Neil O’Brien: Lessons we can learn from fast-growing countries to help us to grow faster

8 Mar

Neil O’Brien is co-Chairman of the Conservative Party’s Policy Board, and is MP for Harborough.

Here’s a striking thing: several countries which suffered decades of communism are now richer than large parts of the UK. In 2018, the GDP per head of Yorkshire, Northern Ireland and the East Midlands (where I’m writing from) were all below Slovenia. Wales and the North East were lower: below Portugal, Estonia and Lithuania. All are now poorer than the old East Germany.

Radical change is needed to claw our way back into the top economic league. And unless we raise growth we won’t escape from demographic trends putting upward pressure on taxes. If you look at countries that have enjoyed rapid growth, they have in common a conscious drive to increase their knowledge, investment and technology.

Take the east Asian countries. Japan, Korea, Taiwan and now China, all followed the same playbook and saw dramatic growth.

Between 1945 and 1970 Japan went from a 20 per vent of the GDP per person of the US to two thirds, rising to 85 per cent by the late 80s. When I was born GDP per person in Korea was a quarter of the UK level. Now they are roughly the same. To have seen as much economic growth as a Korean pensioner has in their lifetime, a British pensioner would have to have been born in the reign of George III.

All four invested heavily in bringing new technologies to the country. Through a mix of government support for new industries and control over the financial system they supported firms to enter new higher tech industries, and soak up the inevitable losses as they learned on the job. For example, TSMC, now the world’s leading chipmaker, was a originally part owned by the Taiwanese government. Likewise Korea’s POSCO, now one of the world’s leading steelmakers.

But unlike many poor countries, they used internal competition between firms and global markets to discipline such subsidies. Companies that grew the national knowledge base and proved capable of export success got subsidies, tax breaks, free land and infrastructure; those that failed were ruthlessly culled (the opposite of what we did with British Leyland).

Industry ministries like MITI in Japan systematically researched and plotted the conquest of one industry after another. China’s NDRC and “Made in China 2025” are similar today. Taiwan created a huge science park and established consortiums of firms to share research, development and knowledge.

Various kinds of regulations and incentives encouraged sky-high rates of investment: even after easing off a lot Japan invests about 25 per cent GDP each year and Korea 30 per cent, compared to 17 per cent in the UK. All four went through periods of importing, copying or frankly ripping off western technologies.

Or if that seems too distant, take an example closer to home. Since 1990 average wages in Ireland went from being 5-12 per cent lower than the UK to being 7-15 per cent higher, depending how you measure it. Ireland attracted four times more inward investment than the UK relative to the size of its economy. Those foreign-owned firms have higher productivity: employing 22 per cent of people but accounting for 57 per cent of value added and 70 per cent R&D investment.

Some recent growth has been driven by highly specific and aggressive tax policies. But the seeds of Ireland’s growth were sown in earlier decades, when Ireland opened up to foreign direct investment and introduced a zero tax rate for manufacturing exporters. From the mid 80’s, Ireland specifically targetted investments from higher tech firms: Microsoft arrived in 1985, Intel arrived in 1989, Amazon, Bell Labs, MSD, Google, Twitter and Facebook in the 90’s and 00’s.

The Irish Development Agency operates a sort of concierge service for inward investors, and recent court cases like that brought by the European Commission regarding Apple show how far Ireland has been prepared to go to attract leading tech firms.

What would it mean to learn from these fast-growing countries today?

First, attracting firms with leading knowhow. We’ve done it before: Mrs Thatcher wooed Nissan to Sunderland with tax breaks. Although evidence suggests previous tax breaks increased foreign investment into poorer parts of Britain, we gradually phased them out, only partly due to EU rules. So the creation of the new Office for Investment is a good start.

Second, improving our innovation-industrial system. Total investment in R&D in the UK is just way too low. The UK invested 1.7 per cent GDP on R&D in 2018, China 2.1 per cent, the US 2.8 per cent, Germany 3.1 per cent, Sweden and Japan 3.3 per cent, South Korea 4.5 per cent and Israel 4.9 per cent. Across the world there’s a clear correlation between government investment and business investment.

