Sunday, March 12, 2017
Now, more than ever, we need productivity to move up through the gears
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

When it comes to budgets, there are some eternal verities. One is the contrast between the picture of the economy painted by the chancellor and the reality of the numbers. Another is the ability of chancellors to get into political hot water even when apparently treading with the utmost care.

George Osborne managed to do so a year ago when trying not to frighten the horses ahead of the referendum. Philip Hammond has followed his predecessor into the mire by announcing increases in Class 4 national insurance contributions for the self-employed and cutting the dividend tax allowance from £5,000 to £2,000.

In the speech the chancellor lauded the “entrepreneurs and innovators” who are the lifeblood of the economy and said he wanted Britain to be the best place in the world to start and grow a business. But fine words butter no parsnips for those facing these tax hikes.

I do not want to dwell on Hammond’s NI problem and his breaking of what was not a very sensible manifesto promise; no government should tie its hands by ruling out increases in the major taxes. But suffice it to say that the contributory principle, which he used to justify raising the contributions of the self-employed, has worn rather thin in recent years.

And, while tax neutrality is a laudable aim, the implicit understanding has always been that the self-employed deserve to be cut some slack because their incomes are less secure and because they do not enjoy the employment rights of the employed. The £500m a year the NI increases will bring in when fully in place could have been secured in other ways, notably by a modest increase in fuel duty, which would probably have been more palatable to white van man. In net terms, after other NI changes, they will bring in only £145m a year.

Not only that, but if you really wanted to tackle the discrepancies in the system – the chancellor cited a £32,000 employee attracting £6,170 of NI contributions and a self-employed person on the same income just £2,300 – you would address the biggest source of that discrepancy, which is that employers pay 13.5% contributions for their employees, but not self-employed contractors.

Anyway, no doubt this will all come out in the wash in the autumn. The Treasury seems determined not to U-turn on the NI increase, though we have heard that at this stage before.

What I did want to focus on was the big disappointment in the budget, the fact that the government’s fiscal watchdog, the Office for Budget Responsibility (OBR), sees virtually no follow-through from the recent better performance of both the budget deficit and growth.

On the deficit, the OBR attributes this year’s (2016-17) big undershoot, from the £68.2bn it predicted in November to £51.7bn now, to one-off effects and methodological changes. After five years it thinks the deficit will be slightly larger than it predicted late last year. Cumulative borrowing will still be roughly £100bn more than it predicted a year ago.

While revising growth up from 1.4% to 2% this year, largely on the back of the economy’s stronger performance at the end of last year, the OBR sees this short-term strength fully offset by weakness later. In fact the economy ends up fractionally smaller in 2021 than it expected in November.

There are a couple of reasons for this. One is that recent growth, driven by consumers dipping heavily into their savings, is seen by the OBR as unsustainable. The other more important reason is that the watchdog thinks the economy is close to full capacity, indeed slightly above it, so future growth will be constrained by the growth in productivity, which the OBR thinks will recover only gradually.

On consumer spending, it offers alternative “boom” and “bust” alternatives. Under the boom scenario, consumers carry on running down their savings and to keep on spending and the economy grows by 4% this year, before slowing abruptly thereafter. Under the bust, consumers rein back, the economy shrinks by 0.5%, and then resumes growth at a far stronger rate. But while the journey is different, the end-point for the size of the economy is the same.

As it happens, I think the OBR is right to take a cautious attitude about the outlook for both growth and the public finances, given the uncertainties ahead. Some economists think it is still too optimistic. But if you wanted to play devil’s advocate, however, you could say that its approach to medium-term forecasting, while very logical, is also rather rigid.

Spare capacity in modern economies, particularly a service-based economy such as Britain’s, is a bit of a will of the wisp. Unemployment rates that in the past would have provoked bigger wage rises no longer do so. The OBR, in common with the Bank of England, has revised down its so-called equilibrium unemployment rate as a result. Expanding service sector activity does not necessarily require a big increase in investment or staff numbers. Caution, as I say, is justified, but the economy’s ability to grow may be more flexible than the OBR has allowed for.

Where we would entirely agree is that the circle would be squared for the economy in so many ways if productivity – output per hour - were to be stronger and come back more quickly than it and other forecasters expect. The OBR expects a gradual pick-up in productivity growth to 1.9%, just below its long-run average, by the early 2020s, though it has been over-optimistic on productivity before,

That slow pick-up will mean, as Paul Johnson put it in the Institute for Fiscal Studies’ post-budget briefing: “Average earnings will be no higher in 2022 than they were in 2007. Fifteen years without a pay rise. I’m rather lost for superlatives. This is completely unprecedented.”

Suppose that, instead of a slow crawl back towards normal for productivity growth, there was a period in which it grew faster than the norm, say 2.5% or 3% a year, clawing back some of the huge gap that has opened up since the crisis.

In those circumstances, the economy’s capacity to grow would be hugely enhanced, households would spend out of real wage rises justified by higher productivity rather than savings, and the budget deficit would be eliminated within the foreseeable future.

Could it happen? Even Hammond’s best friends would concede that, welcome though his measures were, including the new “T-levels” to boost technical skills and training, they and other aspects of his productivity agenda will take very many years to make a difference, and that difference may be small.
Productivity does not, of course, rely only on government. If, within every sector of the economy, low-productivity firms matched the performance of the best, Britain’s productivity position would be transformed.

Until that happens, we have another contrast between what chancellors say in their speeches and the reality. He wants Britain to be “at the cutting edge of the global economy y”. We have an economy with low productivity which relies too much on consumers running down their savings. As the chancellor said, “there is no room for complacency”.