Why has UK productivity been so poor?

The Chancellor, Rachel Reeves, is facing a projected £20 billion fiscal shortfall due to changes in productivity estimates, according to the Financial Times. This is likely to force her into tax rises, spending cuts, increased borrowing, or a combination of the three. The Office for Budget Responsibility is now widely expected to cut its forecast of productivity growth from 1.3% to 1%, which would reduce revenues and make it harder for the government to balance its budget. But what is productivity? Why is it so important, and, perhaps most importantly, why is it so low? 

Put simply, productivity refers to the amount of output generated from a given input, typically measured per hour worked. Productivity growth is important because it is one of the main drivers of per capita economic growth; if each person in the country is producing more, then they can earn more and have a higher standard of living. The government is also keen on productivity growth because it means public services could be funded better at a lower rate of taxation. The only problem: UK productivity is stagnant. 

France and Germany were 13% and 14% more productive compared to the UK

UK productivity (as measured by GDP per hour worked) is struggling, and is behind other economies, such as France, Germany and the US. During 2023, a study found that France and Germany were 13% and 14% more productive compared to the UK. The precise reasons for Britain’s position are contested, but the financial crisis in 2008, Brexit, and the Covid-19 pandemic are often identified as key factors.

After the financial crisis, the UK suffered a significantly larger contraction in labour productivity than our European and American peers, with a fall in investment as the main contributor. Investment is the purchase of capital equipment and is key to driving productivity growth. Each hour of a worker’s time can produce more output if they are using more efficient machines or software, or if they are more highly trained and educated. 

If investment is the reason for low productivity growth, why doesn’t the UK just invest more? Financial crisis and recession do not lead to a favourable environment for private investment, which depends heavily on the confidence of firms, while the Conservative government’s policy of austerity, implemented in reaction to the financial crisis, led to significant cuts in public investment. 

Another significant factor contributing to low investment (and productivity growth) is the lasting impact of Brexit. The Chancellor herself is among those describing leaving the European Union as causing long-term damage to the economy. Uncertainty about the UK’s trading relationship with the EU and the rest of the world has increased the costs of committing to long-term investment. Additionally, trade barriers with our largest trading partner raise costs for firms and reduce productivity by increasing the time taken to perform the same work.

Public services such as the NHS experienced a sharp fall of 14% during COVID and are not predicted to return to 2019 levels until 2029

Another lasting factor on productivity in the UK, particularly in the public sector, is the Covid-19 pandemic. As reported by the Institute for Fiscal Studies (IFS) think tank, public services such as the NHS experienced a sharp fall of 14% during the pandemic and are not predicted to return to 2019 levels until 2029, an estimate that is far from certain. The evidence on the underlying causes of the fall in productivity is limited, with suggestions including staffing costs rising faster than output, backlogs affecting efficiency, and more persistent sickness among employees (particularly in the NHS), but no consensus. Suggestions for improving efficiency in the public sector given by the Institute for Government include greater capital investment and workforce planning, though this would require additional spending, just as the Chancellor is seeking to make savings.

Productivity has an important role in the economy, but reports that the Office for Budget Responsibility (OBR) is likely to reduce its estimates are made even more important by the government’s decisions around fiscal rules. The Chancellor’s insistence on sticking to rules she has set herself about projections on debt means that when the OBR changes its predictions, such as before the spring statement earlier this year, she needs to change spending or taxation in order to keep within the arbitrary targets. This is because the OBR reducing productivity projections reduces expected GDP and tax revenue, leading to the government missing its target of debt falling as a percentage of GDP in five years. This reliance on the OBR’s projections has been criticised by the IFS because it leads to more policy volatility and uncertainty when the Chancellor has to respond to minor forecast changes – the exact opposite effect ‘cast iron’ fiscal rules should have.

Productivity is essential to the government’s decisions around taxation, spending and borrowing. If the higher productivity growth that the Chancellor desires doesn’t materialise, those decisions will be made all the more difficult.