INVESTMENT AND ECONOMIC GROWTH

Scottish Enterprise

December 2007


Table of Contents

1. Introduction 3

2. Why investment is important 4

3. What we mean by investment 5

4. Evidence on investment as a driver of economic performance 5

5. Measuring investment 6

5.1 Capital stock 7

5.2 Capital Services 8

5.3 Gross Fixed Capital Formation (GFCF) 10

5.3 Business investment 13

5.3.1 Information and communication technology (ICT) investm 14

5.3.2 Scottish business investment 15

5.3.3 Why is business investment in the UK lower than other countries? 16

5.4 Government investment 17

6. Conclusions 19

Data Appendix 20


INVESTMENT AND ECONOMIC GROWTH

Summary

·  Investment, defined as the physical capital available to workers, is an important driver of productivity growth.

·  The UK has one of the lowest levels of capital stock (measured per worker or as a proportion of GDP) among OECD countries, although latest data is for 2001. No capital stock data is available for Scotland.

·  Scotland’s rate of annual investment (gross fixed capital formation) is estimated to be slightly below the UK average. The UK’s rate, however, lags most other OECD economies – and has done so for a number of years.

·  Scotland’s investment rate lags each of the Arc of Prosperity countries (equivalent to between £2 billion and £7 billion less investment a year).

·  Business investment accounts for the majority of overall investment. The UK’s rate business of business investment lags all other OECD countries, although it is unclear why this is. No robust data exists for Scotland, although performance is likely to be similar to the UK’s.

·  Government investment rates in the UK also lag most other OECD economies, leading to a relatively poor infrastructure.

·  There is a lack of robust data on capital stock and annual investment (total and business investment) for Scotland. This is a significant evidence gap in the understanding of Scotland’s relative productivity performance.

1. Introduction

Economic growth is dependent on labour utilisation (how many people are employed) and labour productivity (how much output labour is able to produce). In recent years employment has been growing strongly in both the UK and Scotland, with employment rates amongst the highest in the OECD. However, both the UK’s and Scotland’s productivity rates fail to match the top OECD performers and this has resulted in lower economic growth and prosperity (GDP per head) than could potentially be achieved.

The UK’s relatively poor growth performance has prompted a large programme of economic research by the UK government on the factors influencing productivity. This analysis has identified five drivers (outlined in Figure 1 below):

·  Investment

·  Skills

·  Enterprise

·  Innovation

·  Competition

This review considers the first of these, investment. The analysis draws on existing research, for example the HM Treasury’s ‘Productivity in the UK’ series[1], and outlines what is meant by investment, why it is an important driver of growth, what the potential measures/indicators of investment are and how the UK and Scottish economies perform. Where available, performance is compared to the ‘Arc of Prosperity’ countries outlined in the Government Economic Strategy[2].

Figure 1: Growth accounting and the five drivers of productivity growth (HM Treasury[3])

TFP = Total factor productivity (how efficiently labour and capital are combined using technology, organisation, etc)

2. Why investment is important

HM Treasury productivity research series of reports notes that the amount and quality of physical capital associated with a job is a key determinant of workers’ labour productivity. Investment in plant, machinery and infrastructure can increase the productive capacity of an economy by raising the capital stock available to workers. Specifically, raising the capital stock can drive productivity growth in two ways:

·  ‘Capital deepening’ increases the amount of plant and machinery workers have to work with

·  New technologies embodied in investment can introduce more efficient plant and machinery into the production process and boost productivity.

It is important to note that increased capital investment alone may not lead to productivity gains and depends on, among other things, the skills of workers to use capital assets, the skills of management to invest in the appropriate types of capital assets and the right goods and services being produced to meet or create market demand (an indicator of enterprise). This highlights the inter-relationships between the five drivers of productivity outlined in Figure 1 above.

3. What we mean by investment

There are various types of investment that have are important to economic growth[4]:

·  physical capital – refers to the overall level of physical assets (plant, machinery, buildings), that directly influences how much a unit of labour can produce.

·  ICT investment – is a specific component of physical capital and is the most recent example of technological change that can influence production processes across a wide range of sectors.

·  infrastructure – refers to investment that provides a base to support other economic activities. This is often publicly funded due to its wide public benefits, for example transport.

·  public sector capital investment – includes government investment in physical assets that support productivity growth by contributing to a healthy and skilled workforce (investment in school and hospital buildings, medical equipment, etc).

4. Evidence on investment as a driver of economic performance

The Scottish Government Economic Strategy, quoting research into the reasons why UK productivity lags behind other countries, notes that different levels of investment in physical capital stock accounts for 51% of the productivity gap with the United States, 80% of the gap with France and 81% with Germany[5].

Other empirical studies also show that levels of overall physical capital stock are closely correlated with productivity performance. A study in 1991 looking at the relationship between investment in machinery and equipment and economic growth in selected developed countries found that increasing investment by 1% would increase GDP per capita by 0.7%[6].

At the firm level, a study in 2000 looking at labour productivity gaps in the UK between foreign and domestic-owned firms found that the former operated with 50% more capital per worker, and that this explained a large part of the differences in labour productivity between the two types of firm. This result was consistent across most manufacturing and service sectors[7].

