The UK’s innovation deficit

• The gap between productivity in the UK and its G7 peers has widened since the financial crisis, with the UK even lagging behind Italy on output per hour.
• This is partly explained by weak levels of investment. Gross fixed capital formation (GFCF) has recovered to its pre-crisis level in the first quarter of 2015, but as a share of GDP, the UK still spends less on it than other large economies.
• In particular, spending on research & development (R&D)—which is more closely linked to productivity than other forms of investment spending—is well below the EU average. The amount of funds allocated to R&D has stalled since 2007.
• Measures to support innovation in the government’s 2015 budget should deliver some productivity gains, but would benefit from being broadened.

UK productivity is weak relative to the G7 countries. As illustrated in the chart below, the productivity gap with France, Germany and the US has widened since the financial crisis, and a gap has opened up with Italy (which experienced three full-year economic contractions in 2012-14, while the UK economy was growing).

Low levels of investment have contributed to the weakness in UK productivity. The chart below shows that the main measures of productivity (output per hour and output per worker) have followed a broadly similar pattern to levels of GFCF since the end of 2007, when both declined sharply. The productivity ratios recovered in 2009-11 as output recovered faster than employment (which remained low after a sharp contraction in 2008). However, productivity weakened thereafter, as uncertainty over the sustainability of the recovery discouraged firms from increasing capital expenditure. Instead, firms took advantage of the UK’s flexible labour market to increase employment strongly, which both diverted funds from investment and weighed on the output per worker and output per hour ratios.

Supported by a pick-up in domestic demand, an easing in credit conditions and a slowdown in the pace of fiscal austerity, levels of GFCF increased more markedly from early 2013, making fixed investment an important contributor to the recovery of real GDP growth. In the first quarter of 2015, GFCF returned to its end-2007 pre-crisis peak.

The UK lags behind its peers

Despite this recovery, the UK continues to lag behind its G7 peers in terms of the share of GFCF in real GDP.

A dramatic 23.8% decline in investment spending in the UK between the final quarter of 2007 and the second quarter of 2009 saw the share of GFCF in the economy collapse from around 18.4% to below 15%. It remained below its pre-crisis level in the first quarter of 2015, at 17.6% of GDP. Although the gap has narrowed slightly, this share remains low relative to that of the UK’s G7 peers, where investment spending accounts for 20-25% of GDP, and goes part of the way to explaining the UK’s productivity gap with the G7.

As part of a wider effort to boost productivity, the government’s attempt to support investment spending in the 2015 budget centred on reducing the cost of capital, with the headline rate of UK corporation tax set to fall from 20% at present to 19% in 2017 and 18% in 2020—a comparatively low rate among advanced economies. The annual investment allowance will increase eightfold to £200,000 from January 2016, its highest ever permanent level. This allows businesses to deduct the full value of equipment or machinery from their profits before tax.

Low levels of R&D

The Office for Budget Responsibility estimates that government measures aimed at supporting business investment in the latest budget will increase it by around 0.6 percentage points by 2020. However, we do not expect this to deliver a direct boost to productivity levels. This is because of the importance of the composition of investment spending, as well as its overall level.

A more detailed look at investment spending data for the UK reveals particularly low growth in spending on R&D, which is more closely linked to productivity than other forms of investment, such as replacement of equipment. According to the Office for National Statistics (ONS), R&D spending stalled at close to €28bn a year in 2007-13.

This has meant that the UK also lags behind its EU peers in terms of innovation, explaining more of the productivity gap. According to Eurostat, the UK spent less on R&D in 2013 than 11 EU members, including Germany, France and the Nordic countries. At 1.6% of GDP, the UK’s share was smaller than the EU average of 2%, and just under half of the 3.3% of GDP spent by Sweden and Finland.

Reducing the innovation deficit

The government recognises that, as well as investment in physical assets, improving intellectual capital is important for productivity. New tax reliefs in the 2015 budget will support the creative industries and help to stimulate additional R&D. A “science capital commitment” promises to invest £6.9bn in the UK’s research infrastructure up to 2021, while £23m will be invested in six digital economy centres across the country.

These initiatives represent a step in the right direction, but appear unlikely to go far enough to help the UK to catch up to its peers. One limiting feature is that they are largely focused on scientific R&D. According to the latest ONS data, the UK accounted for around one-third of all spending in scientific R&D in the EU in 2012, but only a very small share of R&D spending in the manufacturing sector, which was dominated by Germany across the motor vehicle, electronics, machinery and pharmaceutical subsectors. Efforts to rebalance the UK economy and support long-term growth would be likely to benefit from competitiveness and productivity gains in the manufacturing sector, achieved through greater innovation. Another limiting factor is that the timescales involved in the government’s R&D funding plans may be too short to deliver the kind of technological innovation that will significantly boost productivity.