Investing for prosperity

Skills, Infrastructure and Innovation

The London School of Economics (LSE) Growth Commission published its final report at the end of January. The report is based on evidence taken in a series of public sessions from leading researchers, business people, policy-makers and UK citizens.¹

The Commission notes that the UK has major strengths, which, from 1980 onwards, helped to reverse a century-long relative decline. Amongst these advantages, they cite: the strong rule of law, generally competitive product markets, flexible labour markets, a world-class university system and strengths in many key sectors, with cutting edge firms in both manufacturing and services. These were sufficient, for thirty years after 1980, to support faster growth per capita than in the UK’s main comparator countries — France, Germany and the US.

The report argues that the UK should build on these strengths and, at the same time, address the inadequate institutional structures that have deterred long-term investment to support the country’s future prosperity. The Commissioners (see box below) propose an integrated set of solutions.

Education for growth
Both economic theory and empirical evidence show that in the long run, human capital is a critical input for growth. The growth dividend from upgrading human capital is potentially enormous and improving the quality of compulsory education is the key to achieving these gains.

The quality of compulsory schooling in the UK is a fundamental growth issue. Evidence suggests that increasing UK school standards even moderately — say to the level of Australia or Germany — could put the country on a growth path that would more than double long-run average incomes compared with current trends.

Furthermore, there are other benefits (what the Commission calls a ‘double-dividend’) from improving human capital since many of the gains from growth would accrue to the less well-off, thereby reducing inequality. Increasing the quality and quantity of skills of disadvantaged children will make growth more inclusive by reducing the high levels of wage inequality in the UK In addition to the benefits from lower inequality, reducing the fraction of poorly educated should reduce the welfare rolls and the numbers caught up in the criminal justice system.

The question, of course, is how is this to be achieved? Better buildings, smaller class sizes, higher wages for teachers and greater provision of information technology will all help. But their effects are modest compared with the large potential benefits from increasing the quality of teachers.

Unfortunately, predicting who will be an effective teacher before they start working is very hard and is not well-captured by the formal teaching qualifications held nor by number of years in the profession. But once teachers have been in front of a class, measuring their performance is not especially difficult. Most parents, pupils and especially head-teachers have a good idea of who are the really excellent teachers. In addition, there is now much more data on pupil progression. Thus, a system for improving the quality of teachers has to use information acquired from observing teachers at work and using it to make improvements.

Broadly speaking, The UK is mid-table overall in most international rankings of schools. But one major failing in the UK education system is the ‘long tail’ of poorly performing schools and pupils compared with other countries, particularly at the secondary level. A significant part of the explanation for this is the stubborn link between pupils’ socio-economic background and their educational attainment. Part of the problem is that while current funding arrangements give more resources to local authorities in areas with more disadvantaged children, the evidence suggests that these resources fail to reach them effectively. The recently introduced ‘pupil premium’ is an attempt to attach additional funds directly to disadvantaged children but survey evidence suggests that schools generally still do not use these funds specifically to help disadvantaged pupils.

A further problem lies with the inspection regime and the criteria it employs. A school’s satisfactory performance is generally judged by the proportion of students achieving a specified level in examinations. This leads to a focus upon students at the margin who might just be converted into a ‘pass’. There is no benefit to a school in focusing on most pupils in the long tail.

Recommendations
The report contains a number of very specific recommendations which we can summarise only briefly here. It is interesting, however, to read that ‘our proposals go with the grain of the academies movement. But the system needs to deal more squarely with the UK’s failure to develop the talents of disadvantaged pupils’. Many of the proposals are focused on this issue.

Increased autonomy. School autonomy combined with a strong accountability framework centred on quality provides the best hope for improving school performance. There is evidence that more autonomous schools respond better to local parental choice, so increasing parental choice will not lead to higher standards without greater decentralisation to empower head teachers. Accountability is also fostered through better governance and leadership. To improve school governance, leadership and management, it must become easier for outstanding sponsored academies to grow. By the same token, it should be made easier for underperforming schools to shrink and, if they do not improve, to be taken over or, in extreme cases, closed down.

Shortening the ‘long tail’. Information on school performance needs to be changed to also reflect the performance of disadvantaged children within the school. Such changes should apply to league tables and targets and they should be more closely reflected in Ofsted’s inspection regime. Improving the performance of disadvantaged children should be given a central role when Ofsted awards an ‘outstanding’ grade to a school.

