Autumn Budget 2017 Contents

1The Economy: Productivity

OBR Forecast changes

11.In its November 2017 Economic and Fiscal Outlook, the OBR made a major downgrade to its productivity growth assumptions. Potential productivity growth is now forecast to be just 0.7 per cent in 2018, half the rate of 1.4 per cent that the OBR was forecasting at the Spring Budget 2017. The OBR forecast that productivity growth will rise slowly from 2019 to 1.2 per cent in 2022 compared to the Spring Budget forecast of 1.9 per cent in 2022.

12.The trend growth rate of UK labour productivity (output per hour worked) prior to the financial crisis was over two per cent per annum and deviations from this trend were rare and short-lived. However, productivity—as measured by output per hour—fell 2.2 per cent between 2007 and 2009 and has recovered at an average rate of only 0.5 per cent per annum since then. The latest quarterly data, published after the Budget, showed quarterly growth of 0.9 per cent in the third quarter of 2017, a six-year high.

13.Until 2016, the OBR had forecast that productivity would not ‘catch up’ with projected pre-financial crisis productivity growth. However, it did forecast that productivity growth would eventually return to its pre-crisis trend growth rate of 2.2 per cent.

14.At the Autumn Budget, the OBR revised this judgement, and significantly downgraded its productivity growth forecast. Its latest forecast for the future rate of productivity growth now lies “roughly halfway between the pre-crisis [2.2 per cent] and post-crisis [0.4 per cent] averages”.4

Figure 1: Productivity growth (output per hour) forecasts and outturns

Source: OBR Economic and Fiscal Outlook, November 2017, Chart 1.2

15.The OBR notes that “it is important to stress that this revision has been driven neither by the most recent outturns, nor by a detailed re-evaluation of the likely impact of Brexit. Rather it is a response to the repeated tendency throughout the post-crisis period for productivity growth to disappoint relative to expectations”.5 It adds that “the outlook for potential or trend productivity is the most important, yet most uncertain, element of potential output growth and, indeed, of our forecast in general”.6

16.In its forecasts, the OBR lists a number of factors that could be causing the slow growth of productivity:

17.When asked whether the OBR was being too pessimistic in their productivity assumptions, Professor Jagjit Chadha , Director of the National Institute of Economic and Social Research, told the Committee that “people who have been forecasting a return to productivity for the last 10 years have been burnt by the fact that the outturns have been lower than they have seen in the past”.8 Paul Johnson , Director of the Institute for Fiscal Studies, said that the OBR:

“has basically put a line halfway between what has happened and what it thought before. It is just this judgment: is there any reason to think we are permanently dropping from 2.2 per cent? Perhaps not, but we have had 10 years of 0.3 per cent, so it would seem rather optimistic to assume we will jump straight back up. My take is that [the OBR] has lost patience with its own over-optimism and decided to bring it down […] they are as likely to be on the optimistic as on the pessimistic side.”9

18.The OBR’s forecasts also assume that, while trade intensity will fall as a result of the UK’s decision to leave the EU, this will have no knock-on effects on productivity growth. This is in contrast with the Treasury’s economic forecast of Brexit;10 the Bank of England’s conclusions that “trade openness allows firms to access the most advanced inputs to production, raising their product quality and productivity,”11 and the views of the Secretary of State for International Trade, Dr Liam Fox, who has said “encouraging trade and inward investment policy is one pillar and is key to opening up markets for UK firms, boosting productivity and growth across our economy”.12 The OBR states it has made this assumption due to “the lack of certainty around this link [between trade and productivity]”.13

Government policy response

19.The Autumn Budget lists the Government’s response to persistently weak productivity growth. Previous announcements include:

20.Combined with the Government’s Industrial Strategy, the Government’s policies announced at this Budget to improve on productivity performance are focused on the following areas:

21.The Budget states that “excluding the exceptional years following the financial crisis, public investment as a proportion of GDP will reach its highest level in 30 years by 2020–21”, 2.4 per cent of GDP.17

22.However, the Budget also states that “business investment has been affected by uncertainty”18 and that “despite the recent revisions, business investment growth remains moderate at 2.5 per cent in the year to Q2 2017, below its average annual rate of 4.9 per cent between 2010 and 2015. Private business surveys cite uncertainty as a factor impeding investment”.19

23.The OBR has forecast for “business investment to rise by around 12 per cent between the first quarter of 2017 and the first quarter of 2022, significantly lower than the 19 per cent expected in March 2017.” These changes are illustrated in the chart below:

Figure 2: Real business investment as a share of real GDP

OBR Economic and Fiscal Outlook, November 2017, Chart 3.28 extract

24.Investment currently makes up approximately 16 per cent of GDP. The private sector contributed just over half of this investment.20 This figure does not include private sector housebuilding. If this is also included, the private sector contributes 77 per cent of investment.

