Microeconomic Reform in Britain

Microeconomic Reform in Britain

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Microeconomic Reform in Britain Delivering Opportunities for All HM TREASURY Foreword by Gordon Brown Chancellor of the Exchequer Edited by Ed Balls, Chief Economic Adviser to the Treasury, Joe Grice, Chief Economist and Director, Public Services and Gus O Donnell, Permanent Secretary

Crown Copyright 2004 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their right to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2004 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St Martin s Press LLC and of Palgrave Macmillan Ltd. Macmillan is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 978-1-4039-1250-3 ISBN 978-0-230-51833-9 (ebook) DOI 10.1057/9780230518339 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Microeconomic reform in Britain : delivering opportunities for all / H.M. Treasury ; foreword by Gordon Brown ; edited by Ed Balls, Gus O Donnell, and Joe Grice. p. cm. Companion volume to : Reforming Britain s economic and financial policy. Includes bibliographical references and index. 1. Great Britain Economic policy 1997 2. Microeconomics. I. Balls, Edward. II. O Donnell, Gus, 1952 III. Grice, Joseph (Joseph W.) IV. Great Britain, Treasury. V. Reforming Britain s economic and financial policy. HC256.7.M53 2003 330.941 dc22 2003065840 10 9 8 7 6 5 4 3 2 1 13 12 11 10 09 08 07 06 05 04

Contents List of Tables List of Figures Foreword by Gordon Brown, Chancellor of the Exchequer vii viii xi Introduction 1 1. Overview: Key Principles For Policy Making 5 Part 1 Raising Productivity in the UK 2. UK Productivity Gap and the Foundation for Government Policy 23 3. Trend Growth 44 4. Enterprise and Productivity Challenge: Government Policy to Date 65 5. The Regional and Local Dimensions 88 6. The Environment 122 7. European Economic Reform 145 Annex 7.1 The EMU Assessment: Supporting Studies 167 Part 2 Full Employment and the Labour Market 8. Historical Performance of the UK Labour Market 175 9. Welfare to Work 188 10. Making Work Pay 208 Annex 10.1 The Economics of Tax Credits: Inactivity Participation and Labour Supply 227 Annex 10.2 The National Minimum Wage 232 Part 3 Tackling Poverty and Promoting Opportunity 11. Supporting Families and Children 241 12. Promoting Saving Throughout Life 266 13. Security and Independence in Retirement 281 14. Tackling Poverty: A New Global Deal 298

vi Microeconomic Reform in Britain Part 4 World Class Public Services 15. Public Services Productivity: An Analysis 325 16. Public Service Reform 345 17. Public Investment and Capital Appraisal 362 18. Conclusion: Constrained Discretion The New Model 379 Notes 388 Glossary of Key Microeconomic Terms 399 List of Abbreviations 404 Bibliography 408 Index 423

List of Tables 2.1 Decomposition of the productivity gap, 1999 33 3.1 Real GDP growth between 1972 and 2002 55 3.2 Labour productivity growth rates, 1950 1999 56 3.3 Contributions to trend output growth 63 6.1 Development and implementation of economic instruments 134 6.2 Examples of government policies to address market failures 137 10.1 National Minimum Wage rates since its introduction 217 10.2 Comparison of levels of minimum wages across countries, end 2002 218 10.3 Adult minimum wages as a percentage of full-time median earnings, mid 2002 218 10.4 Number who stood to benefit from the introduction and subsequent increases in the NMW 219 10.5 Weekly Minimum Income Guarantees 224 10.6 The effect of the Government s reforms on high marginal deduction rates 226 12.1 Individual characteristics from 1992 to 2000, by earnings level and pension choice in 2000 270 12.2 Correlation between housing wealth and pension status in 2000 271 16.1 Major public service reforms since 1997 352 17.1 Proceeds of sales of fixed assets, 1991/92 2002/03 370 vii

List of Figures 2.1 Productivity gap with the US 1991 2001 26 2.2 Output per worker 1990 2001 26 2.3 International comparisons of productivity, 2002 27 2.4 The total factor productivity gap, 1999 28 2.5 Relative capital intensity, 1970 and 1999 29 2.6 Changes in labour input by hours and quality, 1986 98 31 2.7 Employees by skill level 31 2.8 The enterprise gap, 2002 37 3.1 Economic (Business) cycle 45 3.2. Trend and observed non-oil GVA 48 3.3 Annual growth in average hours worked 57 3.4 Annual growth in the employment rate 59 3.5 Annual growth rates in population of working age 61 5.1 Within-region dispersion in GDP per head 90 5.2 Relative regional GDP per capita 91 5.3 Decomposition of regional GDP per capita gap with UK Average, 1999 93 5.4 Employment and productivity in UK regions 94 5.5 The regional productivity gap, 1999 95 5.6 ILO unemployment rate by region 96 5.7 Highest qualification, 2001 98 5.8 Education by region 99 5.9 Skill levels: disparities within/between regions 100 5.10 Manufacturing capital expenditure per worker and manufacturing GDP per worker, 1997 101 5.11 Expenditure on R&D performed in UK businesses, 2001 102 5.12 Number of R&D firms in the South West by sub-region, 2001 103 5.13 Business start-ups by region per 10,000 resident adults 105 5.14 Business start-ups (VAT registrations) in the North East 106 6.1 Emissions of greenhouse gases, 1990 2012 140 6.2 Days when air pollution was moderate or higher, 1987 2002 (provisional) 141 6.3 Total road traffic volume, 1970 2002 141 6.4 Rivers of good or fair chemical quality, 1990 2001 142 viii