Data produced by the IMF[8] also suggests a positive relationship between the capital stock available to workers (capital stock per unit of labour) and productivity in eighteen OECD countries over the 1996-2000 period (Figure 2). This data also suggests that the UK has low levels of both capital stock and productivity and is out performed by each of the Arc of Prosperity countries.


Figure 2

Note: See data appendix for full data

Data for UK regions also suggests a positive correlation between investment (defined as net capital expenditure) and productivity[9]. Scotland though appears to be a slight ‘outlier’, with low GVA per worker relative to net capital expenditure (Figure 3).

Figure 3

Note: See data appendix for full data

5. Measuring investment

There are a number of potential measures of investment:

·  Capital stock

·  Capital services

·  Gross fixed capital formation

·  Net capital expenditure per employee

5.1 Capital stock

Capital stock is defined as the value of the assets used as inputs into the production process[10]. This includes, for example, plant and machinery that produce goods and services (including software), the buildings these are produced in and vehicles used to transport them.

Measuring the capital stock in an economy is not straight forward. There are challenges in trying to estimate the value of the current stock of machinery, equipment and buildings and how these depreciate over time. Also, there are issues around measuring the value of software and other intangible assets, as well how ‘quality’ is used to assess values (this is a particular issue for ICT - in recent years the cost of buying ICT has declined significantly at the same time as its quality or productive potential has risen. Using just a monetary value would suggest declining ICT investment).

Approaches have been developed, however, to attempt to provide internationally comparable indicators of capital stock. This involves measuring an economy’s annual investment spending over a number of years and using standard depreciation rates for different types of asset.

There are no capital stock data for Scotland (or the other UK regions) due to a lack of time series capital investment data for service sector businesses[11]. Data, though, does exist at the UK level and for a number of OECD countries, although it is a few years old now. The Keil Institute[12] has estimated capital stock relative to GDP for 2001 and the IMF has estimated capital stock per unit of labour input for the period 1996-2000 (Figures 4 and 5).

Both the IMF data and the Keil Institute data suggest that the UK’s level of capital stock (per worker or relative to GDP) is lower than most other OCED countries – and each if the Arc of Prosperity economies (interestingly, though, the Keil Institute data suggests that Ireland has a low capital stock relative to GDP - this could in part be due to Ireland’s GDP being artificially boosted by the activities of inward investors).


Figure 4

Note: See data appendix for full data

Figure 5

Note: See data appendix for full data

5.2 Capital Services

In considering the contribution of capital assets to the production process and productivity growth, it is now generally accepted that it is the value of the outputs produced by the asset (called capital services) that is relevant and not the value of the asset itself (measured by the capital stock)[13]. Conceptually, capital services reflect a quantity, or physical concept, rather than a value, or price, concept of capital. This helps to address a disadvantage of the standard capital stock measure that does not adequately reflect the shift towards shorter life and more productive investment goods, especially ICT.

The difference between capital stock and capital services is demonstrated in Figure 6 below. In the late 1990s, the growth of capital services was higher than the capital stock, mainly because ICT started to become a more important part overall investment. The price of ICT fell at the same time as its quality or productive capacity rose, leading to a faster rise in capital services then the value of capital stock.

Figure 6

Note: See data appendix for full data

Capital services data is only currently available for a small number of countries (and not for Scotland) and shows annual growth rates up to 2001 rather than absolute monetary values. The latest data available suggests that the UK’s performance in terms of capital services growth is mid-table compared to other countries (Figure 7).

Figure 7

Note: See data appendix for full data

5.3 Gross Fixed Capital Formation (GFCF)

GFCF is defined as investment in tangible fixed assets such as plant and machinery, ICT and software, transport equipment, dwellings/housing and other buildings and structures (housing is included because it is considered to produce housing services that are consumed by owners and contributes to GDP). It also includes investment in intangible fixed assets (such as intellectual property and patents), improvements to land and the costs associated with the transfer of assets. GFCF data is expressed as an annual expenditure figure and so does not measure the capital stock.

In 2005, it is estimated that GFCF in the UK was about £210 billion[14], equivalent to approximately 17% of GDP. Data suggests that the UK has the lowest rate of GFCF (expressed as a proportion of GDP) than all OECD countries (Figure 8), and this pattern has been evident for a number of years (over the last 20 years, most Arc of Prosperity countries have outperformed the UK on this measure). As capital stock is built up through investment over a number of years, the UK’s low level of annual GFCF explains its low levels of capital stock.

Figure 8

Note: See data appendix for full data


Figure 9

Note: See data appendix for full data

GFCF data is available for each of the UK regions, although the latest analysis is for 2000[15]. This data suggests that GFCF (expressed as a percentage of GVA) in Scotland was marginally above the UK level and ranked fifth out of the twelve UK regions (Figure 10). Over the 1998-2000 period for which data is available, Scotland’s rate of GFCF was consistently above the UK’s (Figure 11).

Figure 10

Note: See data appendix for full data

Figure 11

Note: See data appendix for full data

An alternative and more up-to-date source of GFCF data is available from input output tables produced for the UK[16] and Scotland[17]. Data from this source, however, suggests that over the 1998-2003 period, GFCF as a % of GVA was slightly lower in Scotland than the UK (Figure 12). In 2003 (latest available), Scottish GFCF was estimated to be £13.5 billion.

Figure 12