What Kind of Supply-Side Policy for the UK? What Implications for Scotland?

1. What Kind of Supply-Side Policy for the UK? What Implications for Scotland? Nicholas Crafts

2. Competitive Advantage Translate as ‘competitiveness’ in the sense of ‘the degree to which a country can produce the goods and services which meet the test of international markets, while simultaneously maintaining and expanding the incomes of its people over the long term’ So focus is on productivity performance

3. The Five Drivers The previous government identified the following as the key to productivity performance: Investment Skills Innovation Enterprise Competition Still a useful starting point

4. What is Conducive to Strong Productivity Performance? • Strong investment and innovation based on expected profitability • Diffusion of new (especially imported) technology based on good incentive structures • Strong competition in product markets • Success stories: pharma (HK, R & D); ICT diffusion (relatively favourable regulation); financial services (agglomeration benefits)

5. Endogenous Growth: Key Policy Areas • Public capital • Innovation • Regulation • Competition/Openness • Taxation • NB: links to 5 drivers

6. Policy Implications (1) • Should intervene to address ‘market failures’, e.g. where social returns exceed private returns • May be able to raise growth rate.. a bit • Much better to incentivize innovation than physical investment • UK investment subsidies were a very expensive failure – high deadweight loss

7. Policy Implications (2) • Policy could work through raising expected returns or making managers try harder • ‘Productive’ government expenditures can raise the growth rate; ‘distortionary’ taxes do the opposite • Need to decide balance between competition policy and industrial policy

8. Competition and Productivity Growth Absence of competition allows managers to be sleepy if ineffective shareholders Competition is strongly positive for productivity outcomes in UK firms without dominant shareholder (Nickell et al., 1997) Competition promotes better management practices (Bloom and van Reenen, 2007) Strengthening competition addressed Britain’s 1970s’ productivity problemquite effectively (Crafts, 2012)

9. Creative Destruction • Central to technological change and long-run economic growth • Exit/entry of plants accounted for about ½ of TFP growth in UK manufacturing between 1980 and 1993 (Disney et al., 2003) • As with freer trade, economic benefits but lost votes • Commitment technology to prevent intervention may be desirable

10. Government Failure • Politics of improving supply-side policies often unattractive; improving productivity typically means losers as well as winners (cf. trade liberalization) • Lessons of the 1960s and 1970s should not be forgotten; HS2 and ‘save the high street’ belong to those decades • ‘Institutional architecture’ is key area for reform (cf. LSE’s Infrastructure Commission)

11. Diffusion • Matters more for productivity performance than original invention and deserves more attention from policymakers • Vast majority of new technology in UK comes from R & D in ROW (Eaton & Kortum, 1999) • Information does matter but need also to think about absorptive capacity, intangibles and profitability of adoption

12. Sources of Growth in Real GDP/HW in the UK Market Sector, 1990-2008(dal Borgo et al., 2013)(% per year)

13. Top 6 Sector Contributions to UK Labour Productivity Growth, 1995-2007(Crafts, 2012) (% per year)

14. Wholesale and Retail Trade Would be considered irrelevant by traditional industrial policy Does not do much R & D (0.5% of UK R & D) but is the sector that contributed most to recent UK labour-productivity growth Is a big user of new technology Has been adversely affected by planning regulations; TFP in modern supermarkets reduced by at least 20% (Cheshire et al., 2011)

15. Agglomeration Economies • External economies of scale from localisation and urbanisation economies • Increase with city size (though not without limit) • Much bigger in services: financial services = 0.25, manufacturing = 0.04 (Graham, 2007) • Arenot fully realisedif transport inadequate or city size restricted

16. Welfare Loss NW New Net Wage Curve NW3 B Welfare Loss NW2 A1 NW1 A Old Net Wage Curve NB NA N

17. Industrial Policy • Can define as “public sector intervention aimed at changing the distribution of resources across economic sectors andactivities” (Caves, 1987) • Market-failure rationale might be provision of public goods or addressing divergence between social and private returns • Proponents claim positive effects on rate of economic growth

18. Types of Industrial Policy • Horizontal policies target innovation, skills, infrastructure etc. generally though their impact is not necessarily sector-neutral • Sector-specific policies are explicitly selective and aim to increase the size of particular industries • Since the early 1980s the emphasis in UK has been on horizontal policies including especially strengthening competition in product markets

19. Examples of Industrial Policy Instruments

20. UK Success Stories Have been promoted by horizontal not selective industrial policy Pharma:human capital, science base Financial Services:human capital, de-regulation, planning reform, transport ICT Diffusion:human capital, industrial relations reform, less obstructive regulation than elsewhere in Europe

21. Horizontal Industrial Policies: Could Do Better Infrastructure Education R & D Taxation Regulation NB: effects on growth through the incentives to invest, innovate and adopt new technologies

