United Kingdom
Recent Economic Developments

This paper reviews economic developments in the United Kingdom during 1991–96. The paper examines two sets of possible reasons why the United Kingdom's savings and investment rates are lower than elsewhere. The first consists of factors leading to lower optimal rates of savings and investment: these include demographics, economic structure and technology, a liberalized financial environment, and so on. The second consists of distortions leading to lower-than-optimal savings and investment rates. The paper also presents new estimates for the potential growth rate, the output gap, and the natural rate of unemployment.

Abstract

This paper reviews economic developments in the United Kingdom during 1991–96. The paper examines two sets of possible reasons why the United Kingdom's savings and investment rates are lower than elsewhere. The first consists of factors leading to lower optimal rates of savings and investment: these include demographics, economic structure and technology, a liberalized financial environment, and so on. The second consists of distortions leading to lower-than-optimal savings and investment rates. The paper also presents new estimates for the potential growth rate, the output gap, and the natural rate of unemployment.

United Kingdom: Basic Data

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Source: Central Statistical Office, Economic Trends and Financial Statistics; H.M. Treasury; and staff estimates.

For 1996, data for first two quarters of the year at an annual rate, unless otherwise indicated.

World Economic Outlook.

July 1996.

August 1996.

September 1996.

Fiscal year beginning April 1. Estimates for 1996/97 based on staff forecasts.

I. SAVINGS AND INVESTMENT PERFORMANCE IN INTERNATIONAL PERSPECTIVE1

A. Introduction

1. For many years, national savings and investment rates in the United Kingdom have been lower than in many other industrialized countries and have been on a broad downward trend (Chart 1). Is this a problem? Appropriate rates of savings and investment—given that their purpose is the optimal intertemporal allocation of the nation’s consumption—depend on country-specific features, such as actual and prospective demographic trends, which may also change over time. Thus the adequacy of the United Kingdom’s savings and investment cannot be evaluated solely with reference to international or period averages: the reasons for comparatively low savings and investment rates also have a bearing on whether these rates are worrisome or not.

CHART 1
CHART 1

SELECTED COUNTRIES: SAVING AND INVESTMENT

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A001

Source: IMF, World Economic Outlook.

2. This chapter examines two sets of possible reasons why the United Kingdom’s savings and investment rates are lower than elsewhere. The first consist of factors leading to lower optimal rates of savings and investment: these include demographics, economic structure and technology, a liberalized financial environment, and the regulatory structure for public utilities. The second consists of distortions—government dissaving, the taxation of investment income, macroeconomic instability, and inflexible labor market institutions—leading to lower-than-optimal savings and investment rates. The adverse consequences for per capita income and growth of the latter set of factors could diminish if appropriate policies are followed.

3. Although savings and investment can be analyzed separately—on the premise that in an open economy, they can be determined independently, with any difference made up by the external current account—this chapter views them through a single set of lenses. One reason for doing this is that in the United Kingdom low savings have coincided with low investment. This is consistent with the pattern observed internationally, notably by Feldstein and Horioka (1980): low savings tend to go hand in hand with low investment, and conversely. Feldstein and Horioka argued that low national savings are reflected in low national investment due to limitations to capital mobility (investors’ locational preferences); others have advanced alternative explanations based on policy reactions or on common factors operating on both.2 Either perspective suggests that it would be useful to examine savings and investment together.

4. The chapter is organized as follows. Section B presents the facts: how national savings and investment have behaved in the United Kingdom in relation to other countries, and which components account for it. Section C discusses the implications of low savings and low investment for per capita income and growth. Section D discusses the co-movement of savings and investment. Sections E and F discuss the factors accounting, respectively, for low optimal savings and for lower-than-optimal savings. Section G concludes.

B. The Facts

5. This section briefly reviews how savings and investment in the United Kingdom compare internationally and how they have varied over time. Private savings, by both households and corporations, have been low in the United Kingdom for some years, compared with other EU countries (Chart 2); among major industrialized countries, only the United States has had lower savings rates. As in other countries, savings rates have trended down since the early 1980s. A sharp drop in household savings during the latter part of the 1980s attracted particular attention from researchers. However, this drop in household savings rates was largely reversed during the early 1990s. Corporate savings tend to be cyclical, varying with profit levels given dividend payouts that are typically much less variable; even given the high levels of profitability of the early 1990s, they were lower in the United Kingdom than in most other industrialized countries. At the same time, government savings decreased sharply during the late 1980s and early 1990s and fiscal consolidation in the 1990s has only gone a small way toward reversing this decline. It is this deterioration in government savings that mainly accounts for the decline in the United Kingdom’s national savings rate since the early 1980s.

