Solving the productivity puzzle

Regional inequalities are a longstanding feature within UK political debate.

However, they have gained additional pertinence in the years since the 2008 financial crisis.

From the 2016 EU referendum result, through the ‘red wall’ turning blue in the 2019 general election, to the differential impact of Covid-19 across the UK, place increasingly functions as a fault line within UK politics.

It is, then, small surprise that in recent years many a politician has pledged to address place-based differences.

First came the 2010-15 coalition’s ‘rebalancing’ agenda, then the ‘Northern Powerhouse’ initiative and, now, ‘levelling up’.

But can the latest policy drive truly address regional inequalities that have so stubbornly resisted a multitude of past strategies?

The best place to start is by attempting to understand the issues that we want policy to tackle.

It is often stated that the UK is one of the most regionally unequal countries in the OECD.

Just how badly it performs cross-nationally depends both on one’s indicator of choice and on the geographic unit of analysis used.

But there is one measure on which the UK consistently performs poorly compared with other developed economies – productivity.

In 2019, gross value added (GVA) per head of population stood at £49,325 for London.

In the North East, the figure was £20,118, just 40% of the economic value created in the capital city.

Capital ‘outlier’

Arguably, comparing any other part of the UK with London is bound to produce a shocking statistic, given the ‘outlier’ nature of the capital.

But even when we exclude the international superstar city, the gap between the highest and the lowest regional performers remains significant.

In 2019, the North East’s GVA per head was only 67% of that in the South East, which stood at £29,848.

‘Levelling up’ the North East and other UK regions such as Yorkshire and the Humber or Wales to even close to the productivity levels of the South East would produce a considerable impact on gross domestic product (GDP) and living standards.

So, what sits beneath these stark regional productivity performance gaps, and how could policy attempt to address them?

One possible explanation could lie in the employment rate.

If a smaller share of people work in one region compared with another, productivity per capita will naturally be lower.

Although the gap between UK regions has closed quite considerably in recent years, the employment rate among 16- to 64-year-olds in February 2020 ranged from 71% in the North East of England to 80% in the South West.

To a degree, Covid-19 has had a levelling effect – the latest employment figures show that the gap between regions has shrunk.

But at a more granular level, evidence suggests that the pandemic has exaggerated the differences in employment rate between areas.

The largest increases in benefit claims in recent months, for example, were observed in local authorities that already had higher pre-Covid-19 unemployment rates.

The employment figures have a number of implications for policy.

To begin, it is clear that the national ‘back-to-work’ strategy being rolled out by the government as Covid-19 restrictions recede needs to be responsive to local conditions.

Connected to this, the delivery of programmes such as KickStart and Restart are dependent on bodies like JobcentrePlus and local authorities, which have seen their capacity significantly hollowed out over the past decade.

The Department for Work & Pensions has succeeded in recruiting thousands of work coaches in recent months, but building up local capacity remains vital.

Moreover, such programmes can only help people back to work if there are jobs in local areas with which they can be matched.

Regional unemployment rates are instructive and give a sense of where employment opportunities are thinnest on the ground.

In 2019, for example, 6.1% of the North East’s working-age population was out of work, around double the rate in the South West (2.8%), Wales (2.9%) and the South East (3.1%).

What is stopping firms from relocating to areas of the UK with lots of spare – and therefore cheaper – labour? One obvious answer is that there are real benefits to being close to lots of other companies.

Such agglomeration means that supply chains are shorter and specialisation is easier, meaning profits will be higher as a result.

Compared with many other advanced economies, the UK is unusual in having just one city (London) where large agglomeration benefits are observed.

This explains, at least in part, the capital’s longstanding productive advantage, despite having only a middling employment rate.

Critically, other UK cities such as Birmingham and Manchester are not markedly more productive than their hinterlands.

This hints at the big challenge facing policymakers who want to drive economic activity to other less productive parts of the UK – any intervention will need to be done at significant scale to have any real impact at all.

Another reason decision-makers in firms cite for not wishing to relocate to areas with lower productivity is the skills pool available in these locations.

UK universities may be geographically dispersed, but the graduates they produce frequently do not stay in the places where they studied, instead migrating to areas that are already highly productive.

Research suggests that a quarter of graduates work in London six months after leaving study, while large and medium-sized cities see an outflow of this talent.

Policy needs to break the circuit that sees highly skilled workers drawn to already highly productive places, resulting in firms clustering still further in those areas.

Social investment

So how can this be achieved? The government is focused on funding infrastructure investment that allows firms to flourish, transport being the most obvious example.

That is important, but so, too, is social investment in schools, housing and other public amenities, which are so critical for attracting and retaining skilled individuals in less productive areas.

In truth, the government needs to spend big if it truly wants to make a dent in regional productivity disparities.

In February 2020, we estimated that ‘levelling up’ public investment without reducing real per-head spending in any region would require an additional 0.8% of GDP per year – some £19bn in 2024-25.

This is the context for government plans to raise capital spending up to its highest sustained level since the 1970s.

However, ministers must not only ratchet up spending but also channel the money differently than at present.

The UK has one of the most centralised models for funding public investment.

Only 36% of total investment funding is managed by local government, compared with 51% among all other advanced economies.

This might help explain why public investment spending in London and the South East stands at £1,200 per capita, more than 35% higher than the average of £885 per capita in other regions.

In addition, the UK also performs badly compared with other countries when it comes to switching the public investment tap on and off.

Investment funding is much more volatile and vulnerable to the economic cycle in the UK than in any G7 economy other than Japan.

Sustained capital investment in less productive regions requires not just a significant transfer of funds but delivery by bodies that are more beholden to local people.

Housing costs

All that said, productivity is not the be-all and end-all when it comes to place-based gaps.

In fact, when we look at average household incomes across the UK, we observe a much lower degree of variance between regions than we do when we focus on GVA per capita.

One reason for this picture of more equal living standards is housing costs.

Although average earnings are higher in more productive areas, much of this wage gain is wiped out by the higher rents and property prices charged in such places.

a significant transfer of funds but delivery by bodies that are more beholden to local people’

But there are more positive and policy-amenable explanations too.

The commitment to increase the minimum wage relative to average earnings over the past 20 years has disproportionately benefited those who are clustered in less productive areas.

Likewise, the social security system has the effect of smoothing living standards between regions.

As a result, low benefit payment rates are the antithesis of ‘levelling up’.

This point was brought home during the pandemic, when many poorer areas of the UK saw higher rates of infection, at least in part because their many low-paid workers were reluctant to self-isolate because of the low level of statutory sick pay.

Overall, there are no quick fixes for the UK’s longstanding place-based economic disparities.

But there are a number of things the government has in its gift in the short term.

It should increase benefit generosity and continue the policy of increasing the minimum wage ‘bite’.

In the long term, it should provide sustained investment in social infrastructure as well as transport projects.

The size of the challenge may be daunting, but regional productivity gaps are not inevitable – they fell after 1946 in the UK until the 1990s.

Nor are they unresponsive to policy, as the experience of Germany post-unification has so clearly shown.

With the right evidence, the right level of funding and the right level of political commitment, ‘levelling up’ really could be made a reality.

This article was originally published in Public Finance as part of their Perspectives series Equal Opportunity: Making sense of ‘levelling up’