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Resilience and renewal

Understanding the UK’s productivity problem

Author: ICAEW

Published: 26 Sep 2023

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Poor productivity has upset many UK economic success stories across the past half century. There’s no smoking gun or obvious culprit but rather a number of complex reasons. Here we look at three major causes and, in the next article, the role of UK business and accountants in fixing it.

The UK has grappled with low productivity growth for several decades and the gap with its international peers has only widened in the years since the global financial crisis (GFC). A complex and multi-faceted issue, the UK’s chronic lack of productivity is considered a key challenge to address as the UK seeks to navigate a return to strong economic growth, raise living standards and to make sure the benefits of that growth are distributed as widely as possible.

Why is productivity important?

Put simply, productivity is effectively a measure of how efficiently an economy turns its inputs, such as labour and capital, into outputs, such as goods or services. Productivity may be an abstract concept for many, but its consequences are real. Productivity is a fundamental determinant of living standards. Raising productivity over time allows businesses to produce more goods and services with the same number of workers, helping to drive sustainably higher wages, stronger economic growth and tax revenues and so plays a crucial part in how any country crafts a plan for sustainable and resilient economy over the long-term.

“Productivity is one of the key metrics to look at when assessing the welfare of a country,” says Suren Thiru, Economies Director of ICAEW. “Strong productivity means higher economic output, which means higher wages, and therefore higher living standards across the country.”

There are a variety of measures of productivity and, as the OECD notes, the choice of which to use depends on the purpose of the measurement being made. One of the most frequently used measures is output per hours worked (GDP divided by the number of hours provided by the workforce in a given year), along with output per worker, giving an insight into labour productivity. 

The UK’s productivity story

Unfortunately for the UK, productivity growth has been weak for a long time. Labour productivity data from the Office of National Statistics (ONS) shows that the annual percentage change in output per worker has varied considerably over the years, but there is an undeniable downward trend.

“There are short-term, medium-term and long-term issues with regard to productivity in the UK,” states Professor Bart van Ark, Managing Director of the Productivity Institute. “The long-term problem is that the UK has this long industrial history but has lost its industrial leadership over the centuries, particularly after the Second World War. And over the 75 to 80 years since then, it has struggled to reinvent itself. Other countries have been better at reinventing their industrial structure, moving from an industrialised nation to a services-based one.

“The medium-term story starts in the late 1990s to early 2000s, when we actually saw a revival in UK productivity growth. The UK had become a services economy, and some sectors, notably finance and insurance, became world leaders.”

Professor David Miles, a member of the Budget Responsibility Committee at the Office for Budget Responsibility and an ex-member of the Bank of England’s Monetary Policy Committee, also points to the deindustrialisation of the UK as a driver for changing productivity levels, “If you go back, 30 or 40 years, the structure of the UK economy was really quite different. You had a much bigger manufacturing sector. And if you go back far enough, to the early 1970s, we had a pretty significant shipbuilding sector, a mining sector, and the size of the car industry - relative to the rest of the economy - was much bigger, while the services sector was much smaller. There seems to be a sort of regularity across many countries that productivity growth tends to be a bit stronger in industry and manufacturing than in the service sector.”

In particular, productivity took an especially hard knock when the GFC hit in 2008, and it has never fully recovered. As van Ark explains: “When the financial crisis hit in the late 2000s, the financial services and insurance sectors didn’t recover particularly well, and the economic composition of the UK meant that manufacturing and industry could not make up for that loss. As a result, we’ve seen a decade of 15 years of slow productivity growth.”

The UK is not alone in this trend. Most developed nations have also seen productivity growth slow since the GFC. However, international comparisons from the OECD show that the impact on the UK has been harder, and the country continues to lag behind its peers.

And so, to the present, where the aftermath of the COVID-19 pandemic and the Russia-Ukraine war have acted as further brakes on productivity. As van Ark explains: “The short-term story starts with the pandemic. The pandemic created very perverse results for productivity; we saw a big rise in productivity growth, because the least productive industries like hospitality and retail closed down. And if you close down the least productive industries, the average goes up. When the pandemic was over the low-productivity industries recovered and average productivity growth fell. Where we are is not in a very good place because GDP growth has been slow. That's been true, again, for many countries, but it has been slower in the UK than elsewhere.” The impact of this slow growth is borne out by the latest official data from the ONS which shows that output per worker in the second quarter of 2023 was unchanged on the second quarter of 2022.

Regional gaps are wider than the UK’s peers

Of course, the productivity story varies by UK region. ONS data shows that London and the South East outperform the other regions; output per hour in London, for instance, was 33.2% higher than the UK average in 2021, while in the North East it was 17.4% below average.