CHART 2
CHART 2

SELECTED COUNTRIES: COMPONENTS OF SAVING

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A001

Sources: IMF, World Economic Outlook; and OECO, Analytical Database.

6. Investment as a share of GDP is also lower than in other major industrialized countries, although the difference has somewhat narrowed since the mid-1980s. The composition of investment has also changed. Private investment in the United Kingdom (as a share of GDP) is below levels in other large industrial economies; it is sharply below its peak of the late 1980s, but still above rates of the 1970s.3 The share of public investment has declined very substantially since the early 1970s (Chart 3).4 The composition of the lower private investment is spread across categories, including machinery and equipment as well as structures and housing (Chart 4). Lower investment has led to lower capital stock per worker, and lower equipment per worker, than in other industrialized countries (Chart 5).

CHART 3
CHART 3

SELECTED COUNTRIES: GROSS FIXED INVESTMENT

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A001

Sources: IMF, World Economic Outlook; and OECD, Analytical Database.
CHART 4
CHART 4

SELECTED COUNTRIES: INVESTMENT

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A001

Source: OECD, Analytical Database.
CHART 5
CHART 5

SELECTED COUNTRIES: CAPITAL STOCK PER WORKER, 1992 1/

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A001

Source: Bond and Jenkinson, Oxford Review Summer 1996, p.12.1/ Non-residential; 1990 for Germany.

C. Savings, Investment, and Growth

7. Low savings and investment rates can be a cause for concern mainly because of their association with low growth. This section briefly reviews the interrelation between savings and investment and growth.

The impact of growth on saving and investment

8. The GDP growth rate is an important determinant of saving and investment. On the saving side, higher growth could raise the aggregate saving rate because it raises the aggregate income of income-earning households (relative to retirees, for instance). This assumes that higher growth is unanticipated and, therefore, smoothing is backward-looking and consumption catches up to income with a lag. If, however, higher growth is not transitory and is anticipated by rational agents, individual saving rates would reflect forward-looking consumption smoothing, so that the aggregate saving rate need not be higher. Empirical cross-country evidence, nevertheless, suggests a positive correlation between growth and saving. In the United Kingdom, although some empirical research (Bosworth, 1995) provides support for a positive relationship, reflecting mainly lower-than-EU average growth and saving rates prior to the 1980s, the performance in recent years—with faster growth but still low savings—suggests that the relationship may have changed.

9. Investment is influenced by growth through the accelerator hypothesis, as firms increase investment to sustain higher expected output. On this basis, the United Kingdom’s low investment is difficult to reconcile with its higher-than-average growth in the post-1980 era, unless this growth was associated with higher productivity growth, or was viewed as temporary. However, the lower growth rates of the 1980s and 1990s is consistent with the international trend toward lower rates of savings and investment in industrialized countries (Bosworth, 1995); looking ahead, demographic trends would, other things being equal, augur lower growth rates for all industrial countries and thus a lower need for investment, with a smaller effect on savings.

The impact of saving and investment on growth and per capita income

10. To examine the effect of saving and investment performance on growth, a comparison of the United Kingdom with other major industrial countries is useful. Chart 6 highlights the fact that the United Kingdom’s low savings has been accompanied by comparatively low per capita income The relative growth performance was more mixed: over the 1970s, the United Kingdom’s average growth rate was slower than that of other major countries, while in the post-1980 period, the United Kingdom’s growth performance was more respectable (Chart 6).

CHART 6
CHART 6

SELECTED COUNTRIES: SAVING, GROWTH AND PER CAPITA INCOME

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A001

Sources: IMF, World Economic Outlook: and staff calculations1/ Based on purchasing power parity weights.

