Economic and Fiscal Strategy Report 1998
Chapter 2
Sustainable growth and employment
This Chapter spells out the Government's central economic objective of achieving high and stable levels of growth and employment. It also discusses what the Government is doing to address long-standing weaknesses of the UK economy.
The key points made in this chapter are that:
- raising the sustainable level of economic growth and employment will provide greater opportunity, higher incomes, improved public services and higher standards of living for all;
- three areas are vital: economic stability, encouraging work and raising productivity;
- the Government has put in place major fiscal and monetary policy reforms to deliver greater stability, and it has also introduced a wide-ranging programme of structural policy reforms designed to encourage work and raise productivity; and
- these reforms are all in the national interest and they will also help to deliver the stability and flexibility needed to allow Britain in due course to take part successfully in the single European currency, should it choose to do so.
2.1.1 A PROSPEROUS BRITAIN
The Government's central economic objective is to achieve high and stable economic growth and employment. This objective recognises that:
- the level of output per head is a key determinant of our overall standard of living. It also provides the scope for assisting those in need and for meeting the Government's spending priorities. The Government is committed to raising the UK economy's sustainable growth rate; and
- creating employment opportunities will not only promote economic growth but will ensure that the benefits of growth are shared throughout society.
Economic growth is the key to raising incomes and living standards over time. The post-war 'Golden Age' was an exceptional period of rapid growth (3 per cent per year on average), in which GDP doubled in the 25 years between 1948 and 1973. In contrast, growth over the following 25 years has averaged less than 2 per cent per year.
The Government believes that, with persistence and well-judged policies, it is possible to improve on the recent record. A sustained increase in growth would have enormous consequences for income levels and the ability to sustain and improve public services. For example, if the sustainable growth rate were raised by ½ per cent a year that would add over £120 billion to the level of national income in 20 years time.
Our quality of life, however, also reflects a wide range of factors besides measured incomes-for example, health, personal safety and the quality of the physical and social environment. Invaluable contributions made through unpaid household work, carers, and by those working in the voluntary sector are not captured in GDP. The amount of leisure time is another important factor in the quality of life. Our environment-in the countryside and in cities-is also crucial to our well-being.
GROWTH AND THE ENVIRONMENT
Economic growth cannot be considered in isolation from other aspects of development. In particular, consideration needs to be given to environmental factors to ensure that economic growth is sustainable.
The Government is doing this by:
- ensuring policy decisions take account of environmental costs and benefits;
- making greater use of economic instruments for the environment alongside regulation and voluntary agreements;
- encouraging more environmentally friendly transport and reducing greenhouse gas emissions through tax and duty changes; and
- promoting energy efficiency and renewable sources of energy.
The Government is also taking forward work on environmental accounts and indicators which will help to promote growth which is environmentally sustainable. Later this year the Government will publish its Sustainable Development Strategy, setting out its views on the framework within which environmental, social and economic factors should be weighed and balanced.
2.1.2 SHARING THE BENEFITS
Sustained growth will not just benefit those currently in work. A key element of the Government's strategy is to increase employment opportunities, develop a fair tax system and improve the provision of public services, to raise living standards for all.
Higher employment will ensure that more people can contribute to Britain's future. Additional jobs also means that more people are earning incomes, which raises their own standard of living and reduces the call on the public finances. Higher employment raises the level of national income directly.
A modern economy is characterised by continuous innovation and change. The key to higher employment is not to stand in the way of change, but to equip people to meet the challenge of that change. The Government's tax, benefit and employment policies reflect this reality and seek to provide employment opportunity for all-the modern definition of full employment.
Simply examining levels of GDP or average income per head may hide large disparities between rich and poor. The distribution of income in the UK has become more uneven since 1979, and by a greater margin than in the rest of Europe. But there is no reason why economic growth need go hand-in-hand with greater inequality. Quite the reverse:
- faster economic growth should reduce poverty and inequality directly through increased opportunities for work; and
- higher tax receipts increase the Government's capacity to assist those in need.
The tax and benefit system must not blunt incentives. In particular, careful consideration needs to be given to the interaction with economic and employment growth. But a fair tax system produces substantial benefits through increased social cohesion, trust and honesty, and a climate more conducive to economic growth.
2.2 ACHIEVING SUSTAINABLE GROWTH AND EMPLOYMENT
The UK's post-war growth performance has been poor compared with other industrialised countries. Some countries have not only caught up with, but overtaken the UK. As a result, GDP per head is now around 10 to 15 per cent higher in France and Germany, and around 50 per cent higher in the US.
