The productivity gamble

By Shimeon Lee, researcher

Labour and the Conservatives released their manifestos this week setting out their spending plans while ruling out major tax rises. Both parties are instead choosing to rely on economic growth, and the accompanying growth in tax receipts, to deliver on their spending pledges. While the Office for Budget Responsibility (OBR) has forecast that debt as a percentage of GDP is set to fall in five years, giving the next government some room to manoeuvre, this is met by the slimmest of margins -
just 0.3% of GDP or £9 billion.

However, there is significant uncertainty surrounding the UK’s fiscal outlook, casting doubt on whether even this modest fiscal headroom exists. This is because growth in future tax receipts is underpinned by overly optimistic assumptions about productivity growth. The OBR’s assumption for long-term productivity growth currently sits at 1.1 per cent. As the Resolution Foundation points out, this is significantly higher than the post-financial-crisis average of 0.7 per cent, with actual productivity growth repeatedly underperforming the OBR’s expectations. Outturn data for productivity growth in Q1 2024 stood at 0.1 per cent, far below the OBR’s forecast.

If the forecasted productivity growth fails to materialise, the next government’s ability to deliver on its manifesto commitments could be severely undermined. A half percentage point downgrade to productivity growth would add over £40 billion to government borrowing by 2028-29, and even a modest 0.2 per cent downgrade would add around £17 billion to borrowing. This is much larger than the government’s current £9 billion fiscal headroom. 

While efforts have been made to increase productivity such as making full expensing permanent to encourage business investment, we cannot ignore the elephant in the room - the ever-growing public sector. 2023 analysis by the National Institute of Economic and Social Research (NIESR) suggested that once you include those employed by private sector firms but producing services for the public sector (such as cleaners in the NHS and care home employees), a whopping one in three workers are part of the public sector, up from one in four in 1997. This is nearly twice as large as official figures suggest, 10.6 million compared to the 5.7 million typically cited by the government.

According to the NIESR, two-thirds of the increase in the labour force over the last quarter century has been directed into the public sector and away from more productive parts of the economy. This is a problem as productivity growth in the public sector lags significantly behind the private sector. Between 1997 and 2019, public sector productivity increased by just 0.2 per cent per year while private sector productivity grew four times faster, 0.8 per cent per year.

Adding insult to injury, public sector wages rose 0.9 per cent per year in real terms during this period, meaning funding productivity actually fell by 0.3 per cent per year. This is before including extremely generous defined benefit pension schemes that 82 per cent of public sector workers are on compared to just 7 per cent of private sector workers. When pensions and bonuses are included, public sector workers receive 6 per cent more per hour than those in the private sector even after accounting for workforce composition. 

Yet instead of demanding higher productivity and reigning in spending in the public sector, politicians have allowed the tax burden to climb to an 80-year high by 2028-29, with much of this additional revenue directed towards day-to-day expenditures such as wages and pensions for civil servants as opposed to capital investment. While capital budgets have been cut by 2 per cent, departments’ day-to-day budgets are set to rise by 1 per cent above the rate of inflation per year.

Worryingly, increases in day-to-day spending have not been accompanied by an increase in productivity. For example, despite the number of full-time equivalent (FTE) junior doctors and nurses increasing by 16.4 per cent and 10.9 per cent respectively, the number of people being treated in hospitals is only marginally higher than it was pre-pandemic and, on some important metrics, it’s lower. This has not been helped by the 3.9 million working days lost to strikes in 2022/23, 96 per cent of which were from significantly publicly funded industries. 

Overall, public sector productivity remains 6.8 per cent lower than its pre-pandemic level, even lower than it was 25 years ago. With council employees receiving record-high remuneration, more than 1,100 non-jobs across the public sector and the unions pushing for a four-day week, it’s no wonder that this is the case. 

Whichever party wins the next election will only have the fiscal headroom to implement their spending plans if they can deliver productivity growth. This starts in the public sector, where the government must take a good hard look at how taxpayers’ money is being spent.

Cracking down on the overall size of the public sector and reducing day-to-day expenditure would free up labour and capital for more productive uses. Conversely, failure to achieve the OBR’s productivity forecast would result in an even bigger deficit that taxpayers will be left footing the bill for. 

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