11. The lower per capita income is in line with the predictions of neoclassical growth theory, according to which the rate of investment only affects the growth rate during the transition to a steady state. In the long run, investment affects the capital-labor ratio, and thus per capita income, while the growth rate is determined by demographic factors and technological change. Lower investment therefore results in lower capital per worker, and lower per capita GDP.

12. Investment is predicted to have a positive effect on growth in recent models of endogenous growth. In one strand of this literature5, endogenous growth results from increasing returns to scale resulting from, among other things, externalities associated with “learning by doing”, the role of public infrastructure, and the contribution of human capital to production. The implication is that a higher rate of savings and investment may raise the long-run rate of growth, not just result in a step change in the level of per capita GDP.

13. Endogenous growth can explain differences in growth rates during the 1970s where low rates of investment in the United Kingdom were associated with lower growth (see Chart 6). To account for the pickup in growth in the 1980s accompanied by a further decline in investment rates, it is necessary to identify other explanatory factors that have changed.

14. Two key questions are whether investment is sufficient to sustain growth at its trend rate, and whether this trend is appropriate. The United Kingdom’s trend growth rate is estimated to rise somewhat to 2½ percent over the medium term (see below, Chapter II). Consistent with this, the staff project a modest rise in the saving rate as public dissavings decline over the medium term; and in the investment rate, reflecting the continuing efficiency improvements stemming from the financial and labor market reforms of the past two decades. Total factor productivity growth is also expected to be somewhat higher.

15. One benchmark for the appropriate growth rate is the “golden rule of growth”, according to which the trend growth rate should equal the real interest rate. According to this rule, long-run growth of 2-2½ percent would be sub-optimal for the United Kingdom in light of real long-term interest rates around 3½-4 percent. A fuller examination of the issue depends on identifying the factors that have led to comparatively low savings and investment—a subject to which we now turn. We first examine why investment and savings have moved together over time and then consider specific reasons for the comparatively low savings and investment rates in the United Kingdom.

D. Why do Investment and Savings Move Together?

16. There is no obvious single explanation of the United Kingdom’s low rates of both savings and investment, but several partial explanations need to be examined.6 Critical to this discussion is capital mobility: under perfect capital mobility, low savings in one country would not affect investment, but only the external current account; the same is true of low investment. In this case, the confluence of low savings and low investment must result either from a coincidence of factors affecting each, from common factors affecting both, or from policy reactions to limit external current account imbalances.7 Alternatively, along the lines suggested by Feldstein and Horioka (1980), capital mobility may be limited by investors’ locational preferences, despite the absence of obvious barriers to capital mobility; in this case, unusually low savings in one country would be transmitted to low investment in the same country through domestic interest rates or, in the presence of domestic financial market imperfections, through financing flows.

17. By most measures, the United Kingdom is characterized by particularly high capital mobility: gross capital movements in both directions are relatively large, as are stocks of foreign assets in the United Kingdom and United Kingdom residents’ assets abroad. This does not rule out the possibility that locational preferences could make foreign and domestic savings and investment imperfect substitutes for each other, occasioning adjustments in rates of return that would bring domestic savings and investment close together. These adjustments could also result from deliberate policy actions to limit current account imbalances, e.g. by tightening fiscal policy when they appear. However, the data do not provide clear confirmation for either of the simplest stories: that low domestic savings result in higher real rates that stifle domestic investment; or that low domestic investment results in lower real interest rates that sap the incentive for domestic savings: real interest rates in the United Kingdom are neither exceptionally high nor low, and the fact that they are somewhat higher than Germany and France likely reflects factors such as lower monetary policy credibility and the market’s perception that the United Kingdom will not be an early participant in EMU (Chart 7). Another explanation would center on corporate savings and investment: due to informational asymmetries, retained earnings may not be perfect substitutes for funds raised through borrowing and new equity, and empirical studies confirm that movements in investment are significantly correlated with those in corporate savings (Devereux and Schiantarelli, 1989, Schiantarelli 1996).

CHART 7
CHART 7

SELECTED COUNTRIES: REAL INTEREST RATES

(Deflated by CPI, in percent)

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A001

Sources: Office for National Statistics; and IMF, Surveillance Database.