“Regional differences exist in all countries,” says van Ark. “We can't ever expect all regions to have a similar level of productivity or even living standards. The problem in the UK is that these differences are relatively large and persistent. Their persistence has partly to do with deindustrialisation and difficulties in regenerating former industrial areas.”

Professor Dame Diane Coyle, Bennett Professor of Public Policy at the University of Cambridge states: “A big difference in the UK is that we are very centralised and don’t have many productive second-tier cities compared to other economies. Even France, another relatively centralised economy, has constitutional guarantees for levels of funding outside the Paris region, so they have a more equitable spread of public money. And those second-tier cities are where productivity growth comes from in economies because of what we call agglomeration effects, essentially positive feedback loops you get from companies being near their customers and suppliers.”

There are three major causes of poor productivity: a lack of business investment; the skills businesses need and a lack of high-quality infrastructure.

UK's Business investment problem

Unpicking the UK’s productivity challenges is no mean feat, with a multitude of factors at play. Coyle explains “I compare it to the classic mystery stories, where it turns out everybody has played a part in the murder. There are very long-standing issues like skills, development and access to finance for small companies. Demography and an ageing population also play a part. And there is certainly a hangover from the financial crisis. But if you're looking for UK-specific things, I think the story is about the lack of investment in the UK.

“The slowdown in capital investments – for building, machinery, computers and so on – has been worse in the UK than elsewhere. It dates back to the early 1990s when there was a bad recession, and investment dropped everywhere. It bounced back in other G7 countries but didn’t in the UK and has stayed relatively low. That's not just true of manufacturing, where limited investment is a well-known challenge, but it’s also true for some of our success stories, such as information communication and technology (ICT) and finance sectors. So I think we're just broadly under-investing in the UK.”

Investment is important because, as well as helping companies with the ‘business as usual’ challenge of maintaining current inventory to be resilient and ready for unexpected changes, it means they can invest in the latest technology and equipment to help their workforce operate more efficiently. Coyle notes: “You don't make people more productive by getting them to work more. On a construction site, you don't ask somebody to dig faster; you give them a digger. So that's why investment matters, and improving the investment track record is essential.”

The slowdown in capital investment is reflected in the data collected by ICAEW’s Business Confidence Monitor (BCM), one of the largest and most comprehensive quarterly surveys of UK business activity, which shows that growth in capital investment has been particularly lacklustre since the GFC (see Chart 3). From 2004 to mid-2007, average annual growth in capital investment stood at 2.8%. In the three and half years that followed, it fell to 0.7%; over the entire 15 years since it has averaged just 1.8%. This story ties in with the slowdown in productivity that the UK has experienced ever since the GFC. Although there has been some degree of recovery, the ground lost in the late 2000s has never been fully regained, and the later shocks of Brexit, COVID-19 and the Russia-Ukraine war have only compounded this.

Annual percentage increase in capital investment, 2004 - 2023.
Source: ICAEW Business Confidence Monitor

Yet as successive governments have found, stimulating business investment is not an easy task. Giles Wilkes, senior fellow of the Institute for Government and formerly a special adviser to Prime Minister Theresa May on industrial and economic policy, says: “Investing isn't easy. It's something you can easily get wrong as a business. It's not as obvious as just buying working capital to fund your ongoing operations; it’s speculation to a certain degree. And so, conditions really need to be right to encourage it.”

The conditions since the GFC have proven particularly challenging. Not even years of low interest rates and the reduced cost of borrowing have proven enough to revitalise investment. Wilkes says: “Fundamentally, the financial crisis is still the most important economic event of our lifetimes. It momentarily cut off really important sources of finance, led to a period of sustained weak economic demand and a large capacity gap opened up for a long time. That has hit the case for investment very strongly. But then, in the UK, we obviously compounded it with Brexit. Brexit is an absolute classic business environment shock. And you could see how investment intentions fell relative to demand intentions immediately.”

There is evidence of the Brexit impact in ICAEW’s BCM data. After the referendum result was announced in June 2016 and until a new deal was announced in 2020, business confidence averaged -6.1 on the confidence index, though, of course, Brexit was not the only factor at play. It has rebounded since, even with the struggles of the post-pandemic era, averaging 13.1 since the new deal came into force in January 2021. However, once again, the picture varies significantly across sectors as well as regions and the rebound has not always been equal.. The BCM data also shows the impact of weak business confidence on investment intentions; when business confidence falls, as in the aftermath of the GFC and the Brexit referendum result, a drop in capital investment follows in the coming months.

Business confidence by region
Source: ICAEW Business Confidence Monitor

The BCM data also shows the impact of weak business confidence on investment intentions; when business confidence falls, as in the aftermath of the GFC and the Brexit referendum result, a drop in capital investment follows in the coming months.

