Microeconomic Reform in Britain Delivering Opportunities for All HM Treasury Edited by Ed Balls, Gus O’Donnell and Joe Grice Foreword by Gordon Brown Microeconomic Reform in Britain This page intentionally left blank 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 1–4039–1249–1 hardback ISBN 1–4039–1250–5 paperback 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. ISBN 1–4039–1249–1 (cloth) –– ISBN 1–4039–1250–5 (paper) 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 10987654321 13 12 11 10 09 08 07 06 05 04 Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne Contents List of Tables vii List of Figures viii Foreword by Gordon Brown, Chancellor of the Exchequer 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 non- convex 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