E. Reasons for Lower Optimal Savings and Investment

18. Some factors accounting for a low savings and investment imply lower optimal savings and investment rates. Some, but not all, of these factors also result in slower growth rates and/or lower per capita income—but this slower growth may not be judged sub-optimal.

Demographics

19. Demographic developments are well known to affect savings in the context of the life-cycle model.8 If a high proportion of the population is of working age, then the private saving rate is likely to be high, while with a higher share of the young and the retired in the population the saving rate would be low. Demographics could also affect saving from a forward-looking point of view: if the old-age population is projected to rise, then savings would need to be higher now to allow for the consumption of those who will retire. The United Kingdom now has a higher old-age dependency rate than many other industrialized countries, while its projected future dependency rate is lower (Chart 8)—consistent with a lower savings rate both for backward- and forward-looking reasons. The latter, forward-looking dimension is particularly important in countries in which the solvency of the pension system is at issue; the United Kingdom’s pension system is less likely to come under pressure both because it is less extensive and because the anticipated demographic bulge is smaller than in other industrialized countries (Disney, 1996).

CHART 8
CHART 8

SELECTED COUNTRIES: ACTUAL AND PROSPECTIVE DEMOGRAPHICS

(Percent of population, ages 65 and over)

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A001

Source: World Bank, World Population Projections.

Technology and structural factors

20. Investment in the United Kingdom may also be comparatively low for technological and structural reasons. Specifically, a higher productivity of capital would reduce the necessity of additional investment.

21. There have been few studies of capital productivity in the United Kingdom that lend themselves to international comparison. However, a recent study of this issue in the United States context (McKinsey Global Institute, 1996) suggested that international differences in capital productivity may be important. According to this study, higher capital productivity in the United States than in Germany or Japan could explain why the former was able to maintain higher per capita income despite lower saving rates. It argued that higher capital productivity was associated with suffer product market competition resulting from the elimination of regulations that raise barriers to entry and protect existing corporations, and from the greater scope of the private sector. Greater competition in financial markets puts pressure on institutional investors to seek higher financial returns, which in turn put pressure on firms to increase returns on capital.

22. Similar considerations may be relevant in the deregulated product and financial markets of the United Kingdom. Bearing in mind the limitations of using aggregate measures of heterogenous capital and definitional differences across countries, one may make a rough comparative of capital productivities in the United Kingdom and other countries by comparing their output/capital ratios at constant prices (Chart 9). This indicates that in the United Kingdom output per unit of capital has somewhat risen since 1980, while it has declined, sometimes significantly, elsewhere. On the basis of this chart, it is unclear whether this is the result of higher productivity of capital or a shift of economic structure toward less capital-intensive activities such as services;9 more detailed study is clearly needed. However, what does emerge clearly is that the United Kingdom output has grown faster than capital, while the reverse is true elsewhere.

CHART 9
CHART 9

SELECTED COUNTRIES: OUTPUT/CAPITAL RATIO AND RELATIVE PRICE OF INVESTMENT GOODS

(Indices: 1980=100)

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A001

Sources: OECD, Analytical Database; and staff calculations.1/ Fixed investment deflator in the business sector divided by the GDP deflator.

23. Increased efficiency of capital would not necessarily manifest itself in the ratio of GDP in constant prices to physical capital. Higher efficiency may lower the price of capital relative to GDP and thus raise financial returns to capital for the same level of capital productivity. Indeed the relative price of investment goods (excluding buildings) has fallen further in the United Kingdom than in France or Germany (Chart 9). Assuming a constant share of output going to remunerate capital, this would result in more rapid growth in financial returns to capital in the United Kingdom than elsewhere in Europe. This could in part reflect the increasing move toward services in the United Kingdom and the different kind of technology used in the production of services.

Measurement issues

24. Structural changes may also cause measurement problems, understating investment’s contribution to activity. Measurement may have become an increasingly more important issue in recent years because of the increasing expenditure on items such as computers and related equipment. It has been argued that an overly conservative adjustment in the United Kingdom for the improving quality and falling prices of such items could have led to underrecording of investment expenditure relative to other countries.10 The investment ratio at constant prices indicates a much smaller reduction in recent years (Chart 10).

