Productivity politics
Anaemic productivity growth is storing up fiscal problems
Yesterday’s productivity statistics made for grim reading. Productivity growth — the amount we produce per hour of work — is the single most important driver of prosperity, and sustainable wage growth depends on it. For similar reasons, the public finances depend upon it. If productivity growth continues to disappoint it will make yet more tax rises or spending cuts necessary in the years ahead than the ones we’ve already endured over the years since the financial crisis.
The ONS estimates that output per hour increased by a dreadful 0.1% in the first quarter of this year compared to the year before. It’s up by a measly 1% since the start of the decade. Estimates are often revised (and there’s an unusual amount of uncertainty around the labour market at the moment) so there’s no point in getting hung up on one bad reading. But on any assessment we have, so far it seems, failed to break out of the sluggish annual productivity growth rate of around 0.4% since the financial crisis, compared to growth of about 2% annually before it.
The trouble is that trend productivity growth of 0.4% since the GFC (red line in the chart) is well below what the public finances are predicated on, which is around 1% (purple line). Unless something changes the economy will be smaller, and therefore tax revenues lower, by the end of this decade than official forecasts suggest, pushing borrowing up.
The fiscal consequences of this are fairly huge. Back in November the OBR produced a scenario that looked at what it would mean for the public finances if productivity growth ran 0.5 percentage points below their forecast — which is roughly where we are — and the numbers are ugly. They concluded that if productivity grows only at about 0.5%, annual borrowing would be £42bn per year higher in 2028–29 than in their baseline forecast. The current fiscal rule to have debt falling by the end of the forecast period would only be met by raising taxes or cutting spending by around £40bn. To put that in perspective, the cumulative 4p cut to National Insurance Contributions announced in the Autumn Statement and Budget cost the exchequer about £20bn per year by the end of the decade.
The tendency to overestimate productivity growth has been a perennial source of forecast errors for the OBR - and just about everyone else - over the past 14 years. That’s probably because, as I talked about here, they don’t want to trigger unnecessary austerity on the basis of a judgement they can only ever have low confidence in.
But while this optimism is understandable — and probably appropriate — a reassessment of expected productivity growth is beginning to look unavoidable. This comes at a very unfortunate moment, with a general election later in the year.
If the Chancellor chooses to have another fiscal event in the autumn, a productivity growth downgrade at that moment could blow a £40bn hole in the government’s head room on the current set of fiscal rules. Coming just weeks before election day, it would wreck the possibility of the Chancellor announcing further NICs cuts. Indeed the need to announce more tax rises or spending cuts would be a political disaster for the government.
But if the OBR chooses to wait until after the election to downgrade its productivity expectations then the political pain of £40bn of fiscal tightening, or the blame for profligacy, will be laid at the door of the next government. Based on the latest evidence, it’s hard to argue that a downgrade in the forecast should be postponed.
There are several fiscal holes that will need to be filled after the election — including implausibly low public spending plans — and its hard to see how that can be done without significant tax rises. But this technocratic judgement about productivity growth is the largest by some distance. It needs fixing.