There is considerable scope to improve our growth performance and catch up with the higher incomes of other major economies. The Government has a key role to play in meeting this challenge by working in partnership with business, and ensuring that growth benefits everyone.
In order to improve our growth performance, three areas need particular attention:
- assuring greater economic stability;
- encouraging work; and
- raising productivity.
2.3 ASSURING GREATER ECONOMIC STABILITY
2.3.1 ECONOMIC STABILITY
At least part of the UK's poor growth performance can be attributed to macroeconomic instability. That is why economic stability-based on low inflation and sound public finances-is a key platform of the Government's economic policy.
Improved macroeconomic stability will have several major benefits for the UK economy. In particular, it will give businesses and individuals the necessary confidence in future economic prospects for them to plan effectively for the long term. This will improve the quantity and quality of long-term investment and help raise productivity. Furthermore, confidence that inflation will remain low is important to encourage the savings which go to fund investment. Low inflation also reduces the distortion of economic decisions and minimises the arbitrary redistribution of income and wealth.
Macroeconomic instability also has substantial personal costs. The loss of security and self-confidence that arise from unemployment during recessions is considerable. In addition, it makes it difficult for individuals to retain or continue to develop the skills necessary for long-term employment.
The Government has a clear role in delivering macroeconomic stability. Fiscal and monetary policies need to focus on the long term and underpin stability rather than contributing to instability, as has sometimes been the case in the past. In addition, tax and spending regimes need to be as stable as possible to generate greater certainty and give businesses and individuals confidence to plan for the long term.
The international dimension must not be overlooked either. The world economy is now so closely interrelated that adverse shocks are just as likely to originate from overseas as they are domestically. The UK takes its international responsibilities to promote a healthy and stable world economy seriously, for example by helping to ensure an appropriate international response to the South East Asian crisis.
Greater transparency and openness are key weapons in avoiding poor policies and bad decision-making. That is why they play a central part in the Government's approach. They also help to enhance the credibility and effectiveness of policies. Accordingly, transparency and openness are at the heart of the new frameworks for monetary policy and fiscal policy. Furthermore, the Government argued successfully for the IMF to develop a Code of Good Practice on Fiscal Transparency, and is now working, with support from other G7 countries, to help the IMF to develop a parallel code for financial and monetary policy.
2.3.2 THE MONETARY AND FISCAL POLICY FRAMEWORKS
One of the first actions of the new Government was to establish a credible monetary policy framework that delivers low inflation. Low inflation is the most appropriate contribution that monetary policy can make to lasting growth. These reforms have been given a statutory basis under the Bank of England Act which came into effect on 1 June 1998.
The Act gives the Bank of England's Monetary Policy Committee (MPC) the operational responsibility to set interest rates to meet the Government's inflation target. This clear division of responsibilities means that the Bank can focus on the question of what level of interest rates are needed to achieve the target.
The new arrangements make the UK framework among the most transparent and accountable in the world, characterised by the publication of the minutes and the Inflation Report, and the immediate announcement of decisions. The new framework also enhances Parliamentary scrutiny and makes the MPC democratically accountable.
The monetary policy objective of the Bank of England is to maintain price stability and subject to that, to support the Government's economic policy, including its objectives for growth and employment. The remit that the Government has set for the MPC-confirmed in the Chancellor's letter of 3 June 1998 to the Governor of the Bank of England-is an inflation target of 2½ per cent (for retail prices excluding mortgage interest payments). Inflation needs to be consistently low. So the target applies at all times.
These arrangements have already established a much higher degree of credibility than those in place previously, and long-term interest rates and inflation expectations have fallen sharply since May last year. However, there is still more to do. In particular, those involved in wage bargaining in the private sector need to recognise that the new environment means low inflation permanently. Failure to do so will lead to unnecessary job losses and lower growth.
A more credible monetary policy framework, and the achievement of permanently low inflation and inflation expectations, are also key factors behind the achievement of sustainable economic convergence in preparation for the single currency. The Government is committed to creating the period of stability necessary to ensure the UK has a genuine choice of joining EMU early in the next Parliament.
The Government has made major changes to the fiscal policy framework as well, including strict fiscal rules and the introduction of a new Code for Fiscal Stability. This is discussed in more detail in Chapter 3. Chapter 4 announces the fiscal strategy for the next three years, further strengthening the framework. Together, the new fiscal and monetary policy frameworks will generate the necessary confidence to encourage businesses and individuals to plan for the long term.
2.4 ENCOURAGING WORK
In the three months to March 1998 there were 1.9 million people unemployed and a further 2.4 million people of working age who wanted a job but were either not seeking or not available for work. At the same time there is widespread evidence of skill shortages. Correcting this structural weakness requires a framework that rewards and encourages work. That means:
- helping people from welfare into work; and
- making work pay, by removing disincentives to work
- and ensuring decency and fairness in the workplace.
