Fixing the UK’s investment problem: three areas to consider

For a chancellor in a fiscal hole, Rachel Reeves did something unusual in her first budget.

Rather than cutting capital spending she decided to increase it – relative to her predecessor’s plans, at least. At around 2.5% of national income, it is settling at a level higher than it has been in decades.

Why investment is a challenge

Decisions over when, where and how much to invest are inherently difficult. Returns are uncertain and often take years to materialise. The investment itself is often irreversible: once a road, data centre or water pipe is built, it’s difficult to back out.

But just as firms that do not invest are eventually overtaken, so too are countries. Leaders are aware of this. They know that investment decisions are central to economic growth and, over the medium term, national and corporate success.  

To break down the challenge, it’s worth distinguishing three ways in which the Chancellor can think about investment: direct investment, regulated investment, and other incentives on the private sector to invest.

Three ways to think about investment

1. Direct investment

We generally think of investment spending by the government as being good for growth. That can be true. Spending on transport infrastructure should be very growth friendly, if well directed. The same is true of R&D spending.

But the relationship between growth and other forms of government investment is less certain. We need to build new hospitals and schools, but their impact on growth is one step removed (a healthier population being more productive) or longer term (a future workforce with needed skills). 

In these cases, there isn’t always a sharp distinction between the effects of current spending (paying for teachers) and investment spending (building schools). In any case, investment alone does not guarantee growth.

If you look at the breakdown of the government’s capital spending by function, the biggest element is accounted for by defence – buying tanks, warships, drones and the like. Planned increases over this parliament also focus on defence, as well as energy and net zero. This spending may be justified, but it’s unlikely to be the most growth friendly way of allocating resources. 

Even so, the Office for Budget Responsibility estimates that “a sustained 1 per cent of GDP increase in public investment could plausibly increase the level of potential output by just under ½ a percent after five years and around 2½ per cent in the long run (50 years).”

Investment spending by the UK government has been low by international standards for decades, reaching a nadir in the 1990s. Had public sector investment equalled the OECD average for the past 20 years, we would have invested an additional £500 billion or so.

That implies a lot of lost infrastructure – and a lot of lost growth.  

2. Regulated investment

It is the private sector, though, which accounts for some 80% of total investment. And the UK’s performance here is at least as bad. 

One report, from the Resolution Foundation, suggests that “if UK business investment had matched the average of France, Germany and the US since 2008 – with 2 per cent of GDP additional investment each year – our GDP would be nearly 4 per cent higher today.”

Government influence over private sector investment is less direct than over its own, though in the regulated utilities – like water and energy – public regulators play a big role. The trade-offs involved, between consumer prices, public spending and incentives for private investment, are central to public policy decisions.

One area that will require particularly large capital investment is meeting the UK’s net zero targets. As the Climate Change Committee has set out, achieving net zero should ultimately reduce energy costs, but it will require major upfront investments, peaking at over £30 billion a year at the end of this decade.

At present, most policy costs are recovered through consumer bills rather than general taxation. For example, Contracts for Difference (to pay for renewable generation) and the Nuclear Regulated Asset Base levy flow via suppliers, while network upgrades are recovered through transmission and distribution charges. Because these line‑items are so visible on bills, the political pressure can be even sharper than for general taxation. Funding investment through bills can also misdirect incentives, and it can be regressive. 

Many organisations have called for a shift towards general taxation, but given the state of the public finances that looks unlikely for now. The practical focus should be on mitigating the worst impacts while keeping investment moving – for example, via well‑designed social tariffs and complementary reforms.

3. Other incentives for private sector investment

It is not just through the regulated utilities that the government has an impact on private investment. Other areas of policy have a bearing too.

Planning

Planning constraints are among the most significant drags on growth. They not only prevent building work that would be economically valuable, but they also increase costs, create delay and introduce uncertainty. 

And Britain has a particularly poor record here. Between 1990 and 2014, every country in the G7 saw substantial increases in the amount of land built on, with one exception – the UK. 

The OBR has concluded that this government’s (relatively modest) declared planning reforms could, by raising the amount of capital in the economy, increase national income by 0.2% per cent – that’s about £7 billion – by 2029-30. The scope for more investment-friendly, and hence growth friendly, reform is considerable.

Tax

For the rest of the economy, the design of the tax regime is important. The government can encourage R&D investment directly via the R&D tax credit. It can make the UK more attractive for some investment via the so called ‘patent box’, which reduces the rate of tax on profits earned from development of intellectual property.

More fundamental features of corporation tax also matter. Full expensing for some kinds of investment should act as an incentive, but many types of equity-financed investment are still discouraged, and investment in growth-friendly ‘intangibles’ like AI and software are often not recognised by the tax regime at all.

Uncertainty and instability in the tax system also discourage investment. And the UK has had plenty of both – under the current government and across the last two decades. Rumours that the government might change the taxation of banks, constant chatter about a wealth tax, and uncertainty about the taxation of investment and savings generally will all have harmed confidence.

Conclusion: the UK must turn its investment record around

No government can provide investors with complete certainty. Nor will all government policy and investment spending be focused on growth, even where that is a stated priority. There are always choices and trade-offs.

But over many decades, UK governments have undermined conditions for effective investment.

On the public side, investment levels have been low and volatile – though with some improvement in the most recent period. There has been little consistency of policy for the regulated utilities. Economic policy in general, and tax policy in particular, has been unpredictable. Planning and regulatory regimes have been allowed to grow in ways which add costs and uncertainty. There is a particular imperative for the UK to be investing in AI, R&D and new technology – but policy-induced headwinds make such investment riskier and more costly.

An effective industrial strategy must have investment at its heart. That means certainty about national infrastructure policy. It also means a supportive environment for private investment – investment in innovation as well as in more tangible assets. The fact that we have been a long way from effective support in this area for a long period of time is at least one reason for our two decades of minimal productivity growth.