However, government investment is more geared towards prompting business investment in some countries. We’re now growing government investment in R&D after decades of neglect, but we must also make it more business-focused. Government should implement the proposals set out in a recent NESTA report to support innovation in poorer parts of the UK.

Third, we need to bring the same focus to manufacturing and tech policy that we’ve had for decades on financial services. We have a city minister, and have quite rightly intervened and changed the tax system to promote financial services, because finance has high wages and productivity growth.

But so do manufacturing and IT. Between 1998 and 2018 output per hour grew £20.60 in manufacturing and £22.70 in IT, compared to £11.90 in leisure, £11.50 in retail, £9.50 in admin support services and £7.20 in accommodation.

Outside London, weekly pay in manufacturing is nearly a quarter higher than the economy as a whole. However, over recent decades poorer parts the UK have seen employment dramatically shifting out of manufacturing, and into these slower-growing local services. Though this holds down unemployment, it represents a sort of economic Dunkirk. The pace of this shift has dramatically slowed since 2010, but not been reversed.

Fourth, we need to address the UK’s longstanding low rates of physical investment. As the excellent Plan for Growth published last week noted: “The UK has a lower proportion of innovating firms overall than other advanced economies and weaker business investment”.

One cause of this is that Britain has had the most miserly tax allowances for investment in the G20. So the “super deduction” unveiled by Rishi Sunak last week is a huge step in the right direction. It should boost investment everywhere, but particularly in poorer places where there is more manufacturing.

Last but not least, a lesson from the high growth countries is about making sure that finance serves growth, rather than itself.

Again, the budget saw steps in the right direction. The Hill Review will enable dual class shares, which tech firms (like Google, Facebook, Lyft, Pintrest etc) increasingly use to offset market pressures for short termism. The new Infrastructure Bank in Leeds will catalyse private infrastructure investment, while further extensions of the British Business Bank will support lending and equity for growing companies (it is gradually filling the hole where 3i used to be).

The next challenge is to unlock more institutional investment into venture capital. Sunak has set in train a review of the EU-imposed Solvency II regulations for insurers. Shifting even a small sliver of such vast institutional cashpiles out of gilts and into growth enhancing venture capital could be transformative for growing businesses. There’s also arguments for reviewing similar rules around pensions too.

Making Britain into a tiger economy is a daunting challenge – particularly its less prosperous parts. But the challenges facing other countries at different times have been at least as daunting. If we don’t want a future of ever higher taxes and slow growth, we simply have to make it happen.

Neil O’Brien: How can we make the economy grow faster?

14 Dec

How can we make the economy grow faster? That’s going to be a big question in 2021 as we bounce back from an unprecedented recession, and start trying to make up lost ground.

There’s lots of things we need to look at. Obviously the big questions are about whether we get an EU deal and how fast we recover from the virus. But one of the other places to look is how we turn our savings into investments.

Rishi Sunak’s clearly interested. Recent weeks have seen him announcing a new infrastructure bank; reviewing Solvency II (regulating insurance firms investments); creating Long Term Asset Funds and extending a tax break to encourage investment. During his first weeks as Chancellor, he mandated the Bank of England to work on “the supply of productive finance, in all regions and nations of the UK” to “assist the Government’s levelling up agenda.”

They’re all welcome moves, because this is a huge issue for the UK.

One recent review noted that “the proportion of UK start-ups which scale into large businesses lags significantly behind the US”, and lots of start ups complain about access to finance. From a macro point of view, Britain has long had a lower stock of capital than other similar countries – at least when it comes to tangible, physical stuff. More machinery, better IT, more automation and stronger infrastructure would help us be more productive.

These are long-running challenges. Previous attempts to address them include the Myners Review (2001), Kay Review (2012), and Patient Capital Taskforce (2017) plus various select committee reports.

So what might be getting in the way of successful matchmaking between opportunities and funding?

1) Regulation and market structures

Riskier, longer term investments have higher returns. Pensions, banks and insurers face complex rules governing their investments, to control the share of their investments in such things.

In some cases, UK investors are putting less of their money into these growth areas than firms elsewhere. As Anna Sweeney from the Bank of England notes, “UK insurance companies only allocate around two per cent of their assets to unlisted equity. This is a smaller share than many of their European peers.”

