The IFS released a new report today saying that a worsened public finance outlook is likely if current low levels of productivity growth are the “new normal”. The report was prompted by the recent suggestion that the Office of Budget Responsibility will lower its productivity growth forecast for the UK economy in its upcoming November report. Lower productivity growth creates pressure on the budget because it implies lower tax receipts, even when levels of unemployment are low.
The IFS considers three scenarios. In a ‘moderate’ scenario, it assumes growth is downgraded in line with the Bank of England’s forecast up to 2019 and the average of independent forecasts beyond that. In a ‘very poor’ productivity growth scenario, it assumes productivity growth of only 0.4% per year. In a ‘weak’ productivity growth scenario, the IFS considers the effect of productivity growth being halfway between the OBR’s March forecast and the “very poor” case, implying an average growth rate of 1.0%, substantially higher than that over the last seven years.
The IFS finds that even the “weak” growth scenario has a major effect on the public finances. Borrowing would be forecast to be around over 50% higher in 2020–21 rather than the £21 billion forecast in March and so the target to eliminate the deficit by the mid-2020s would look even more difficult than it did in March. In the weak scenario, things are worse: the Chancellor could not expect to meet his fiscal targets for the current parliament and the ambition to eliminate the deficit entirely by the mid-2020s would seem almost sure to be abandoned.
So, the key question is whether current low productivity growth is likely to persist. UK low productivity growth has many causes. But it is possible that some features that are currently leading to low growth are temporary. First, low wage growth provides no incentive for firms to invest in productivity-enhancing machinery and wage growth may well pick up in the next few years as the labour market tightens, partly as a result of reduced migration following Brexit. Second, part of recent low wage growth is due to the rapid expansion of mainly low-pay service jobs (e.g. coffee shops, and online delivery services such as Deliveroo). These are businesses that provide a valued but unsophisticated service with limited room for productivity improvements. This rapid expansion cannot continue forever. Third, low-productivity firms have been kept afloat by low interest rates, and we are now (albeit) slowly entering a period of rising interest rates. So, it is likely that the IFS’ worst-case scenario is too pessimistic.
On the other hand, some of the causes of low UK productivity growth are more permanent and harder to change, such as low workforce skills, poorly trained managers, and low levels of product market competition. Overlaid on this, of course, are the risks associated with Brexit. So, the IFS report deserves serious attention.
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