CHART 10
CHART 10

UNITED KINGDOM: TOTAL INVESTMENT

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A001

Sources: CSO, Economic Trends.

Financial deregulation

25. The fact that the United Kingdom and the United States both have lower savings and investment rates than other industrialized countries points attention to these countries’ more liberalized and market-oriented financial systems. This could affect savings via the relative freer availability of consumer credit, which reduces the necessity for households to save in anticipation of major purchases. The process of financial liberalization, by easing liquidity constraints on consumption, would be expected to reduce aggregate household savings rates, even though it would have a net beneficial effect on economic efficiency to the extent that it enables households to exercise freer choice in the allocation of lifetime consumption (Franklin and others, 1989; Bayoumi, 1993). The rising prevalence of financial asset holdings (noted e.g. by Banks and Tanner, 1996) may also have had similar effects in easing liquidity constraints. This process is going on in many countries, and a study by Japelli and Pagano (1994) suggests that this has contributed to the decline in savings rates across the industrialized world. In the case of the United Kingdom, the latter study suggests that deregulation explains 60 percent of the 2-percentage-point reduction in the national saving rate over the period 1960–85. In the model presented by the authors, this detracts from economic welfare; however, in a more general context, a reduction in the savings rate associated with an easing of constraints on households would tend to move society closer to a social optimum—albeit one with lower steady-state per capita income and, possibly, growth rate.

26. It is also possible that financial deregulation allows the saving rate to be lower than it would otherwise be, because where investment divisions are guided by market considerations capital is allocated more efficiently. The need to meet a market test imposes discipline on corporate decisions, checking projects whose contributions to the firm’s net worth is limited. The associated reduction in investment could in principle result in a smaller capital stock employed more efficiently. On the other hand, it has been argued that possible that extensive deregulation may result in too little investment due to the alleged “short-termism” of equity markets (Rose, 1996). This short-termism is associated with the more diffuse ownership structure and the prevalence of hostile takeovers in disciplining management, in contrast for instance to some continental European countries where banks play a greater role in corporate governance. However, the evidence on short-termism is mixed, and much of the criticism discounts the role that hostile takeovers and payouts can play in imposing discipline on management that could otherwise become detached from its shareholders’ interests.

Regulation

27. The regulation of public utilities also affects the incentives for investment Traditional rate-of-return regulation creates well-known incentives for over-investment, in order to expand the base on which the rate of return is calculated. The price cap system adopted in the United Kingdom has a different effect: it does not provide any explicit reward for investment, but allows the regulated utility to reap the cost savings from the resulting increase inefficiency, up until the time when the price cap is re-adjusted. This system, in principle, should result in a lower but more efficiently targeted level of investment.

F. Reasons for Below-Optimal Savings and Investment

28. There are also several reasons for lower savings and investment that may imply a loss in welfare. We examine some that involve distortions attributable mainly to public policy.

Public dissaving

29. Public policy may have an important effect on national savings through publicdis savings—whose deterioration was responsible for the decline in savings in the United Kingdom since the mid-1980s, albeit not for its relatively low level.11 However, as already mentioned, increased government dissaving was not offset by increased private savings as predicted by Ricardian equivalence—consistent with international evidence (Masson, Bayoumi, and Samiei, 1995). This could reflect liquidity constraints, including non-negativity constraints on intergenerational transfers, that prevent the private sector from fully offsetting the saving or dissaving that the public sector is carrying out on its behalf. In this context, deficit-reducing tax increases would be a form of “forced savings”, raising the national savings rate (although not, of course, necessarily welfare-improving). Fiscal consolidation since 1993 has reversed some of the sharp rise in public dissaving that took place in the late 1980s and early 1990s. Improving the public finances remains essential for raising the saving rate in the United Kingdom. According to staff projections, under the assumption that the deficit falls to 1½ percent of GDP by the end of the decade, the gross national saving rate would rise by 1½ percentage points in 1996 to 17¼ percent.12 Under the more optimistic scenario of a balanced budget over the medium term, as envisaged in the 1995 budget, the national saving rate could rise by as much as 2 percentage points, to about 18 percent.13

30. At the same time, low public investment is an element in low national investment (as discussed in Section 2). It is difficult to measure the productivity of public investment or to establish a bench mark for its level. However, the fact that the United Kingdom’s public investment rate is below both previous rates and rates in comparable countries argue for caution in any further reductions.

