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Productivity and a New Fiscal Framework for the UK

Commentary by Professor Bart van Ark, Managing Director of The Productivity Institute & Professor of Productivity Studies, University of Manchester on Designing a New Fiscal Framework: Understanding and Confronting Uncertainty, NIESR Occasional Paper LXI by Jagjit S. Chadha, Hande Küçük, and Adrian Pabst.

The launch of a series of insight pieces by the National Institute of Economic and Social Research (NIESR) on the contours of a new fiscal framework for the United Kingdom has important implications for investment, productivity and sustained growth – not only for the UK but also for other countries. The economic recovery from the pandemic and the transition to a net-zero economy places a gigantic demand on sound fiscal policies around the world. In addition, the UK is also committed to levelling up disadvantaged regions while retaining and potentially strengthening its global competitiveness in the post-Brexit world.

Thinking about productivity and fiscal policy, American economist Paul Krugman’s quip couldn’t be more appropriate for the discussion of the relationship with fiscal policy: “productivity isn’t everything, but in the long-term it is almost everything.”

If fiscal policy is short-term focused, productivity growth is irrelevant. Productivity growth is very volatile in the short-term, especially since the pandemic started. While a spending spree is likely to create some temporary pro-cyclical demand effects on productivity, it mostly doesn’t shift the supply-side factors in terms of more human capital creation, innovation and technological change. In other words, short-term fiscal policy targets do not get the structural changes in the economy underway that drives productivity growth in the long-term.

Three medium- to long-term issues make productivity a key topic for fiscal policy: the short-term recovery from the pandemic, the leveling up agenda and the transition to a net zero economy.

Recovery from the pandemic

As we are hopefully emerging from the worst of the pandemic, there is a short-term temptation to wind down business support and furlough programmes quickly. Doing this in a drastic way during the summer, could provide a boost in productivity through a shock effect by getting rid of zombie firms or other firms that are underperforming. However, such a shock therapy would only show positive results if conditions are there for surviving and new firms to grow, which means access to human capital, having hard and digital infrastructure in place, and providing access to multiple financial instruments to grow and workable innovation ecosystems.

Without these conditions a short term shakeout therapy is likely to raise inequities: well-funded firms will do great, and those which can get by with very little resources (meaning low wages, weak innovation, etc.) might also survive. But some good firms may not survive if they run out of short-term funding. It might therefore be advisable, for example, to take more of a sector approach to the unwinding of the support programmes, and allow for a better health check of how firms are being affected.

Levelling up the economy

To level up the economy by raising productivity in those regions which have fallen behind, we need to address three key areas of underinvestment: human capital, knowledge capital and infrastructure. This raises a lot of questions from a fiscal policy perspective. Investment for productivity is not just about the size of the actual spend. It is primarily about the real returns on the investment and about the efficiency by which we put those public resources to use. Returns on public investments are often provided by some type of cost-benefit analysis which in turn depends on how many parameters one wants and can take into account.

There are many questions to be addressed on how much productivity growth a new investment can deliver. For example:

  • How to compute the productivity spillovers from investment, which represent the gains in terms of total factor productivity, arising from technological change and innovation, which are highly uncertain and very difficult to forecast.
  • How can we capture the complementarities between different types of investment – skills, infrastructure and technology? How do they impact on each other, create externalities – positive or negative?
  • When should we treat something as a public spend and when as an investment? How do we think, for example, about spending on education and other intangibles? And what are the implications of that for borrowing instruments?

The regional element of levelling up does not allow for a one-size fits all. Investments need to be understood in the light of the regional context. A national Research and Development (R&D) target of 2.4% is not helpful in the light of different needs across regions. The Productivity Institute has therefore launched eight Regional Productivity Forums to identify the largest gaps in investment and the biggest needs in terms of policy measures.

I therefore especially embrace the recommendation in the NIESR volume that “fiscal strategy has to be joined up across the UK and all its constituent parts, with particular attention paid to distributional effects, productivity, well-being and ecological sustainability.” (p. 23).

Transition to a net zero economy

The third big policy challenge of the coming decades is to achieve net zero targets as laid out in various government plans with increased levels of ambition. The investments needed to reach net-zero carbon emissions, including large goals for renewable electricity generation, hydrogen heating, decarbonisation on industrial production and construction, green transportation, net zero emission vehicles, and green financing.

The productivity effects of the massive investments in the net zero strategy, and therefore the effects on GDP and other performance measures, are highly uncertain. For example:

  • The transition of energy supply from fossil to non-fossil is unlikely to create productivity gains very quickly.
  • Green and sustainable industrial production raise questions about whether such processes will on balance become more labour intensive (not good for productivity), capital intensive (good for labour productivity, but not necessarily for spillovers and total factor productivity in the long term) or innovation driven (good for productivity, but what will it do to wages and living standards?)
  • Shifts in consumer behaviour and ensuing demand effects are also difficult to predict. How quickly will consumers want to go green, and how many are willing to pay for it? How do consumers at different income levels respond?

Towards a productivity-friendly fiscal framework

An effective and responsible fiscal policy framework that can withstand the pressures of daily economic and political issues is now perhaps more important than ever.

Given the vast transitions discussed above (recovery from the pandemic, levelling up and net zero transition) dealing with uncertainty is critical. The NIESR volume’s call for clear guidance on how risks will be managed, create built-in flexibility and a provide a role for the Office of Budget Responsibility to do frequent updates of fiscal forecasts and scenarios (p. 21) will go some way toward resolving that concern.

One big issue in any fiscal framework is the question on how to determine ‘trend productivity’ which directly feeds into the measurement of potential output growth. This is a minefield for forecasters, with big implications for policy success, as we can currently see in the debate on the impact of the massive Biden/Yellen stimulus program which focuses on inflation, but is ultimately about the capacity of the real economy to grow.

The volume also argues for the need of a new body of independent experts for ex-ante and ex-post evaluation (p. 23). At The Productivity Institute we are launching a Productivity Commission with impartial experts to provide the government with independent evidence-based advice on how different policies impact on productivity. This does not only involve fiscal policy, but also important structural policies, including education, infrastructure, innovation. Joining up really requires different perspectives.

Finally, there are at least two risks for a comprehensive fiscal policy framework for the medium- to long-term. The first is the tension between different time frames on economic and political cycles, which is extensively discussed in the volume (Chapter 9). The first is that there are too many cooks in the kitchen causing a more fragmented policy agenda which may be difficult to manage. The policy framework therefore needs to determine the guard rails which set out the principles and which preferably are widely supported across the political spectrum. Within those guardrails, there should be flexibility for short-term deviations driven by economic circumstance or political priorities.

This blog was first published by the National Institute of Economic and Social Research (NIESR).