List of Figures ix 6.5 Population of wild birds, 1970 2000 142 6.6 Percentage of new homes built on previously developed land, 1989 2001 143 7.1 GDP per person employed and employment rate, 2002 148 7.2 Total and female employment rates, 2002 149 7.3 Total and older worker (aged 55 64) employment rates, 2002 150 7.4 EU employment rates and the Lisbon Agenda targets 151 7.5 The enterprise gap, 2002 156 7.6 R&D as per cent of GDP 159 7.7 Percentage of firms reporting increased competition from elsewhere in the EU, as a result of the Single Market 162 7.8 State aid to industry by Member State, 1991 2001 164 8.1 Employment and ILO unemployment 177 8.2 Lone parent employment rate by age of youngest child 179 8.3 Working age claimants of incapacity-related benefits, 1979-97 182 8.4 Changes in the way households organise their work 183 8.5 Claimant rate, UK regions, April 1997 185 8.6 Total and average hours worked, 1992-97 187 9.1 Long-term unemployment, youth and 25+ 191 9.2 Employment and ILO unemployment 194 9.3 Earnings and unemployment 195 9.4 Total and average hours worked 196 9.5 Lone parent employment rate 199 9.6 Working age claimants of incapacity-related benefits, 1979 2002 202 9.7 Percentage activity and employment rates for population of working age 204 9.8 Children in workless households, 1990-2002 205 10.1 Wage bill impact in the low paying sectors of the October 2001 Uprating of the NMW 221 10.2 Average net gain from an increase in the National Minimum Wage to 4.50 222 10.3 Gains to work for different households with one child 224 10.4 Gains to work for people aged 25 and over without children 225 10A.1 Individual labour supply choice in the presence of a nonconvex and non-linear budget set 228 10A.2 Impact of the WTC on choice of labour supply: non worker 229 10A.3 Impact of the WTC on choice of labour supply: worker 230

x Microeconomic Reform in Britain 10A.4 The minimum wage in a competitive model 233 10A.5 The minimum wage in a monopsony model 236 11.1 Percentage of children in low income households in the European Union 246 11.2 Children in low income households by family type, 1979 and 2001 02 247 11.3 Gains for families with children as a result of tax credits and other children s measures introduced between 1997 and 2004 252 11.4 The widening mortality gap between social classes 258 11.5 Investment in housing as a percentage of GDP 260 11.6 Permanent dwellings completed in Great Britain 261 11.7 Children in low income households 264 12.1 Households savings ratio, 1963-2002 267 12.2 Distribution of net financial wealth in 2000 268 13.1 State Second Pension accrual rates, compared to SERPS 285 13.2 The Pension Credit 287 13.3 Overall gains for pensioner families from pensioner policies, by income decile 290 15.1 Healthy life expectancy within the UK s main competitors 328 15.2 Health expenditure and life expectancy 329 15.3 Distribution of service performance across local authorities 330 15.4 Distribution of service performance by service area 330 15.5 Local authorities use of resources and their services performance 331 15.6 Operating costs for major Registered Social Landlords in England, 2002 332 15.7 Unit costs by probation area, 2001 02 332 17.1 Distribution of public sector assets, March 2002 363 17.2 Public sector net investment, 1975 1998 364 17.3 Gross fixed capital formation, by government sector, 1969 1997 365 17.4 The sustainable investment rule, 1989 2009 367 17.5 Public investment in public services, 1997 2006 367

Foreword Gordon Brown Since 1997, our Government s central objective the heart of our vision for a prosperous Britain has been to promote opportunity and security for all. Our first priority was to address our country s chronic macroeconomic instability. And as the companion volume to this book, Reforming Britain s Economic and Financial Policy: Towards Greater Economic Stability, set out, putting in place a wholly new fiscal and monetary framework including the independence of the Bank of England and new fiscal rules was a crucial step towards meeting this goal and has already produced real benefits unemployment has fallen to levels not seen since the 1970s, while inflation and interest rates remain at historic lows, and Britain has experienced the longest period of sustained peacetime growth since records began over 130 years ago. But a sound macroeconomic framework is a necessary but not sufficient condition to achieve, in what is an increasingly competitive global economy, a Britain where there is opportunity and security not just for some but for all. That is why, since 1997, we have also introduced policies which aim to improve the supply-side of the economy. Our approach has been to make the UK more productive by promoting, on the one hand, competition, enterprise, science and skills while on the other hand, reforming the welfare system and public services as a route to a more efficient and fairer Britain in which every individual can realise their potential. This book focuses on the agenda for microeconomic reform in those areas setting out what has been achieved over the last seven years and the challenges for the way ahead. And it tackles important questions about the relationship between individuals, government and markets acknowledging that whilst in some areas it is clearly in the public interest for markets to have an enhanced role, in others market failures need to be addressed to make markets work better and in some cases markets cannot safeguard the public interest. Equally, we must put the case for a reformed and renewed public sector with clear and long-term objectives, devolution of power and transparent mechanisms for accountability. xi