Teacher quality. This needs to be improved through better conditions for both entry and exit. Teacher recruitment and training could be improved by expanding the ‘Teach First’ programme. Mainstream recruitment should be focused on the best universities and schools. The probation period should be extended to four years. Less attention should be paid to candidates’ grades and formal qualifications in order to encourage a wider range of applications and a greater emphasis on teaching skill. The sharing of best practice should be encouraged. The system of pay and promotions requires attention— ending automatic increments; basing pay on performance and local market conditions; and offering extra rewards for teachers of core subjects in tough schools. The report also recommends piloting the release of teacher-level information on performance (in similar vein to NHS data available on surgeons).

Other issues. The criteria for receiving the pupil premium should be broadened, the premiun increased and part of the premium should be paid to the pupil’s family, conditional on improved performance.

Serious attention needs to be given to intermediate skills which are very poorly developed in the UK. Apprenticeships need to be of much higher quality and more readily available.

It is well-known that the UK’s higher education system ‘punches above its weight’ in a number of respects. The sector benefits the UK economy as a source of skills, of innovations that raise productivity and of valuable exports earnings in the form of foreign students who choose to study here (an enormous industry of global growth). There are potential advantages to the UK from having the world’s leaders in economy, society and government educated here. For these benefits to be sustained the Commission argues that the current policies on student visas and work visas for non-UK citizens are damaging because of their direct impact on the ability to recruit. We recommend that if the net immigration target itself is not dropped, then students should be removed from the target. Furthermore, universities enjoy a high degree of operational autonomy. (Indeed, there may be lessons here for the rest of the educational system). The flexible ecology of higher education allows freedom to build bridges with industry, either in the form of sponsored research or through collaborations in student degree programmes. There is further scope to strengthen and enhance these linkages in undergraduate programmes.

Infrastructure for growth
The UK’s infrastructure of transport, energy, telecoms and housing are essential facilities for growth. Substantial investment is needed in all these areas as well as determined efforts to address the problems that have constrained growth in the past. The effect of those problems was illustrated in the 2012 World Economic Forum report on global competitiveness where the UK was ranked only 24th for ‘quality of overall infrastructure’. The long-running issue of airport capacity in the south-east of the UK is a potent symbol of what is wrong.

Among the key problems in relation to all areas of infrastructure are:

• Vulnerability to policy instability – a lack of clarity about strategy, frequent reversals and prevarication over key decisions. Electricity supply is a good example.
• Difficulty in basing decisions on sound advice and assessment of policy alternatives built on unbiased appraisals (as opposed to lobbyists).
• The limitations of a planning system that does not properly share the benefits of development from implementing strategy and tackling problems. This has created the incentives for small groups of influential citizens and politicians to obstruct projects with wide economic benefits.
• A series of public sector accounting distortions that have made it difficult to weigh up benefits and costs in a coherent way. In particular, targets for fiscal policy often draw on measures of public debt while failing to account for the value (and depreciation) of public assets.

These problems apply to all major areas of UK infrastructure, but the report focuses on housing, transport, energy and telecoms.

When it comes to recommendations the Report argues for a new institutional architecture to provide better delivery and funding of major infrastructure projects. This requires 
three core institutions:

• An Infrastructure Strategy Board (ISB) to provide the strategic vision in all areas: its key function would be to provide independent expert advice on infrastructure issues. It would lay the foundation for a well-informed, cross-party consensus to underpin stable long-term policy.
• An Infrastructure Planning Commission (IPC), which would be charged with delivering on the ISB’s strategic priorities.The IPC is designed to give predictability and effectiveness to (mostly private) investment that drives implementation of strategy. It must not be misunderstood as a ‘central planner’.
• An Infrastructure Bank (IB) to facilitate the provision of stable, long-term, predictable, mostly private sector finance for infrastructure. It can help to reduce policy risk and, through partnerships, to structure finance in a way that mitigates and shares risk efficiently. This will require a whole range of financial instruments including equity and structured guarantees. There are good practical examples that show the advantages of a bank with this sort of mandate, such as Brazil’s BNDES, Germany’s KfW, the European Bank for Reconstruction and Development and to some extent the European Investment Bank.