It also means making individuals more productive by improving skills and helping people move up the employment ladder. This is covered in Section 2.5.1.
2.4.1 FROM WELFARE TO WORK
The Government's New Deal initiative to help young people back to work is now a national programme, guaranteeing new employment and training opportunities to all those aged under 25 who have been out of work for 6 months or more. In its first full year, around 290,000 young people are expected to enter the programme, with over 100,000 to be placed into regular employment.
For those who do not find regular employment from the gateway programme of intensive job search, the New Deal offers the option of a subsidised job, full-time training, work with the voluntary sector or a place on the Environmental Task Force. All options include a training element, and those who complete their options will be given extra assistance to help them stay in work. This month also sees the national start of a new self-employment option; helping those for whom starting their own business offers the best route into the labour market.
The response from employers has been very encouraging, with over 10,000 having signed the agreement to participate. Building on this success the Government is now extending the New Deal to long-term unemployed people aged over 25. The New Deal for lone parents is the first serious national effort to help lone parents who want work to find it, and New Deal opportunities are also being made available to people with disabilities, and partners of the unemployed who find themselves out of work.
Alongside the New Deal, the Government is also developing approaches targeted on areas where long-term unemployment is particularly high. Five areas of the country have been selected as Employment Zones, where partnerships are developing innovative and flexible new approaches to make the best use of government funding. The New Deal for Communities will focus help on particularly disadvantaged housing estates, where poor employment prospects interact with wider problems of social exclusion, crime and poor housing.
2.4.2 MAKING WORK PAY
For the majority of people in work, there are clear financial rewards. But for those out of work who are able to command only low wages, potential in-work income may not be large enough to provide an incentive to work. In addition, for those in low-paid jobs, the tax and benefit systems may mean that they have very little incentive to increase their hours worked, or their hourly wage. The tax and benefit system therefore needs to help those in need whilst not discouraging people from working-the unemployment trap-or from moving up the earnings ladder-the poverty trap.
The 1998 Budget took important steps in tackling these problems through:
- a Working Families Tax Credit (WFTC) to replace the Family Credit system from October 1999;
- a new Disabled Persons Tax Credit to help make work pay for people with disabilities; and
- significant reform of National Insurance contributions to remove distortions at the lower end of the earnings distribution.
These reforms will be underpinned by the national minimum wage.
Together these reforms start to tackle the features in the tax, benefit and national insurance systems that distort the labour market; particularly through the effect they have on low paid workers, and those moving from unemployment into work. For instance, the reforms will cut the numbers of families facing high marginal deduction rates: the numbers facing rates of more than 90 pence of any extra £1 will fall by about four-fifths. In addition, these reforms will boost the effective hourly wage rates for low paid workers. Every working family will be guaranteed an income for full-time work of at least £180 per week. And no family with earnings of less than £220 a week (half average male earnings) will pay net income tax.
2.5 RAISING PRODUCTIVITY
Besides increasing the number of people in work, the other side of the growth strategy is to help each worker to become more productive. A productive labour force is essential to achieving high and stable levels of growth and employment. What is needed is a skilled and flexible labour force that is able to respond effectively to new challenges offered by a dynamic business sector.
Measured by either output per worker or output per hour, the UK has a poor productivity record. US productivity leads the UK by about 40 per cent, and France and Germany are at least 20 per cent ahead of the UK. These large productivity gaps go to the heart of the UK's legacy of under-performance.
Productivity can be raised by increasing and improving the stock of physical capital per worker and by raising skill levels. However, productivity growth cannot be considered in isolation from the fundamental role of innovation, nor from the competitive framework which drives it.
Of clear importance is the need for:
- high levels of educational attainment and training;
- the workforce to be supported by sustained capital investment;
- markets to be open and competitive to create the right incentives for continuous improvement; and
- dynamic and innovative businesses continually developing new products and processes.
In taking this forward, the Chancellor and the President of the Board of Trade have launched a joint programme of seminars with leading business people and others to work together to find ways of bridging the productivity gap.
2.5.1 IMPROVING EDUCATION AND TRAINING
High productivity is associated with an educated and skilled workforce. Improving the skills of those in work and ensuring new workers are highly trained will therefore help employers to raise productivity.
An effective basic education is important for both individuals and the economy alike. Early investment in a child's education will help to raise growth by improving the employability of all, especially the least skilled, and relieving skill shortages. The self-confidence and skills that a good basic education instills can also help to prevent many social problems, and the costs they entail, arising in later years.
