It's the productivity, stupid

Here’s the real story of the week: productivity in Britain is only 1.4% higher now than it was ten years ago, nineteen percentage points below trend, so the public finances are even more of a mess than we thought. The lighter blue line in the chart below shows how we’ve done; the dotted yellow line shows the 1997-2007 trend. 

This is an astonishingly bad performance, worse than every other G7 country apart from Italy:

I believe that most of Britain's political problems are down to this. We’d be done with austerity if tax revenues hadn’t grown so much slower than we expected back in 2010. I don’t think you get Corbyn or the lurch against productive, tax-paying immigrants without years and years of near-zero wage growth for the median worker. And would Theresa Miliband really get away with proposing wage and price controls if the economy was chugging along normally? 

No. Near-nonexistent productivity growth is the story of our age, and it’s a safe bet that it is why, when ten years ago we had Blair and Cameron, today we have May and Corbyn. 

In describing this as the ‘productivity puzzle’, there’s an implication that this is all out of our control and that there’s nothing we could have done to avoid this. So instead we get the politics of managed decline – nationalising the railways so that we can subsidise them more, putting price caps onto energy companies so that their 3% profit margins can be eliminated, worrying endlessly about the salaries of the one hundred CEOs who run the country’s most successful businesses, holding the future of EU citizens hostage to extract concessions in a trade negotiation. 

Managed decline is what the 1970s were about so it feels apt that Theresa May and Jeremy Corbyn each represent a return to their parties’ 1970s policies. My strongest impression from this year’s Conservative Party Conference was of a party that is confused about what to do next and afraid about what happens if they get it wrong. And they should be.

Boris’s speech about “letting the British lion roar” lacked many actual ideas to boost productivity and wages – just attacks on Labour and repetition that the Tories were actually doing a bang-up job already. So who do you believe – Boris or your lying wallet?

In other words, the Conservative leadership seems out of ideas. But, at the Adam Smith Institute, we are not. When thinking about the work that the Adam Smith Institute has focused on in recent years, what struck me recently was how much of it is focused on solving this problem. Almost by accident, our focus on policies where small changes would yield big improvements to people’s lives has ended up with the core focuses of our work being on fixing the productivity ‘puzzle’. So, to whoever ends up running that Party once May goes, here’s your crib sheet for policy success:

1. Fix the housing market. 

You saw that one coming, I know. There’s nothing we’ve talked about more in recent years than the housing market, which at its heart is broken because supply is so tightly constrained. It’s a mistake to think that this is best captured by looking at house prices, which are a function of interest rates as well as supply and demand. It’s much better captured by looking at measures of housing costs, like rents per square foot, which are mostly driven by simple supply and demand measures and are remarkably high by international standards.

This is not just a problem because it raises people’s cost of living. It affects productivity because high housing costs stop people from moving whether they can work most productively, and to such a high degree that the entirity of foregone productivity growth since 2007 might be achievable just by fixing the supply side. It also means that housing is most people’s biggest investment asset. That means that money that could have gone into productive business investment goes into the price of land instead. It also means that businesses can’t use property efficiently, because planning laws constrain land-use and stop, say, grocery stores from being easily turned into offices. 

How to fix this? Our most recent report, YIMBY (Yes In My Back Yard!), has solutions to re-align incentives so that local landowners win when new developments take place near them. In the past we have suggested the use of planning permit auctions or changes to the rules around councils purchasing land that would allow them to capture the enormous uplift in value that takes place when planning permission is granted. And our famous report The Green Noose makes, to my mind, the definitive case against the green belt. 

2. Rationalise the tax system.

Everyone knows that George Osborne cut corporation tax when he was Chancellor. And corporation tax receipts actually rose slightly after he did that – the Laffer curve in action, right? 

Wrong. To offset the lost revenue, Osborne cut capital allowances, which allow firms to write off capital investments from their tax bill in the same way that they can write off wage costs and purchases of pens and paper. Even though the headline rate fell from 30 percent in 2007 to 20 percent in 2016, in practice this meant that for many firms the effective marginal rate did not fall by much, and for some it rose. 

The more you invested in things like machinery and property as a business, the less you benefited from the Osborne corporation tax cuts:

The UK’s effective marginal tax rate (EMTR) on new investment actually climbed from around 20 percent in 2007 to 23 percent in 2010 even as the corporate rate declined by five percentage points. Overall, the EMTR only fell by three percentages points from 2007 and 2016, from 20 percent to 17 percent, while the statutory corporate tax fell by 10 percentage points.

This is obscure but incredibly important. Fix this, and go further by allowing firms to immediately write off the cost of their investments, and you will have effectively stopped corporation tax from falling on investment at all. Sam Dumitriu explains the logic behind this here.

Taxes affect behaviour in other ways too. In a forthcoming report, Ben Southwood will explain why stamp duty land tax is possibly the most damaging tax we have, gumming up the housing market and stopping people from moving to the house that suits them best – particularly elderly people who would like to downsize (freeing up their house for a younger family), but would face a massive tax bill if they did. Stamp duty brings in about ten billion pounds per year but probably costs us much, much more than that. 

3. Get serious about innovation and immigration.

A Bank of England comparison of like-for-like firms operating in the UK found that foreign-owned firms were about 50% more productive than British-owned ones. The big reasons: foreign-owned firms invest in R&D more, are better managed, and collaborate with other organisations more. 

Why? Andy Haldane has discussed this but his policy proposals are a little lacklustre, in my opinion, focusing on helping existing firms to raise their productivity. The work that’s being done by The Entrepreneurs Network, the ASI’s sister think tank, focuses on the other side of things – bad firms not being eliminated by betters rivals effectively enough.

It might be because our approach to regulation is excessively cautious, especially in areas dominated by the state such as healthcare. Mark Lutter’s paper from earlier this year outlined how we might make it much easier to use medicines and instruments approved for use abroad in the UK and encourage more innovation domestically. Regulatory ‘sandboxes’ and explicit rules that preserved permissionless innovation would help here too, but I don't think we have a full idea of how to solve this problem just yet, or indeed where innovation really comes from. Thanks to ASI stalwarts like Dr Anton Howes, we're beginning to understand the past, and on the policy side, watch this space.

It blows my mind when I hear politicians talk about making Britain a leader in innovation one minute, and then about the need to restrict immigration the next. Innovation is a product of institutions and people – so making it harder for would-be innovators to cluster in certain places to collaborate (and compete!) with each other probably doesn't help. Anecdotally, most of the tech startups and bigger tech firms I have spoken to in the past few years have said that cracking down on immigration has made life much harder for them, and hurt an area where the UK should be excelling. 

There are two straightforward solutions to this. One, eliminate barriers to migration altogether between the UK and other countries above a certain income level – the rest of the OECD, say – and do not put new ones up. Two, allocate additional visas through a sale system where a would-be immigrant can pay a certain amount for the right to reside in the UK, instead of trying to micro-manage which industries have ‘skills shortages’. Get the best people in, and get as many of them as you can. We have a paper discussing this option in the pipeline.

Managed decline is a choice. On planning, tax, innovation and immigration the policies to reverse it are out there. We just need leaders who will take them.