By reviewing regulations like Solvency II, as the Chancellor is, we could refine the rules to safely enable more growth, not least because it was designed to fit the EU as a whole, not tailored to each country. We could also reshape regulations to make it easier to invest in long term funds. That’s the thought behind the plan to create Long Term Asset Funds.

And on top of the regulations, there might be related factors we could fix. As the Bank of England Financial Stability Report notes, the current industry norm is to value pensions (a long term investment) in ways that force them to behave like short term investors: “Daily trading and pricing is also common practice for [Defined Contribution] schemes, which is another constraint on investment in illiquid assets.”

The Bank should be prepared to act radically: tackling these barriers could mean more money for long term investment and more in your pension because of it.

(2) Public listed companies & short termism

We shouldn’t be too doomsterish about short termism. Plenty of money is being piled into tech firms that have never turned a profit, so clearly there are investors out there prepared to wait and accept risk in the hope of a good return.

But there is a real problem, particularly for public companies. It’s striking that privately owned companies invest somewhere between four to eight times more than public listed companies of the same size.

There’s long been concerns that relentless quarterly scrutiny of returns faced by public firms pushes managers towards short-termism: cutting investment in R&D or entry into risky new markets means profits will be better today, but worse tomorrow. But if your remuneration is based on your share price today, its tempting to go short term.

Managers agree there’s a problem: A survey of over 400 executives found three quarters would give up a project with a positive value in the longer term to smooth out earnings.

Investors agree too: in a CFA Institute survey of European investors 70 per cent said short-period evaluation cycles by asset owners are an impediment to long-term investing. Two-thirds of members of the National Association of Pension Funds said investment mandates encouraged short-termism.

If the investment gap between public and private firms reflects short termism, the economic costs of it would be pretty huge. As a paper by Andrew Haldane, the Bank of England’s Chief Economist and others, notes: “the elimination of short-termism would then result in a level of output around 20 per cent higher than would otherwise be the case.” That’s a big number.

Trying to escape short termism has led to two trends.

First, more and more public firms being taken private. “Public-to-private” deals where publicly-traded firms are taken private, plus fewer public listings (at least until this year), has been leading to “de-equitisation”. Across the US, UK and Eurozone the number of public listed companies has declined. But publicly listed firms remain a huge part of the economy, so if there is a short-termism problem there, it’s still going to have a huge economic impact.

Second, in the US new tech firms increasingly set up voting structures to keep founders in charge through dual-class share structures. Mark Zuckerberg has special shares with ten times more votes than ordinary shares. US firms like Google, Lyft, Pintrest and Snap use this kind of structure, allowed there since the 1980s. But in the UK dual class structures aren’t able to get premium listings. If this model particularly suits tech firms with hard to value intangible assets, perhaps that should change?

3) Tax?

One of the biggest, but hardest to fix distortions is the differential taxation of debt and equity. The fact that you can get tax relief on debt but not equity means firms load up on debt more than they otherwise would, and invest less overall. The Institute for Fiscal Studies’ landmark Mirlees Review suggested creating an “Allowance for Corporate Equity” to fix this.

But the cost to the Exchequer of such taxbreaks would be huge. Alternatively, any rebalancing by reducing the tax relief on debt would probably have to grandfather this debt somehow, as firms have borrowed heavily on the assumption of relief. It’s a very, very hard problem to crack, but that doesn’t mean a (very) long term solution is impossible.

4) Small business lending and equity

The most common financing problems MPs hear about is bank lending to small businesses. The problem’s a long running one.

The truth is that it’s a low-margin business for banks to analyse the finances of zillions of small firms, yet the provision of such loans has wider benefits to the economy. That’s why over decades governments have created a succession of bodies to support lending: from ICFC to 3i to the British Business Bank (BBB) we created in 2012. With the Bank of England predicting large numbers of unlisted firms will need to raise equity to grow (given their post-pandemic debts), it’s encouraging to see the BBB now growing its role in providing equity too. It’s a success story, and we should continue to support its growth.

As the economy bounces back next year, lots of firms will be in debt. But there are also real opportunities to reform regulation and market structures to help money flow into new opportunities. It’s a great place for the Chancellor to be looking to get growth going.