There is evidence that the UK has a lower level of basic skills in literacy and numeracy than other major economies. The first step to address this problem is to enable a much higher proportion of 11 year olds to leave primary school with adequate skills in literacy and numeracy through:
- focused and intensive literacy and numeracy strategies;
- reduced class sizes for 5 to 7 year olds; and
- freeing up teachers? time to teach.
In the July 1997 Budget, the Government recognised the importance that well-maintained school buildings can play in helping to raise standards, both for pupils and teachers. The Chancellor allocated £1.3 billion from the windfall tax to tackle the backlog of school repairs. This New Deal for Schools has proved an effective measure, with a quarter of all UK schools having been allocated funding already.
Learning basic skills at a young age is fundamental to success in later life. By the time they leave school, children should be able to read and write fluently and handle numbers confidently. The Department for Education and Employment has announced ambitious targets for both literacy and numeracy for 11 year olds. By the year 2002, 80 per cent of 11 year olds will have reached the standards expected of their age in English, and 75 per cent will have achieved the standards expected of their age in Maths (as against 58 per cent and 54 per cent respectively in 1996).
The further education (FE) sector provides a key link between school and the workplace. In 1996-97 there were 1 million students studying full-time in the FE sector and over 2.8 million studying part-time. Of those students, over half were studying to improve basic skills. The Government is developing a range of measures, known collectively as Investing in Young People. These will encourage increased participation and enhance the quality of learning opportunities.
High participation in good quality higher and further education will also help to promote innovation, for example by making it easier to assimilate new ideas or develop and use new technologies.
The Government is taking steps to enable those already in the workforce to improve their level of attainment and to establish a culture of life-long learning. This will help individuals move up the employment ladder and allow them to respond to change throughout their working lives. The Green Paper The Learning Age announced proposals to achieve this end. They include setting up the University for Industry and introducing Individual Learning Accounts.
More immediate action has been needed to address particular skills shortages faced by parts of the economy at present. Inadequate education in the past means that information technology and other high technology parts of the economy are struggling to obtain adequate supplies of skilled workers. In the 1998 Budget, the Chancellor allocated an additional £100 million to tackle skills problems, including establishing forty Centres of Technical Excellence and training 20,000 people to tackle the Millennium Bug problem.
Further proposals and targets for education will be announced as part of the Comprehensive Spending Review.
2.5.2 CAPITAL INVESTMENT
A relatively low level of business investment per worker is another key factor in explaining why the UK has a lower level of labour productivity than other major economies. In particular, the UK invests less per worker and has a lower non-residential capital stock per worker than the US, France or Germany. Public sector investment has also been low (see the paper by HM Treasury on Fiscal policy: current and capital spending). Improving the amount and quality of capital should help to raise trend growth.
There are a number of possible reasons for the UK's low level of investment. High hurdle rates for investment are probably partly a result of the UK's history of macroeconomic instability as uncertainty about inflation raises risk premia on long-term investment. The UK's relatively low supply of savings may be another factor, which is why the Government is committed to fiscal prudence as a necessary pre-condition for achieving prosperity. In the past, the tax system has also distorted investment decisions. For example, tax credits encouraged firms to pay out dividends rather than reinvest retained profits. For some firms, the availability of external finance has been a constraint on investment and in some cases management attitudes and shortfalls probably also play a part.
The Government is seeking to create a pro-investment business climate. In the last two Budgets, important changes were made to corporation tax and capital gains tax to promote high quality long-term investment. The Chancellor also extended enhanced capital allowances for small and medium-sized enterprises (SMEs). This will assist cashflow and encourage SMEs to invest and modernise.
The Government also wants to improve the climate for external finance. To this end, it has reformed the Enterprise Investment Scheme to stimulate the provision of equity capital for smaller, higher risk trading companies. A University Challenge Fund will also help universities bridge the funding gap which has in the past prevented them successfully transforming good research into good business. External finance will be a continuing theme in the preparation of the next Budget.
INVESTMENT AND NATIONAL SAVING
In an open economy, the level of national investment need not be matched by the same amount of national saving. Foreign capital inflows can be used to finance domestic investment, so long as the returns on domestic investment generate the necessary income to pay the foreign investors.
Nevertheless, in the past both the levels and changes in domestic saving and investment have been found to be related strongly in the long term.
For the economy as a whole, it is overall national savings-the sum of private and government saving-that matters for economic growth. One direct contribution that the Government can make to increasing national saving is to improve its own saving performance. The main factor in the decline in national saving since the 1970s has been higher public borrowing.