Taxation

31. The tax system may affect both savings and investment.14 In the United Kingdom, attention has recently been focussed on the effect of taxes on corporate savings and investment. Retained earnings are closely correlated with investment, as informational asymmetries result in imperfect substitutability between inside and outside finance. In the United Kingdom, a particularly large share of investment, relative to other major industrial countries (Chart 11), is financed by retained earnings.

CHART 11
CHART 11

SELECTED COUNTRIES: FINANCING OF INVESTMENT 1/

(In percent)

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A001

Source: Bond and Jenkinson, Oxford Review Summer 1996, p. 12.1/ Data sample: 1970-94, except for Germany (1970-92).

32. One aspect of taxation that has recently received particular attention in the United Kingdom is the tax treatment of dividends (Devereux and Schiantarelli, 1996). Since 1973, the United Kingdom has had a system of imputation of corporate tax, such that shareholders receive a tax credit for corporate tax the company has paid on their behalf. This system is desirable in eliminating the double taxation of dividends that in some countries has led to the “trapped equity effect”—whereby the tax incentive to avoid dividend payouts may prevent the allocation of funds to its most efficient uses. However, in the United Kingdom the imputation system has led to the reverse problem, as shareholders are eligible for the tax credit on imputed corporate tax regardless of whether they themselves are taxable. Given that about half of the shares in the United Kingdom are held by tax-exempt shareholders such as pension funds and the pension business of insurance companies, this imputation provides a strong incentive for dividend payouts, reducing corporate savings. This in turn may have a depressing effect on investment, given the importance of retained earnings as a source of financing. Various solutions have been proposed for this issue: the Institute for Fiscal Studies (1994) has proposed effectively exempting all investment income from tax,15 eliminating the need for an imputation system. Alternative proposals (Kay and King, 1986) include a flat tax on all forms of investment income (interest, dividends, and capital gains) as has been introduced in some Scandinavian countries.16

33. The mix of direct and indirect taxes could also affect investment. Some cross-country evidence suggests that factor income taxes have significant negative effects on the investment rate, while the consumption tax and the investment rate are positively related (see Mendoza, Milesi-Ferreti, and Asea, 1995). The gradual move away from income taxes toward consumption taxes in the United Kingdom should, over the medium term, encourage investment.

Inflation and macroeconomic instability

34. Inflation may affect saving for a number of reasons: to the extent that it erodes financial wealth, it needs to be offset by higher nominal savings as the resulting higher nominal interest rates leads to higher measured household income and saving. It is also unclear how expectations of inflation, and its perceived variability, have changed with the decline in actual inflation in the United Kingdom since the beginning of the 1990s; certainly market expectations of inflation, as reflected in yield spreads, at around 4 percent, remain high in the United Kingdom compared with actual inflation.

35. Uncertainty about both inflation and real activity are likely to affect both savings and investment. Households and firms in the United Kingdom have been in for a rough ride over the past quarter-century, with greater variability of both growth and inflation than in most other major industrialized countries (see Table below).

Variability of GDP Growth and Inflation, 1970-96

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36. To the extent that this variability over the past is translated into greater uncertainty about the future it may have an implication for forward-looking decisions on both savings and investment. Higher inflation uncertainty may also lead to a portfolio shift out of financial assets and into durable goods. Greater uncertainty about employment and incomes has the (counterfactual) implication of higher savings for precautionary reasons—particularly given the less comprehensive system of social protection in the United Kingdom than in Continental Europe. For firms, macroeconomic instability may translate into greater uncertainty about future demand, prices, and costs, which in general would be expected to reduce investment (see discussion in Chapter II below).

Labor markets

37. The incentives for investment depend on the extent to which the returns to investment can be appropriated by the firm making the investment. This depends on labor market institutions: firms’ incentives to increase efficiency will be diminished if this is expected to result in higher wage demands from workers (Grout, 1984), or if employment cannot be adjusted as improving efficiency reduces labor requirements (Crafts, 1996). The United Kingdom’s turbulent labor relations in the 1960s and 1970s may well have contributed to the low investment and growth of that period. With the labor market reforms of the 1980s, the extent of appropriability of the returns to capital may have been increased, increasing the incentive for investment, and the efficiency of investment, relative to those in Continental Europe where labor market institutions are less flexible. This is also reflected in the United Kingdom’s favorable performance in attracting foreign direct investment (see below, Chapter VII).

