Two key statistics about the UK’s recent productivity performance are now common currency. First, there is a productivity gap of between 23 and 32 per cent between the UK and otherwise comparable countries: Germany, France, the Netherlands and Belgium. Second, there is a productivity gap of 17 per cent between the UK’s current level of productivity and what it would have been if it had continued to increase, at the average rate for the 25 years up to 2007, both during and after the 2007–2008 financial crash.

This report presents new evidence on both aspects of the UK’s productivity puzzle. We have used ‘shift-share’ analysis to decompose these productivity gaps into the part that is due to differences in productivity within sectors, and the part that is due to structural differences in the sectoral mix of the economy (plus a cross-effect), with the aim of arriving at a better understanding of why the UK’s productivity performance has been so poor.

This new analysis demonstrates that the productivity gap between the UK and the four European countries mentioned above is wholly the result of lower productivity within industries in the UK, and not the result of a bias in the industrial composition of the UK economy as a whole towards relatively low-productivity sectors. Specifically, the UK’s relatively poor productivity in manufacturing, wholesaling and retailing, and transport, accommodation and food services explains much of the aggregate gap. Manufacturing in the UK is 27 per cent less productive than in France, and 33 per cent less productive than in Germany; the comparable figures for wholesaling and retailing, transport, accommodation and food services are 25 per cent and 16 per cent respectively.1

Similar analysis shows that the productivity growth that the UK has ‘lost’ between 2008 and 2015 is wholly the result of developments within sectors. Falls in productivity in North Sea oil and gas production, and in parts of the financial sector – the former a long-term trend, the latter the result of the financial crash – are important, but only explain a small part of what has happened. Across almost all sectors of the economy (the main exceptions being the administrative and support services sector and automobile production), productivity growth since 2008 has been lower than it was prior to the crash.

However, based on our analysis of the historical and international records, we suggest that over the last seven years there were two distinct phases of productivity weakness which should be analysed separately, and which pose two distinct questions. First, why did employment not fall further during the recession, given how much output fell? Second, why did productivity not increase over the last three years, despite economic recovery becoming firmly established?

When we analyse these two periods separately, we find that poor performance in terms of productivity during the recession was wholly a within-sector phenomenon – the result of labour-hoarding and a shift in the capital–labour ratio facilitated by falls in real wages. However, while within-sector effects remained a drag on productivity between 2012 and 2014, around half of the weakness in productivity growth in this period was the result of an unfavourable shift in the structure of the economy. While jobs growth may have been strong during these three years of decent economic growth, it was disproportionately in low value-added – and low-paid – sectors of the economy. A larger proportion of the labour force now works in relatively low-productivity sectors – particularly the accommodation and food sector – and a smaller proportion works in high-productivity jobs in finance and manufacturing.

The key to restoring productivity growth is, therefore, to shift job-creation towards higher-productivity sectors, while encouraging firms to invest more in order to boost the productivity of their existing workforces.

An improvement in the UK’s productivity performance would enable average living standards to increase. It would also make it easier for the government to eliminate its budget deficit during the current parliament. Kick-starting Britain’s productivity engine should be an economic policy priority for the government.

In this respect, the government’s decision to increase the minimum wage – or ‘national living wage’ – to £9 by the end of the decade is to be welcomed. If unemployment remains low, there is a good chance that lifting the wages of low-paid workers will encourage firms to improve their productivity performance. However, this alone will not be sufficient. This report does not contain a detailed discussion of policy options, but its analysis indicates the need for the government to change its current focus.

At present, the government’s efforts are for the most part concentrated on support for high-end manufacturing industries, including the automobile and aerospace industries. There are, for example, nine catapult centres covering areas such as high-value manufacturing, digital, precision medicine and energy systems, but none for the domestic service sectors such as wholesaling and retailing, accommodation and food. Millions of people are employed in these sectors, and their share of the economy has been increasing in recent years. The country’s productivity gaps cannot be closed unless productivity in these areas is lifted. The government should do more to support them.

It should also think more carefully about the effects that its spending policies have productivity. Cuts to capital spending on infrastructure, further education and, in real terms, the science budget during the last parliament are likely to have contributed to the weakness of productivity by discouraging business investment. Similar cuts over the next few years risk holding back future productivity growth.

1 See table 2.2 for definitions of the nine sectors examined in this part of our analysis.