Furthermore, the UK needs to take a lead from other countries and institute generous compensation schemes to extend the benefits of infrastructure projects to those who might otherwise stand to lose, either due to disruption caused by the construction phase or by the long-term impact on land and/or property values. The principle is to share the broad value that the implementation of the national strategy will bring. Such compensation schemes should be enshrined in law and built into the thinking of the ISB and the operations of the IPC.

Finally, serious attention should be given to the accounting methods used in the evaluation of public investment projects. At present, these give undue attention to the debt incurred and fail to offset this by recognising the value of the assets created. Inevitably, all public sector investment looks unduly expensive. The use of the newly developed Whole of Government Accounts would avoid this.

The projects considered and promoted within this framework would be those of greatest national priority, such as ones in roads, aviation and energy. But it would also accommodate large-scale regional project infrastructure proposals from local enterprise partnerships.

Investment in equipment and new ideas are crucial engines of growth. UK investment as a share of GDP has historically been lower than in France and Germany. This largely accounts for the country's lower GDP per hour worked. Moreover, the make-up of UK investment is heavily skewed towards property and buildings, rather than equipment, innovation and new technologies.

UK investment performance has been weakened by a number of factors, including those (above) that have inhibited the development of human capital and infrastructure. In addition to these however, there is a poor record of turning research and invention into practical innovations and also a poor level of management quality, when compared with the UK’s obvious comparators.

But there is a further issue holding back investment and innovation according to the Report. Investment performance has been weakened by a series of problems in the functioning of capital markets. These include an inadequate supply of finance to young firms and small and medium enterprises (SMEs); ‘short-termism’ by fund managers and investors; insufficient competition in the banking system; a bias towards debt rather than equity in company finance; and the lack of a long-term industrial strategy.

When it comes to recommendations, the Report begins with two that have already developed a degree of momentum for other reasons. The first is to increase the competitiveness of the banking system by lowering barriers to entry, making charges more transparent and facilitating the transfer of accounts.

The second is the development of a ‘Business Bank’. At present, the remit of the bank is to deliver the existing programmes of the Department for Business, Innovation and Skills (BIS). But this could be widened and the ability of the bank to The Business Bank’s lower cost of capital and a wider remit to consider social returns would allow it to make loans that would typically be avoided by commercial banks. In particular, it would be able to take
a wider economic view of the benefits of investing in certain sectors, including cases where there are potential long-term social returns from developing new technologies. This would mean a particular focus on lending for innovation investments to new and growing firms, which experience the most acute financial market failures and where the externalities will be greatest.

The Business Bank does carry risks. To be effective, its governance has to be removed from immediate political pressures and it needs to operate on the basis of clearly defined economic objectives. The Report recommends that it is run by an appointed independent board to over- see operational decisions independently from BIS. The proposal for a Business Bank also has to be a long-term commitment supported by cross-party consensus to avoid the perennial process of abolition, reinvention and rebranding that has characterised much government policy in the past.

Other recommendations include measures to discourage ‘short-termist’ investment strategies and modifications to the tax regime on lines suggested in the Mirrlees Review.
Ignoring taxation, equity finance is more suitable for young firms because of the uncertainty of cash flows. However, the corporate tax regimes encourages the use of debt by allowing interest payments to be tax-deductible. Mirrlees proposes an ‘allowance for corporate equity’ (ACE) which would level the playing field between debt and equity. By lowering the cost of capital. Mirrlees estimates an ACE could boost investment by around 6.1 per cent and boost GDP by around 1.4 per cent.

How to get to where we want to go
Professor Tim Besley, one of the two co-chairs of the LSE Growth Commission, comments:

‘Despite the current gloom, the UK has many important assets that can be harnessed to create growth, including competitive product markets, flexible labour markets, openness to foreign investors and migrants, independent regulators and a world-class university system.

‘But making the best of them and building institutional structures to support vital investments requires a bold and decisive strategy with an approach driven from the heart of government.’

Professor John Van Reenen, the other co-chair, adds:

‘Economic problems that have built up over many decades will not be resolved in the space of a few years. So it is vital to develop policies that look beyond the next budget cycle, the next spending review and the next parliament. 

‘This is a manifesto for growth. We challenge the main political parties to form a consensus for long-run investment to achieve prosperity for our nation.’

Notes:

1. The full report, documents submitted in evidence and more details of the Commission’s work can be obtained from its website: http://lse.ac.uk/researchAndExpertise/units/
growthCommission/home.aspx