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Resilience and renewal

Tackling the UK’s productivity problem

Author: ICAEW

Published: 26 Sep 2023

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The UK’s persistently poor productivity must be tackled if we are serious about renewing economic growth and raising living standards. Businesses and accountants have a core role in that endeavour. Here we look at what they need to play that role.

As we covered in the first article in this series, the UK has a decades-old problem with low productivity growth. It lags behind its peer group of the world’s most developed economies, and this has real effects on people’s standard of living and well-being.

It’s clear that all UK-based businesses, from microenterprises to the very largest global companies, have a huge role to play in boosting productivity growth, but they do need support. This support may come principally from policymakers who need to create the right long-term conditions, but those running businesses and those advising them need to understand how to boost productivity and how to make the most of the support that does exist. In short, it requires a collective effort from a lot of different groups.

The importance of being certain

First and foremost, when asked about reforms to boost productivity, most experts wholeheartedly point to the need for a stable political, economic and fiscal environment. The past 15 years, and in particular the post-Brexit years, have been one long tornado that’s hampered business investment. Unquestionably, a lack of certainty reduces business confidence and together with Brexit, the two are significant inhibitors of business investment. Although there is now greater certainty about the UK’s relationship with the EU, there remains a great deal of uncertainty in other respects, most notably a clear political agenda and economic strategy.

Yael Selfin, Chief Economist at KPMG in the UK, comments: “Businesses in the UK still face relatively high uncertainty, and that will continue with a general election due in 2024. At the moment, there is not a long-term political direction that businesses can focus on, and business investment tends to work to a long-term timeframe. From a political perspective, having more clarity of where the government wants to focus in relation to the economy and the business environment would be very helpful. However, part of it is due to the fact that our political cycle of five years is relatively short compared to the timeframe of larger business projects.””

Constant policy changes have also blighted business confidence in the UK. The need for greater political consensus and long-term planning is a recurring theme. Professor Dame Diane Coyle, Bennett Professor of Public Policy at the University of Cambridge, says: “One of the big problems in the UK is constant policy flip-flop. Even initiatives launched as strategies, such as the 2017 industrial strategy, get ditched within a couple of years. This creates an environment of extreme policy uncertainty, which does not help when asking businesses to invest on a 20-year horizon.”

Capital allowances and other tax policies

There is a propensity for “policy flip-flop” in the fiscal regime. : “We’ve had an inconsistent attitude toward capital allowances, which are really important tax-wise. After going through repeated cuts to the headline tax rate companies were beginning to rely on, we’re now reversing that with a new approach. I don't know any other country that seems to change its tax strategy towards investment and profit taxes as frequently as we have.”

Suren Thiru, Economies Director at ICAEW, elaborates: “There’s been a myriad of tax incentives to encourage investment, which is all well and good, but it creates more uncertainty if you try one tack for two or three years, then stop and try another approach. The super-deduction in place for a couple of years. In the latest spring budget, the government announced full expensing, another tax break, but it is only in place for three years.” Regardless of the precise approach, the call for a consistent, long-term strategy for capital allowances comes through loud and clear from every expert on the topic of how to stimulate business investment.

One of the biggest challenges with using tax as a policy lever is putting measures in place that genuinely stimulate additional investment rather than rewarding expenditure that would have taken place anyway. For example, the government has sought to quantify how much “additionality” is generated by R&D tax relief. In its recent R&D tax reliefs review, it noted that additionality for the SME R&D scheme is lower than that for R&D expenditure credit (RDEC). The SME scheme is incentivising as little as 60p to £1.28 of additional R&D for each £1 spent, compared to as much as £2.40 to £2.70 additional R&D per £1 of RDEC. At the same time, the SME scheme costs more than RDEC and has grown at a faster rate. Companies undoubtedly welcome the relief provided, but the degree to which R&D tax credits reliefs drive business decision-making when making new investment in R&Ds remains an open question.

When it comes to boosting regional productivity, one of the latest initiatives from the government is the planned creation of 12 investment zones across the UK, which will receive tax and regulatory incentives to drive economic growth. As the Institute for Government notes, the concept of creating economic growth zones with special exemptions is not new; in fact, there are 48 enterprise zones still in existence in England from a scheme introduced by former Chancellor George Osborne in 2011.

Many of these previous efforts have struggled to make a real impact on economic growth, a challenge being that they have simply relocated business investment that would have happened elsewhere. Yet a point of difference with the new investment zones is that they are designed to develop and improve existing technology clusters and will be linked to university research centres. They will also be required to focus on one of the government’s five priority sectors: digital and tech; green industries; life sciences; advanced manufacturing; and creative industries. This more focused approach and, in particular, connecting the zones to university research has generally been well received. However, the potential for such zones to truly transform economic growth is considered relatively limited.

How do investment zones compare to freeports? Well, the direct tax benefits of freeports and investment zones are broadly identical, subject to any differences for devolved taxes. Both freeport and investment zones can have up to three unique tax sites with a total maximum size of 600 hectares. There are, however, some differences between investment zones and freeports to be aware of, as analysis by ICAEW’s Tax Faculty reveals.