Chronic labour and skills shortages

Labour force challenges and skills shortages are another key contributor to the productivity challenges faced by the UK. After all, if the right skills are not in place, businesses cannot perform optimally.

Historically, labour growth has been strong, and the UK has one of Europe's most liberalised labour markets, providing low unemployment and strong labour market participation. However, workforce participation has fallen since the pandemic, and businesses have had to contend with tight labour markets. ICAEW's BCM data shows a sharp uplift in the proportion of businesses that cite staff turnover as a challenge. Between 2017 and 2019, an average of 21% of businesses considered this an issue, but between Q3 2020 and Q2 2023, this proportion jumped to 35%. The ICT sector has been particularly hard hit, reporting a change of 23% to 32% over the same relative time periods (Q3 2020 and Q2 2023); similarly, Energy, Water & Mining reported a change of 21% to 35%.

While BCM data shows concerns over staff turnover as a business challenge has eased from a peak of 43% in   2022, to 25% in Q2 2023, this reflects more a cooling jobs market as higher interest rates weaken the economy rather than evidence that these labour force challenges and skills shortages are easing.

Percentage of businesses citing staff turnover as a key business challenge.
Source: ICAEW Business Confidence Monitor

“We’ve made a lot of progress in the last few decades on university education, and there are a lot more graduates in the labour market now,” states van Ark. “But we have not been very successful in what we call intermediate qualifications - for example, engineers and other skilled workers from further education and technical colleges. We have huge shortages now. These are the people we need, particularly if we want to develop more of a manufacturing industry and if we want to apply new technologies like digital.”

In addition to technical skills shortages, a paucity of management skills also affects businesses. Yael Selfin, Chief Economist at KPMG in the UK, says: “Productivity can be raised by improving people’s skills. It's about upskilling the workforce, and that doesn’t just relate to technical skills but also extends to management skills. A large proportion of businesses in the UK are small and medium-sized companies, where the people who run the business have not had any professional management training, nor the bandwidth to pick those skills up.”

Yet recent educational developments give some cause to be optimistic in the medium to long term. “In the past ten years, we might finally have settled into a stable set of further education policies,” says Wilkes, “though many of them, such as T-levels, the lifelong learning entitlement and so on, have only recently launched and their impact will take some time to feed through.”

Creaking infrastructure

A third key contributor to poor productivity growth is the lack of public infrastructure investment. Thiru explains: “The UK doesn't do well at infrastructure investment. There are two aspects to consider here. The first is physical infrastructure; we’re not very good at large building or transport projects. A good transport infrastructure means people can get to work more quickly and carry out business. The second aspect is digital infrastructure. The UK also lags here; for instance, there are parts of the country with poor wifi and these basic sorts of things.”

Yet, with the UK’s public sector debt levels reaching highs not seen since the 1960s in the wake of the pandemic, it is harder for the government to justify new spending. As Selfin notes: “When government finances are under strain, it is harder for them to justify large investment products even though it might improve productivity further down the line.”

Nonetheless, the lack of infrastructure investment has a material impact and feeds into the many regional inequalities. “Large parts of the country are stuck in a persistent low growth model. London, the South East and some other parts of the country including East Anglia, Cheshire and parts of Scotland are OK, but elsewhere it is a challenge,” explains van Ark, “ lot of that seems to be related to the fact that there's a lack of physical mobility and people going to work in different places. And in turn, that has to do with the fact that planning is really complicated in this country. There are issues with road or public transport planning, housing, issues with setting up new industrial structures and so on.”

Of course, the levelling up agenda, which is still a part of this current government’s policies, will have a role to play, but it has its limitations. “The levelling up funds that have been announced are evidently too small. If the GVA of a region is £1.2trn or similar, additional funds of a couple of billion aren’t going to be sufficient. What’s needed is sustained investment and things that these regions haven’t had, like an internal travel network,” states Wilkes. However, he adds: “levelling up is important. It’s an important political thing to do, and it's a governance problem for the whole economy that we look to Westminster for to solve these issues in the regions is just inefficient. Many would agree that we need something more like the mayoral system in other places, but it takes a bit of courage to do this.”

The UK’s chronic productivity challenge is a hugely complex subject, with a large number of interrelated factors at play. Reversing this trend is not a matter of making a few simple reforms or tweaks, but rather a long-term plan to boost business investment, resolve key skills shortages and improve many elements of the UK’s public infrastructure.

And what is abundantly clear from everyone you speak to is that implementing this plan will take a sustained, clear-eyed, coordinated effort on the part of businesses from every industry and part of the country and a successive series of governments, regardless of political persuasion.

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