25.In November 2016, the OBR revised down its potential productivity forecast “on the grounds that the Brexit vote and the UK’s subsequent departure from the EU were likely to create greater uncertainty over investment returns and that this would lead some firms to cancel or postpone some productivity-enhancing capital investment projects (i.e. a slowing in ‘capital deepening’)”.21

26.Ann Pettifor, Director, Prime Economics told the Committee that increasing investment in the economy was a key government policy that could increase productivity.22 Both Paul Johnson and Professor Jagjit Chadha agreed. Professor Chadha stated that “low levels of investment […] probably contributed to the low levels of productivity”23 but that it is “to some extent the responsibility of government, but it is also the responsibility of the private sector and relates to the impairment of the financial sector […] the Government have a role in dealing with offsetting uncertainty and making plans that offset private sector uncertainty”.24

27.In common with many other forecasters, the OBR has been consistently overly optimistic in its forecasts for productivity growth. It has now chosen a path for productivity that lies between the pre- and post-financial crisis trends. Productivity will need to increase to a rate more than twice as fast than has been achieved for the past nine years, if it is to grow in line with the OBR’s forecast.

28.Just as the causes of persistently weak productivity growth in the UK and the rest of the developed world are poorly understood and are widely described as a productivity puzzle, so the optimum policy response from Government is not obviously clear. No one single policy measure in isolation is likely to address the large number of potential causes of the productivity puzzle.

29.A rise in well-focused investment, both public and private, is likely to improve productivity growth in the long term. The Government has set out plans to raise public investment to the highest level, as a percentage of GDP, for the last 30 years. This is a welcome commitment. Nevertheless, a revival in productivity will also require a response from the private sector, which accounts for three-quarters of investment. At the moment, the OBR expects a fall in private sector investment, as a proportion of GDP, over the coming five years, owing to Brexit-related uncertainty. The Committee reiterates its conclusions about the urgency of reaching agreement on transitional arrangements for Brexit that reduce short-term uncertainty for business, and the importance of establishing clarity on the long-term UK-EU economic relationship.

30.As the UK leaves the EU, continued openness to trade, foreign investment and migration are likely to be prerequisites to a revival in productivity performance.

31.The OBR has stated that the link between trade intensity and increased productivity is insufficiently well understood to be included in its forecast, and as a result has not included any decline in productivity due to reduced trade intensity in its post Brexit forecast. The Committee is concerned as this conclusion stands in contrast to the assumptions made by the Treasury, Bank of England and the Secretary of State for International Trade, that higher trade intensity leads to higher productivity growth. If trade intensity initially declines as a result of Brexit, as is forecast by the OBR, and does lead to a decline in productivity (as is assumed by the Treasury, the Bank of England and the Secretary of State for International Trade) it would significantly worsen the expected economic and fiscal consequences of leaving the EU, compared to what the OBR forecasts at present.

4 Office for Budget Responsibility, Economic and Fiscal Outlook, Cm9530, November 2017, Paragraph 3.27

5 Office for Budget Responsibility, Economic and Fiscal Outlook, Cm9530, November 2017, Paragraph 3.29

6 Office for Budget Responsibility, Economic and Fiscal Outlook, Cm9530, November 2017, Paragraph 3.19

7 Office for Budget Responsibility, Economic and Fiscal Outlook, Cm9530, November 2017, Paragraph 3.22 and 3.23

8 Q102

9 Q103

10 In The long-term economic impact of EU membership and the alternatives, Cm9250, April 2016, paragraph 3.34, the Treasury modelled a 2 per cent reduction in productivity after 15 years if the UK remained within the EEA, a 3 per cent reduction if the UK negotiated a bilateral agreement, and a 3.7 per cent reduction if the UK fell back to WTO rules.

11 Bank of England, EU membership and the Bank of England (October 2015), p 36

12 Department for International Trade, ‘Liam Fox welcomes industrial strategy commitment to UK trade (23 January 2017), accessed 17 January 2018

13 Office for Budget Responsibility, Economic and Fiscal Outlook, Cm9346, November 2016, paragraph 1.18

14 HM Treasury, Autumn Budget 2017, HC587, November 2017, Paragraph 4.4

15 HM Treasury, Autumn Budget 2017, HC587, November 2017, Paragraph 4.6

16 HM Treasury, Autumn Budget 2017, HC587, November 2017, Paragraph 4.7

17 HM Treasury, Autumn Budget 2017, HC587, November 2017, Paragraph 4.8

18 HM Treasury, Autumn Budget 2017, HC587, November 2017, Paragraph 1.2

19 HM Treasury, Autumn Budget 2017, HC587, November 2017, Paragraph 1.7

20 Office for National statistics, ‘Gross Fixed Capital Formation by sector and type of asset’, accessed 17 January 2017

21 Office for Budget Responsibility, Economic and Fiscal Outlook, Cm9530, November 2017, Paragraph 3.20

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23 Q79

24 Q79

19 January 2018