2.5.3 OPEN AND COMPETITIVE MARKETS
Dynamic and efficient product markets are good for both consumers and for the economy as a whole. They give customers lower prices, more choice and higher quality; and they provide strong incentives for companies to innovate and improve productivity, driving forward economic success.
Exposure to competition and trade sharpens incentives, encourages the diffusion of technology and opens up opportunities to catch up with the world's leading firms. Moreover, increased market size allows greater specialisation and exploitation of comparative advantage. Episodes of trade liberalisation are, almost without exception, associated with rapid growth in trade and an increase in economic growth.
The UK benefits, in a similar way, from inward foreign investments; while outward investment has enabled UK firms to expand and develop markets overseas. Maintaining a high level of overseas investment will produce better returns and help spread risks for UK savers.
Over the past year, the Government has begun an ambitious programme to improve the dynamism of product markets. The approach has focused on encouraging competition, improving regulation and promoting open markets, through:
- introducing a new Competition Bill to create a modern framework for competition policy based on a tough and rigorous approach to abuses, whilst increasing transparency and accountability. The Government will also ensure that the Office of Fair Trading has the resources to implement these new arrangements and uses them effectively in those areas that will generate the greatest economic return;
- publishing a Green Paper on regulation of the utility industries. This sets out the Government's strategic proposals for these key industries for the next decade, with the objectives of fairness and efficiency. The aim is to set a long-term, stable and effective framework that safeguards the interests of consumers and shareholders and anticipates changes in market structure; and
- establishing an independent advisory task force to look at regulations protecting the interests of consumers and employees-another element of an efficient market economy. A report will be published in September 1998.
There is also a crucial international element to this agenda. In international groups the Government plays a leading role in pressing for further liberalisation of trade and investment and for competition policies which ensure free and open markets. In Europe, the Government recognises the need for a more effective Single Market. It is looking for action in a range of areas to improve the functioning of product markets, such as liberalisation of telecommunications and energy markets, public procurement and reform of agricultural support.
2.5.4 STIMULATING INNOVATION AND RESEARCH AND DEVELOPMENT
Research and development (R&D) and innovation by businesses is generally positively associated with economic growth in industrialised countries. The diffusion of ideas and technology has clear potential benefits for the wider community. Basic research also contributes to economic growth, by training skilled individuals for the business sector and by contributing to the stock of knowledge more generally.
In aggregate, the amount of R&D undertaken by UK firms has declined relative to our competitors. Total R&D spending in the UK is ¼ to ½ per cent of GDP less than in most other major economies. UK businesses spend relatively more in high-technology sectors such as chemicals and less in medium and low-technology sectors. But the overall figures are heavily influenced by a few star performers, as nine companies undertake one third of all UK business sector R&D.
The reforms to capital gains tax, corporation tax, and the initiatives to help small and medium-sized enterprises raise finance are important steps towards creating a more favourable environment for investment, including investment in R&D. In a wide-ranging review on how to improve the UK's record of investment in R&D, the Treasury and Department of Trade and Industry's consultative document, Innovating for the Future, identified several key issues to explore further, including:
- funding R&D, and the need to attract more finance into high-technology enterprises, especially in the early-stages of their development;
- the appropriate tax treatment of R&D expenditure and intellectual property;
- the right balance between the legal protection of intellectual property and encouraging the diffusion of innovation; and
- how the UK can exploit its science and engineering base better and develop management best practice, especially amongst technology-based companies.
2.6 EMU AND ECONOMIC REFORM
All of these policies directed at reforming markets will help to deliver the vital flexibility should the UK choose to join the single currency. But high and stable levels of growth and employment are also an objective for the European Union on which much of our prosperity depends. The Government believes that economic stability, encouraging work and raising productivity are also key areas for the European Union. Economic and Monetary Union and the introduction of the single currency in 11 Member States on 1 January 1999 will help to lock in monetary and fiscal stability throughout Europe. The single currency will provide a competitive base to European business. Firms and consumers stand to benefit from the greater price transparency, the reduction of transaction costs and the elimination of exchange rate uncertainty.
For these benefits to be realised in full the single currency must be based on solid foundations. More progress is required in two areas, fiscal discipline and economic reform. In particular:
- for labour markets, the key is to increase employability. With a single currency, it will be even more important for Europe to have a well-trained, adaptable and motivated labour force, able to adjust to changes in economic circumstances;
- for better functioning markets for products and services, Europe needs to build on the single market, promote entrepreneurship and improve access to finance. Within the single market this means liberalising markets and promoting better public procurement; and
- for deeper, more competitive and more integrated capital markets, the single market in financial services must be implemented effectively
Prepared 11 June 1998
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