G. Conclusions

38. It is clear that savings and investment are lower in the United Kingdom than in neighboring countries. It has been noted that some of this performance may reflect more favorable prospective demographics and possibly a more efficient use of a smaller capital stock. In particular, there is evidence that during the post-1980 period the linkage between savings and investment and growth has changed due to improvements in capital productivity, financial deregulation, changing economic structure, and measurement issues. At the same time, public dissavings, the tax system and macroeconomic uncertainty distort both savings and investment decisions, resulting in suboptimal savings and investment and growth.

39. The jury is still out on the relative importance of various explanations, but there is still reason to remedy the factors that have been identified as distortionary. The fact that the United Kingdom’s living standards are below those in comparable countries by itself argues that greater attention be given to this issue. In particular, removing fiscal imbalances could raise national savings significantly—by perhaps two percent of GDP—over the medium term. Implementing policies that sustain a low real interest rate, further reforming the tax system, and maintaining a more stable macroeconomic environment would encourage investment, and allow the benefits of financial and labor market reforms of the past decade to feed into higher productivity and output growth.

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1

Prepared by Timothy Lane and Hossein Samiei.

2

The correlations observed by Feldstein and Horioka (1980) have occasioned a flood of comment, both with regard to their interpretation and also their empirical robustness (Devereux 1996) On the latter, see e.g. Coakley, Kulasi, and Smith, 1994.

3

It is sometimes pointed out that business investment is no lower in the United Kingdom than in many continental European countries. However, this appears to be mainly attributable to differences in the definition of business investment and in the scope of the business sector (especially given the prevalence of privatization and contracting out in the United Kingdom). See Bond and Jenkinson (1996).

4

General government capital expenditure showed a sharper decline since the late 1980s and its level is below that in other major EU countries.

5

The other strand of the literature, Schumpeterian growth theory, considers endogenous technical change such that increased economic activity creates incentives for innovation. For a review, see e.g. Crafts (1996).

7

Bayoumi and Rose (1993), however, present evidence on interregional capital flows in the United Kingdom that tends to support the hypothesis of perfect intranational capital mobility—therefore, by implication, constituting evidence against the hypothesis that the Feldstein-Horioka results reflect common shocks affecting both savings and investment.

8

Banks and Blundell (1993) argue that the effect of age may be confused with cohort effects—that is, specific differences in savings behavior of those in a particular age cohort.

9

The share of non-government services in the United Kingdom’s GDP was recently around 50 percent, similar to Italy and France and higher than Germany, but lower than Japan and the United States; such comparisons are, however, fraught with measurement problems.

10

See, for example, Davis (1996).

11

Edwards (1995) uses a political economy model to examine reasons for international differences in government savings and investment.

12

This is expected to occur despite some private sector offset reflecting an expected one-percentage-point fall in the personal saving rate to 9½ percent as consumer balance sheets improve further.

13

The difference between budget and staff projections arises from differences in macroeconomic assumptions and the fact that the latter assume that beyond the period to which the control totals apply, the ratio of spending to GDP remains unchanged. For a more detailed discussion, see Chapter III below.

14

Boadway and Wildasin (1994) review issues in the effects of taxation on savings.

15

This would be done by replacing existing tax-exempt savings plans and retirement schemes with an Extended Personal Equity Plan, contributions to which would be fully taxable but income from which would be tax exempt. Another integral part of this proposal is to allow corporations to deduct an allowance for the imputed cost of corporate equity (ACE), in order to remove the current tax advantage of debt over equity financing. See Institute for Fiscal Studies (1994).

16

Cummins, Hassett, and Hubbard (1995) examine the effect of tax reforms on investment in a panel of countries, finding a significant effect in many cases including the 1990–91 reduction in the United Kingdom’s corporate tax rates from 35 to 33 percent.

United Kingdom: Recent Economic Developments
Author: International Monetary Fund