Funding and access to capital

Access to capital plays a huge role in encouraging investment. The credit crunch during the global financial crisis was particularly acute and even though it recovered to some degree, funding remains a growth challenge for many businesses. The ICAEW's Business Confidence Monitor (BCM) that 11% of businesses cited access to capital as a growing challenge between Q3 2018 and Q2 2023, compared to 8% over the previous five years. The situation varies greatly by sector, with the property sector most likely to find financing an issue with an average of 17% of surveyed businesses citing this as a rising challenge. The energy, water & mining (15%) and construction (13%) sectors are also particularly affected.

Percentage of businesses citing access to capital as a key business challenge (Q3, 2013 - Q2, 2013 and 2018 - Q2, 2023)
Source: ICAEW Business Confidence Monitor

Yet, with the UK’s strong financial markets, funding should be a potential bright spot in the UK’s productivity challenge. “Compared to the rest of Europe, we have a thriving venture capital and private equity ecosystem, which makes it potentially much easier, especially for small and medium-sized businesses, to grow, particularly with the right business support and advice,” says Selfin.

Here again, however, the story of ‘London vs the rest’ is retold. Professor Bart van Ark, Managing Director of The Productivity Institute, explains: “The financial market is not as rich and well-developed everywhere as it is in London, and there is a real issue with risky investments; access to venture capital is not as great as in the US. Even so, this is one area where the UK actually does have an opportunity compared to Europe. But we’re not always able to really attract the amount of venture capital funding we need, and small and medium-sized firms can find it really hard to access finance or, if they can, it is very costly for them.”

In particular, funding for scale-up businesses is a weak spot. “We’re good at supporting start-ups,” states Coyle, “but there’s the traditional problem of scaling up. With capital markets crumbling, the only option seems to be to sell out to a large company.” And then this, of course, can mean seeing successful growth stories exit the UK and take the myriad benefits of that success with them.

The role of chartered accountants as trusted advisers to business in securing access to appropriate finance, among other business-related matters, is crucial. Businesses tend to be more successful with funding applications via accountants, business advisers or qualified brokers, as these intermediaries have a good understanding of the wider funding marketplace. Therefore, signposting to key services such as ICAEW’s Find a Chartered Accountant, is vital.

Technology remains a big factor

Investment in technology also offers some of the greatest potential to improve productivity. Over the centuries and decades, numerous technological advancements – from the invention of the steam engine to the dawn of the internet – have seen step changes in how companies operate. Professor David Miles, a member of the Budget Responsibility Committee at the Office for Budget Responsibility and former member of the Bank of England’s Monetary Policy Committee, points out: “The history of productivity growth, over the last 200 years, which has been absolutely enormous, has not been the history of governments working out how to make economies work better; it is the history of people discovering new things and ways of working that have transformed people’s lives.”

Today, we are arguably at the start of the age of artificial intelligence (AI). AI and machine learning have existed for decades, but the recent advances in generative AI, particularly its low-cost accessibility to anyone with access to a device and the internet, could see the discovery of many new ways of working and producing what people need with fewer resources.

“Technology is an enabler for business. The right technology can help businesses achieve whatever their objectives are, whether that goal is expansion or cutting costs,” says Esther Mallowah, Head of Tech Policy at ICAEW. “If we look at technologies like AI and automation, they can make processes that would normally take a long time and require human input to be done faster, and sometimes to a better quality. So, businesses can use technology to drive efficiency and growth, as well as staff retention and well-being.”

Yet, while the potential advantages of AI are undeniable, there is a question of uptake. Coyle explains: “Companies, not just those in the UK, are finding it very hard to use the new digital technologies. And it seems to be only very productive companies, large companies, or new start-ups in technology areas that can use these tools. As a result, the most productive companies are pulling further and further ahead of the rest. The top 5% or so are seeing big productivity gains, and big differentials are opening up within sectors of the economy.”

Once again, skills shortages are often to blame for this. While technology can bring enormous benefits, to access these companies need people who know how to implement and use the technology, and this is a particular challenge for smaller businesses. Mallowah adds: “I say the ‘opportunity’ that tech provides because I think sometimes there’s a misconception that simply implementing technology will lead to productivity benefits, but there’s a whole lot of other things that go around that, such as skills. So, for technology to lead to productivity gains, there needs to be changes to processes and work in training and upskilling employees.”

Paul Scully, Minister for Tech and the Digital Economy, details some of the work being done to help companies with skills: “I co-chair the Digital Skills council, and we work alongside business and academia to co-create solutions and promote the value of apprenticeships for SMEs, and we’re working with industry to develop programmes to boost numbers. Then, through the Department of Education, we’ve also scaled up the Skills Bootcamp and provided £150m of new funding. This provides free courses on subjects such as software development, digital marketing and data analytics.”

