Why Lower UK Productivity Forecasts Lead to Tax Hikes: A Comprehensive Analysis
The upcoming UK budget on November 26th has Chancellor Rachel Reeves contemplating tax increases, primarily due to a key factor: the Office for Budget Responsibility (OBR) is revising its UK productivity growth forecast downward for the next few years. This article delves into the intricate relationship between productivity, tax revenues, and government borrowing, shedding light on why this forecast revision could have significant implications for the UK's financial landscape.
Understanding Productivity and its Impact
Productivity, in simple terms, measures the output of goods and services per hour of work done by the UK's working population. It's a crucial indicator of a country's economic efficiency and overall productivity. Higher productivity often correlates with increased average wages and incomes.
In the Spring Statement of 2025, the OBR projected a modest 1% annual growth in UK productivity over the next five years. However, a slowdown in productivity growth means that GDP and tax revenues will fall short of initial expectations.
The Institute for Fiscal Studies (IFS) highlights a critical point: each 0.1 percentage point downgrade in the official productivity growth forecast translates to an additional £7 billion in government borrowing by 2029-30. If the OBR's forecast is revised from 1% to 0.8%, the impact is more severe, increasing projected borrowing by £14 billion.
This significant figure, £14 billion, erases the 'headroom' Chancellor Reeves had set aside to meet her borrowing rules in 2029-30, potentially pushing the government into a projected deficit.
Long-Term Trends in UK Productivity
The UK's productivity growth has been unusually weak since the financial crisis, with output per hour growing by only 0.4% annually since 2010, compared to the 2% average between 1971 and 2009. This slowdown is not unique to the UK but has affected most advanced countries post-2010.
The UK's decline has been more pronounced, with a 1.9 percentage point drop in average annual growth rate compared to the 1971-2009 period. This performance is worse than that of other G7 nations, except for Germany and Japan.
Factors Behind the Productivity Slowdown
Economists have grappled with the UK's productivity slowdown, lacking a clear consensus on its causes. Some attribute it to the lingering impact of the financial crisis, given the UK's heavy reliance on financial services through the City of London.
Others point to the austerity era spending cuts and tax rises under the previous Conservative-led government, which reduced economic activity at a time when the UK could have grown faster without inflationary pressures.
Brexit has also been identified as a contributing factor, with reduced trade and uncertainty in business investment post-2016 referendum affecting the UK's economic growth potential.
Despite ongoing debates, many economists believe historically low investment levels in the UK economy, both from the private sector and government, play a significant role in the productivity slowdown.
Predictability of the Downgrade
The OBR's recent optimism regarding UK productivity growth, exceeding that of other forecasters like the Bank of England and the International Monetary Fund (IMF), makes the downgrade less surprising. In March, the OBR projected a 1.79% medium-term potential supply growth, higher than the Bank of England's 1.5% and the IMF's 1.36%.
This persistent optimism since 2010 suggests that the OBR's revision aligns with other forecasters' views, indicating a more realistic assessment of UK productivity.
Public finance experts suggest that had Chancellor Reeves allocated more headroom in March 2025, she might not have needed to raise taxes in response to the downgrade. However, the vulnerability of her tax-raising pledges is a concern, as highlighted by public finance experts post-October 2024 budget.
Conclusion
In summary, the OBR's downward revision of UK productivity forecasts has significant implications for the government's budget and borrowing plans. The intricate relationship between productivity, GDP, and tax revenues underscores the need for careful financial management. As the UK navigates economic challenges, understanding these dynamics is crucial for policymakers and citizens alike.