xii Microeconomic Reform in Britain The context for this book is the growing competitive challenges of the global economy. Within twenty years half the worlds manufactured exports from cars and clothes to computers and microchips may be produced outside Europe, Japan and America in low wage developing countries. Up to five million British, European and American jobs could end up outsourced offshore in countries like China and India as they strive to become the world s second and third largest economies. And even today China s significance to the global economy is that every year it, on its own, is adding as much output as the whole of the G7 put together. For Britain this means recognising that there is no escape from uncompetitiveness by resorting to loss making subsidies, artificial barriers or protectionist shelters. Indeed, the price of failure is not a long period of slow decline but sectors going under altogether. And the opportunity for us is that as low cost, low value production comes under increasing pressure, the high valued added, high tech, high skilled, science-driven products and services are the key to wealth creation in the future. So to succeed in this modern global economy we need to enable markets to work better and create an environment in which firms can operate effectively and in which they have the certainty to invest in the future. At the same time, if we are to make the most of the potential of open trade, we also need greater flexibility as we respond to new technologies and adjust to shifts in consumer demand. The more we are internationally interdependent, and thus the more our regions face intense global competition, the more successful will be the regions and localities that have the flexibility to adapt to change. This new approach has led to fundamental changes in direction not just in macroeconomic policy but in microeconomic policy. Since 1997 by strengthening the competition regime we have encouraged firms to innovate and minimise costs, which advances the public interest through providing better quality goods and services for consumers. We have put in place a new industrial policy replacing the old centralisation of national champions, picking winners or offering special subsidies to loss makers with a level playing field for all. We are celebrating the entrepreneurial culture opening up opportunity for those with ideas and dynamism, and reducing regulation where is does not serve the public interest. Investment in science is now a central priority. And instead of the old protectionism, we advocate open markets and free trade. At the same time, the new realities of fast changing labour markets mean there is a constant need for retraining and up-skilling by the British workforce. Instead of thinking of employment policy as maintaining people in old jobs even when technological and other change is

Foreword xiii inevitable, it is by combining flexibility helping people move from one job to another with active intervention to provide skills, information and financial support that is the best route to full employment. As a result of the New Deal and our other employment programmes, there are 1.7 million more people in work now than in 1997. And the next stage of the New Deal is to help people move from low skilled work to higher skilled work including a second chance for adults without basic skills to learn through further education, distance learning or work-based training. A modern global economy also requires a more modern welfare state that responds to the needs of working families while protecting the most vulnerable, including children and pensioners. The world has moved on a great deal from when Beveridge set out his plans in 1942, but the principles which underpin the welfare state remain the same: opportunity for people to improve their circumstances and those of their families; security to protect people from undue hardship that can arise from life events; and the responsibility of everyone to make the most of the opportunities on offer. The new welfare system puts into practice these principles transforming the passive and reactive system of the past into one which provides support for all, alongside the right incentives for people to move into, and progress in, work. Taken together, these reforms are not only supporting but enhancing markets in the public interest. But we must also have the courage to recognise where markets do not work well and lead to outcomes which are inequitable, inefficient or both and hence where market failure can be dealt with best through public provision. But even when a market is inappropriate, old command and control systems of management are not the way forward. Instead, our significant and sustained investment in Britain s public services must be tied to reform and results and in doing this, we have to develop decentralised models for public provision that respond to people s needs, extend choice and get the balance right between efficiency and equity. The modern challenge is to move beyond old assumptions under which equity was seen to go hand in hand with uniformity; or diversity appeared to lead inevitably to inequality. Instead we should seek the maximum amount of diversity consistent with equity. As a result, we are now stepping up our efforts to pioneer decentralised public service delivery to ensure greater freedom and flexibility for local providers; and empowering Regional Development Agencies, local authorities and the private and voluntary sectors to deliver services in innovative ways which meet local needs.

xiv Microeconomic Reform in Britain All this opens up a challenging agenda for reform and one which is continually evolving as technology and rising expectations challenge each generation s vision of what is possible and best. But as this book suggests, it is an agenda which can meet the contemporary challenges of competitiveness and equity creating a Britain where instead of enterprise thriving at the cost of fairness or fairness at the cost of enterprise, we can advance both enterprise and fairness together and provide opportunity and security for all. Chancellor of the Exchequer