivity, while productivity rises in value-added service sectors largely concentrated in the Southeast, will make levelling up even harder.

The manufacture of transport equipment (largely automotive and aerospace manufacturing) was the worst hit sub-sector across the private sector between 2019 and 2021, experiencing the largest decline in value-added (within effect) in addition to a fall in employment share (between effect). The effect of non-tariff barriers including customs declarations, rules of origin certification and new VAT processes which are required to continue trading with the EU are expected to cost the aerospace industry an extra £1.5bn per annum. This fall in relative competitiveness is likely to continue to place downward pressure on productivity growth.

With the levelling up White Paper expected imminently, the recent data not only shows negative private sector productivity growth since 2019, but a pattern that indicates a worsening of the country’s regional imbalances. The government will need to expand its arsenal of policies if it is to succeed in tackling the challenge.


[1] Derived from Labour productivity by industry division – Office for National Statistics (ons.gov.uk)  and GDP output approach – low-level aggregates – Office for National Statistics (ons.gov.uk)  using Tang & Wang 2004 methodology which decomposes labour productivity growth into a within effect (value-added) and between effect (labour share)

Authors

Thomas Aubrey

Thomas Aubrey is the founder of Credit Capital Advisory. He has written widely on financial and economic issues including Profiting from Monetary Policy (2012) and co-authored Prediction Markets: The end...

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