22. Infrastructure: Government Failure Pre-crisis investment in public capital shortfall: 1.3% GDP per year below growth-maximizing amount (Crafts, 2009) E.g, lots of road projects with high BCR not done Eddington Report (2006) – big welfare gains and tax revenues from efficient programme of roadbuilding and road pricing– ignored Perhaps roads should be provided by a regulated utility (Helm, 2012)

23. Education: Could Do Better ‘Cognitive skills’strongly correlated with long-run growth; 100 test-score points → 1.4 ppts per year (Hanushek & Woossman, 2011) Institutional design matters a lot for educational outcomes (principal-agent) International comparisons suggest UK could raise scores considerably by greater private operation (and probably by having higher-quality exams) (OECD, 2007) Key point: better incentive structures could improve educational qualitywithout spending more money

24. Cognitive Skills: Top 6 and UK, 2009(OECD, PISA Maths & Science average)

25. R & D: a Mixed Picture • SME Innovation Support: has incentivized innovation with high BCR (Foreman Peck, 2013) • R & D Tax Credit: also has high BCR but design issues (Griffith et al., 2001; Bond & Guceri, 2012) • Patent Box: badly targeted, revenue reducing, benefits highly questionable (Griffith et al., 2012)

26. Tax Doesn’t Have to be So Taxing Mirrlees Review(2011) presents powerful case for reform For example, revenue-neutral extension of VAT base to all consumption and reform of capital taxation by exempting normal rate of return to raise GDP by 1.4% and investment by 6.1% More generally, OECD research finds significant increases to GDP from shifting taxes from income to consumption and property(Arnold et al., 2011)

27. Planning Rules Matter An important horizontal ‘industrial policy’ Planning restrictions impose massive distortions in land use – regulatory tax rate of around 300% makes office space in Manchester more expensive than Manhattan (Cheshire & Hilber, 2008) Successful British cities are too small and constraints on growth threaten to undermine competitive advantage Spatial adjustment to globalization is inhibited

28. What is the Most Effective Role for UK Government? Good horizontal industrial policies and strong pro-competition stance; not back to the 1970s Address market failures and remember CBA Facilitate diffusion;don’t fixate on R & D Recognize that the globalized world of today has implications for the design of industrial policy

29. Two Technological Revolutions • Steam: Transport costs fell Industrialization & deindustrialization Lancashire cotton • ICT: Communications costs fell Vertically-disintegrated trade Computers and robots

30. Smile-Curve Economics: • Fabrication stages become commoditized • Value shifts to pre- and post-fabrication services Share of value added 2012 value chain 1970s value chain Stage Sales, marketing and after sales services Product concept, Design, R&D Manufacturing stages

31. % Breakdown of Nokia Phone Price, 2007(Ali-Yrkko et al., 2011)

32. Value Chains • Now more complex and more globalized • Big ‘manufacturers’, e.g., Rolls-Royce, make a lot of their money from services • Need much better metrics to understand how these input-output connections • ‘Rebalancing’ should not be conceptualized simply in terms of ‘manufacturing’

33. Implications of Vertically- Specialized Trade • Most value added not in making manufactures • Need to think in terms of stages notsectors of production; so horizontal industrial policies matter more • Successful rebalancing implies more jobs in business services which is where ‘real engineering’ will be found in future

34. Successful Cities • Fundamental to competitive advantage (cf. The Netherlands of 2040); attracting the right people is key. • Have hard-to-replicate agglomeration advantages • Underpinned by good horizontal policies, notably, land-use planning and transport • NB: Edinburgh (4th) and Glasgow (16th) in 2013 competitiveness index for British cities

35. Implications for Scotland • An independent Scotland could make horizontal industrial policies more growth friendly • If Ireland is a role model, it is only in the Celtic Tiger period – not before or since • As a small country, the optimal rate of corporate profits tax would be lower

36. Absorptive Capacity • Even more than for UK as a whole, diffusion is key for Scotland so absorptive capacity of business really matters • Worrying diagnostic that relatively few Scottish businesses are ‘innovation active’ (33% compared with 60% in Ireland and Sweden) • A high priority is to understand and address this shortfall (Turnbull & Richmond, 2013)

37. Policymaking Architecture • Need to do better than UK in mitigating ‘government failure’ especially given post-recession populism • Serious independent evaluation and surveillance of microeconomic policy • Could consider an equivalent to OBR or NICE (cf. the Australian Productivity Commission)

38. Varieties of Capitalism • UK policy discussion has really been about improving the functioning of a ‘liberal market economy’ (Hall & Soskice, 2001) • Perhaps Scotland would like to become a ‘coordinated market economy’? • If so, comprehensive institutional reform would be the focal point to move to an economy with more patient capital, more training and wage moderation

39. Conclusions • Evidence-based supply-side reforms could improve UK productivity performance • The politics of improving productivity is challenging • An independent Scotland should consider institutional as well as policy reforms • A return to the 1970s is not a good idea