Finally, there is also the question of what regulation will shape how new technologies are used. Mallowah says: “For topics like AI, it’s not entirely clear what the expectation will be in terms of the regulation, audit and what methodologies companies should adopt to implement the technology. So that’s also holding businesses back.”

However, some work is underway. The government has published its AI White Paper, which seeks to boost innovation. Scully says: “We want to be at the forefront of AI regulation. We want to be talking about the implications of AI from the very beginning rather than trying to put the regulatory genie back in the lamp, which was the case with the internet.”

Reaping the benefits of net zero

Alongside technology, there is also the question of how businesses can use investments in the net-zero transition to boost productivity. In theory, shifting to renewable energy and other carbon-neutral technologies can bring significant cost savings and help drive efficiencies. As Professor Jonatan Pinkse, Professor for Strategy, Innovation and Entrepreneurship at the University of Manchester, points out, the transition to net zero is generally sold on the many other benefits it brings: “The typical argument is that it is not just about investing in net zero, but it’s about all other kinds of things as well, such as levelling up and job creation. Of course, if businesses can make the transition, net zero really can help industry, but there are a lot of ‘ifs’ on that journey.”

The reality is that for many businesses, particularly SMEs, the long-term benefits don’t outweigh the very real short-term costs. Pinkse explains: “We know many smaller businesses are struggling with the transition. If your carbon impact is only based on electricity use, it’s a fairly simple change for businesses [to remove that carbon]. But we’re currently doing a project about adopting electric cars, and most SMEs don’t even want to talk to us about it. Because they know it’s more expensive and more difficult. And if they are not being forced, they will not go there for now because they simply can’t see benefits when they compare it to the added costs. Larger companies, on the other hand, have more opportunity to step in, but even some of them are hesitant and slow, and this is where you need government to step in.”

Unfortunately, the regulatory and policy side of the net-zero transition is mixed. Richard Spencer, Director of Sustainability at ICAEW, explains: “It’s quite a messy landscape in regulation because the government hasn’t said yet if it will adopt the new International Sustainability Standards Boards (ISSB) requirements or whether they will make them mandatory. The Financial Conduct Authority has made ESG reporting mandatory for big financial institutions, and the government is also consulting on whether that should apply to private businesses. Regulation will come, though. You can see elsewhere that it’s becoming much more aggressive. The corporate sustainability reporting directive in the European Union will apply to about 50,000 businesses.”

And while regulation is essential, many other factors are at play in adopting net-zero practices. Once again, the theme of skills shortages arises, with a dearth of green skills expertise to help businesses manage the transition. There is also the question of understanding the motivations of each business sector. Pinkse says: “The idea that just one policy change is needed is not how it works. We did an in-depth case study of the construction sector, where we tried to understand what is needed to push housebuilders to do something more to help with net zero, and there were so many factors. 

“Currently, housebuilders mainly make their money by land banking; they buy land and hold it until they can build something on it and sell it for much more money. They are speculating on the land rather than making money from building. All these things do not help with the move to net zero; if housebuilders are not making the most from the actual building, if you say you need to build something that’s more expensive and there isn’t customer demand, they are not enthusiastic. It’s not their priority because it doesn’t fit how they do their business.”

Of course, not all businesses require the impetus of government regulation. Spencer says: “There is the market norm that you can see playing right across businesses because businesses have to have a business case to back up doing things. They will primarily look to drive efficiencies. Then you have another driver, the social norm, which is about doing the right thing. Some businesses recognise that we are in the middle of a climate crisis, and they have a role to play. There is also a public expectation nowadays, which I think is a gradual shift, which is that businesses shouldn’t just prioritise profits but should also have a responsibility to society. These businesses will be more inclined to rethink their business model and put the climate change problem at the heart of their actions.”

Those running businesses should note that a more active approach will produce productivity and competitive benefits. Pinkse says: “We recently looked at long-term investments in renewables and green energy from the electric utilities in Europe. We found that the companies that really started talking about it a long time ago are the ones that are doing well today. Those companies that resisted and waited for regulation or believed regulation was unfair are not. It is challenging because it is not just about the technology but the skills, the wider capabilities and processes. Those companies that have been doing it for many years have learnt a lot and how to do it better. So, when everyone needs to do it, they really do have a first mover advantage.”

Of the messages that come through loud and clear, the need for certainty is arguably the loudest; a lack of vision, combined with policy flip-flop in so many areas, has not been conducive to driving investment. But equally, it also needs to be recognised that improving productivity is not just down to government policy; it also requires businesses to take an active approach to the latest technological developments and to think critically about how shifting global trends present both risks and opportunities. For example, the widespread adoption of generative AI and machine learning in the workplace could bring about the biggest change to working practices since the Industrial Revolution of the 1700s.

The role of chartered accountants as trusted advisers will be fundamental in helping businesses, particularly SMEs, reap these benefits and ensure they are well-placed to play their part in creating a more resilient economy that is more sustainable, accountable and fair, by lifting productivity and living standards across the UK.

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