6 October 2017

Can Hammond solve the productivity puzzle?

By Jan Zeber

With his last budget, Philip Hammond showed himself to be a very different sort of Chancellor from that of his predecessor. Having been dealt a couple of aces – with higher than expected tax receipts and growth forecasts stronger than initially suggested – “Spreadsheet Phil” decided to bank the winnings and create a “Brexit War Chest”, though many others would have been tempted to score political points by carefully targeted giveaways.

Today, it appears that Phil’s decision has paid off; he was right to resist the allure of spending increases motivated by positive OBR forecasts. These were, after all, intended to inject a degree of realism into public finances – not create theoretical future revenues to be spent today. For that, Hammond deserves praise.

However, the £26 billion headroom he created – the war chest – is expected by internal Treasury analysis to be slashed by two-thirds following revisions in OBR productivity growth forecasts. It is creating what some officials have labelled a “bloodbath” in the public finances. Is anyone really surpised? The OBR has overestimated productivity growth for seven years in a row. Today they’ve been proved wrong yet again, as output per worker for the whole economy has fallen again for the second quarter of 2017.

It’s a bit of a spanner in the works for next month’s Budget, when the Treasury might have hoped to use the wiggle room to pay for the policies announced in Theresa May’s conference speech. The tuition fees reform, freezing the fees at £9,250 per year and raising repayment threshold to £25,000, is expected to cost the taxpayer £2.3 billion a year. The new council house building programme, aiming to build 25,000 new council houses over two years, is estimated to cost a further £2 billion. And that’s on top of the pressure to scrap the public sector pay cap – adding £4 billion annually if applied to all of the public sector.

The news should act as a wake-up call to politicians, policymakers and all those who care about making Brexit Britain a success. The “productivity puzzle” is not an abstract concept but a real threat – solving it should be at the forefront of Government’s agenda post-Brexit. And no matter which of the “Four Theories” of slow productivity growth one finds most attractive, it is clear that encouraging business and investment through cutting taxes and reducing unnecessary regulation is the surest way to growth.

Take the United States in the Eighties. Reagan’s tax cuts resulted in the US economy growing by a third over seven years – even though he entered office during the grim economic period of the early 1980s which featured runaway inflation, increasing poverty rates and falling median family incomes. Reagan’s four-point plan of deregulation, tax-cuts, spending reductions and anti-inflation measures was a staggering success. According to Arthur Laffer, Reagan sowed the seeds of a 25-year boom, calling the period of 1982-2007 “the greatest period of wealth creation in the history of the planet”.

This supported by studies such as that of Barro and Redlick, who found that in the period of 1912 to 2006, cutting the average marginal tax rate in the US by 1 percentage point raised the following year’s productivity by 0.5 per cent. Labour becomes more valuable when you cut taxes as workers keep more of what they earn, which means people are incentivised to work longer hours, which increases the per-person average output.

It’s the same story with deregulation. In a paper for the National Bureau of Economic Research, Alesina et al analyse OECD historical data to find a strong correlation between deregulation and level of investment in a given industry, with reduction of barriers to entry being the most important component. Ironically, they find it is the strongest in transport, communication and utilities – precisely those sectors which Labour wants to nationalise.

Which brings us to the final point – the OBR announcement also highlights just how far from the real world Labour has strayed. Increasing taxes to levels unseen during peace time and putting spending on par with the 1970s is anathema to the growth and productivity we so badly need.

A run on the pound, already weakened by Brexit uncertainty, would be an economic disaster, causing widespread panic in other markets with significant UK exposure, downgrading of our sovereign rating, political risk markups in any foreign investment in Britain… the list goes on.

In his forthcoming budget, the Chancellor needs to be bold, stick to his guns and resist the pressure for any further significant spending increases. The answer to Britain’s productivity puzzle is complex, but history shows us what has worked in the past. And it can work again, given a chance.

Jan Zeber is a policy analyst at the TaxPayers Alliance