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The following OECD assessment and recommendations summarise chapter 1 of the Economic survey of the United Kingdom published on 27 September 2007.
The United Kingdom has embraced globalisation and been rewarded with a strong growth performance
Living up to the challenges posed by globalisation is the over-arching theme of this Economic Survey. Compared with its large European neighbours, the United Kingdom has been more proactive in adapting to international economic forces. This is reflected in support for free trade, openness to foreign direct investment, a willingness to open its labour markets to the citizens from the new EU member countries that joined in May 2004, the adoption of regulatory policies that promote efficiency and a macroeconomic policy framework that has enhanced economic resilience. This willingness to embrace the opportunities offered by globalisation is generally backed by widespread support among key groups, including politicians, trade union leaders and employers. This has been rewarded with a stronger economic performance. The level of gross domestic product (GDP) per capita is now the third highest in the G7 (after the United States and Canada). Ten years earlier it was the lowest in this group. The United Kingdom’s GDP per capita ranking among all OECD countries has also improved. GDP growth has been close to its trend rate of around 2¾ per cent for a number of years, suggesting that the amplitude of the economic cycle is smaller now than in previous decades.
Strong GDP growth
Percentage change in real GDP
1. Break in series in 1991: western Germany up to then, total Germany thereafter.
Source: OECD (2007), OECD Economic Outlook: Statistics and Projections, No. 81 online database.
The near-term outlook is more uncertain, given recent financial market turbulence
Despite buoyant activity in recent years, strong inward migration has contributed to an easing in labour market tightness. Although the unemployment rate has crept up over the past two years, particularly among young unskilled school-leavers, it is still relatively low at around 5½ per cent. Consumer price inflation temporarily spiked to just above 3% earlier this year, partly because of unusually large increases in electricity and gas prices, but has since dropped back to just under 2 per cent. Looking ahead, the interest rate increases over the last year, together with recent financial market volatility, are expected to slow the housing market. Prior to the recent financial market turmoil the OECD projected growth of 2¾ per cent this year and 2½ per cent next year, with inflation remaining close to the 2% target. However, although indicators of economic activity have been robust in 2007 to date, there is now a risk that growth will be weaker going forward, which could imply a need for interest rate reductions. A slowing in growth, together with reduced profitability in the City, could also reduce tax revenues and imply a rise in the budget deficit, which is still relatively high by international comparison.
Earnings growth has remained moderate, despite significant concerns earlier this year that the spike in inflation might push up wage inflation. Strong inward migration helped in this regard by filling skill shortages and preventing labour market bottlenecks. Wage bargainers typically use as their inflation benchmark the retail price index (RPI). However, neither this index nor the consumer price index (CPI) are ideally suited for this purpose. An improved index would be based on the CPI but include a better measure of housing costs. The UK authorities should continue to support the development of the CPI index to include housing.
The size of government has grown and the deficit remains large
Government revenues and outlays – but particularly the latter – have trended upwards over the past few years as a share of GDP, albeit from relatively low levels by UK historical standards. Increased spending was a deliberate policy choice, motivated by the desire to improve certain government services, notably health and education. This contrasts with a general tendency towards spending restraint in most other OECD economies. The government deficit has fallen from 3.4% of GDP in 2003 to 2.7% in the year to March 2007, but the cyclically-adjusted budget shortfall is still substantial and significantly larger than in most other OECD countries. There is a need to further reduce the government deficit, which will require much slower growth in government expenditure – as the 2007 Comprehensive Spending Review promises to deliver – and more effort devoted to ensuring that publicly-funded services provide good value for money.
In 2005 the government renegotiated the policy that would have raised the normal public sector pension age from 60 to 65 for existing workers from 2013 in return for a commitment from unions that they would agree other reforms in the pension schemes to recover equivalent costs to those that would be lost by retaining the existing pension age for existing workers. Some of the subsequent negotiations have yet to be finalised and the final savings are not yet known, but the government is optimistic that the measures should deliver significant cost reductions.
The fiscal rules could be refined
The golden rule explicitly permits the government to borrow to pay for capital investment while the sustainable investment rule puts a limit on the extent of borrowing – by limiting public sector net debt to 40% of GDP. The golden rule only requires that the current budget is in surplus or balance over the cycle, and so does not require the accumulation of surpluses. Thus, it does not by itself explicitly address the perceived need to go further in preparing the public finances for the long-term challenges due to the ageing of the population. However, the government publishes annually the Long-Term Public Finance Report, which provides a comprehensive assessment of long-term fiscal sustainability, including the impact of ageing. Moreover, by separating current and capital spending, the fiscal rules have helped to tackle the United Kingdom’s historical bias against capital spending and low investment in public infrastructure. The rules have also put the public finances on a more sound and sustainable footing than in previous economic cycles and have played an important role in anchoring expectations and improving the transparency of fiscal policy. But some refinements to the rules could be considered. In particular, the golden rule relies on the notion of a clearly defined economic cycle, which has become harder to identify given that the economy has remained close to full capacity for a prolonged period of time. In addition, revisions to the cycle dates have occurred, which may have undermined the credibility of the golden rule. The golden rule could be made less reliant on cycle dating and output gap estimates, possibly by replacing it with a positive target level for the current budget balance over the medium-term, together with a comprehensive independent auditing of revenue projections. This could be accompanied by mechanisms that put a tighter constraint on overall spending and prevent the spending of revenue windfalls. The fiscal framework should also be transparent about fiscal drag, either through indexing tax brackets to wage growth or through efficiency enhancing tax reform. In addition, greater account should be taken of the large off-balance-sheet liabilities, which are not currently monitored under either rule. This could be done by publishing estimates of other public sector liabilities on a regular basis alongside those of public sector net debt and by setting a ceiling on a broader measure of public sector liabilities.
Productivity has been boosted by foreign direct investment, multinational enterprises and offshoring
There are a number of channels through which globalisation has spurred productivity. Openness to trade has promoted competition and encouraged economic resources to shift towards those sectors in which the United Kingdom has a comparative advantage. As a result, the manufacturing sector has shrunk as a proportion of total output, while knowledge-intensive and other business services have grown. This means that the United Kingdom is little affected by head-to-head competition from the emerging markets. Offshoring has facilitated productivity growth by allowing UK firms to re-locate lower-value-added production and service functions (such as information technology) to lower-cost locations, while increasingly specialising in areas of comparative advantage. There is evidence that foreign direct investment and multinational enterprises – particularly those from the United States – have also contributed to productivity growth, by facilitating the transfer of new technologies. Somewhat fortuitously, living standards have also been boosted by terms-of-trade gains, because the United Kingdom has tended to import those goods which have experienced the largest price falls, while being a leading services exporter, where prices are rising. In addition, the United Kingdom is nearly self sufficient in oil and the terms of trade have therefore not been much affected by higher world oil prices. There are some uncertainties regarding the extent to which these positive benefits can be relied on in the future. Compared with many other OECD countries, the labour share of income has been relatively stable over the past decade, rather than declining. This may be a positive reflection of policies that encourage labour to move to where it is most productive and policies that have ensured a relatively low rate of structural unemployment.
How to obtain this publication
The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.The complete edition of the Economic survey of the United Kingdom 2007 is available from:
For further information please contact the UK Desk at the OECD Economics Department at email@example.com. The OECD Secretariat's report was prepared by Anne-Marie Brook, Åsa Johansson, Petar Vujanovic and Marte Sollie under the supervision of Peter Hoeller.