Insights on productivity growth and fiscal policy from the Welsh Government Tax Conference 2025

Fergus Jimenez-England, an Associate Economist at the National Institute of Economic and Social Research (NIESR), summarises his insights on productivity and fiscal policy from his presentation on behalf of NIESR and The Productivity Institute at the Welsh Government Tax Conference 2025.

What are the challenges facing the UK’s fiscal position?

Fiscal sustainability refers to a government’s ability to finance its debt position in the long run. The burden of debt interest repayment is large by historical standards. In the 2024-25 fiscal year, the UK paid £105.5 billion in debt interest payments, roughly equal to 3.6 per cent of GDP. Debt interest is forecast to maintain the same size relative to GDP over the horizon of the Office for Budget Responsibility (OBR)’s March forecast.

However, if inflation is higher or growth is lower than expected – it is very possible that both could occur – then the size of debt interest could increase as financial markets price in higher interest rates and/or seek a higher risk premium. This would reduce the amount of funding available for public services.

An ageing population, climate change, and defence spending will also add pressure to the UK’s fiscal position in the foreseeable future. This means that demand for public services looks likely to rise in the future while the relative size of the tax base shrinks. Increasing the real value of tax receipts per head should be a policy priority if we are to sustain real terms funding for public services. This means that productivity-enhancing policy must be a priority.

What is productivity and why is it important?

Productivity measures how much economic value one can produce for a given set of inputs. A common measure of productivity is labour productivity, typically defined as gross value added per hour worked. Higher productivity is important because it increases the supply of real goods available and is therefore reliably associated with higher living standards.

Productivity growth is important for the government on two fronts. First, real wage growth expands the tax base in real terms, thereby increasing real tax revenues for a given tax rate. This means that productivity growth can help to increase fiscal capacity without changing tax policy or increasing borrowing. Second, if productivity growth also raises the rate at which the public sector turns inputs into outputs, then it can also raise the efficiency of public spending. In short, with productivity growth the government can finance more borrowing while also needing to borrow less.

How can fiscal policy boost productivity?

In their Productivity Agenda, TPI identifies three problems that must be addressed to boost productivity: chronic underinvestment, inadequate diffusion of productivity-enhancing practices between firms and places, and a lack of joined-up policymaking.

1. Tackling underinvestment

The UK economy suffers from chronic underinvestment in both the public and private sectors. Therefore, public investment should aim to crowd-in private investment wherever possible. Public investment can boost productivity growth by providing the private sector with the tools (e.g., infrastructure) it needs to run more productively, but also by bolstering confidence among private investors.

In a forthcoming TPI paper, research by NIESR finds that higher public investment financed by income taxes has a net positive effect on economic growth and welfare given the low starting point of public investment as a share of GDP.

Productivity-enhancing fiscal policy must also make efficient use of the investment intentions of the private sector. This goes beyond crowding-in via public investment and involves setting out appropriate tax incentives, nurturing animal spirits, and being fiscally credible.

2. Diffusion of best practices

Research suggests that public R&D spending complements private sector R&D and helps to spread out investment into the peripheral regions of the UK. In particular, public R&D helps smaller and less productive firms.

Ring-fencing R&D funding for smaller and less productive firms operating in low-tech industries and peripheral regions could boost productivity across the UK. This would help regions such as Wales, for example, which has low public and private spending compared to the UK and has relatively more SMEs. In short, public R&D spending could help firms in peripheral regions to adopt and develop best practice technology.

3. Joined-up policymaking

Well-balanced governance and inter-departmental collaboration are vital to implementing productivity-enhancing fiscal policy. TPI recognises a lack of a regional government structure across England and across the devolved structures in Northern Ireland, Scotland and Wales. This hinders the implementation of place-based investment strategies. Additionally, inter-departmental collaboration is essential if policymakers are to leverage complementarities between pro-productivity policies.

The UK Government Spending Review from a productivity perspective

When it comes to productivity growth, we need to look at capital spending allocations.

A majority of the UK capital spending budget has been allocated to defence, of which 7.4 per cent has been allocated for R&D spending. For reference, the R&D intensity of capital spending for the Department for Business and Trade and the Department for Science, Innovation, and Technology is 25 per cent and 93 per cent, respectively. The R&D intensity of the Department for Health and Social Care is almost twice as high as defence. While the R&D intensity of defence is higher than the average government department, it is not a high-flyer. This undermines its potential to boost productivity growth, potentially making a case for funding this permanent increase in defence investment via taxes rather than borrowing.

The reallocation of capital spending away from HS2 toward other transport projects is likely to boost productivity. These investments are likely to crowd in private sector activity and help reduce regional disparities in transport connectivity, thereby improving resource allocation in recipient areas.

Despite being positioned to receive the largest increase in real terms day-to-day spending over the Spending Review period, the Department for Health and Social Care has been allocated relatively little capital spending. The large share of government spending occupied by the health sector means that productivity gains could go a long way towards sustainably easing fiscal pressures. The unimpressive capital budget for health suggests that it will be difficult to improve NHS productivity over the parliament.

Implications for Wales

As highlighted by recent work from the Wales Productivity Forum, Wales remains the least productive region in the UK. Although Wales has been catching up to the UK average over the past decade or so, it is converging more slowly than the other devolved nations of Scotland and Northern Ireland, suggesting that there is scope for faster progress. Within Wales, productivity performance varies considerably. However, no Welsh region is steaming ahead of the UK average; rather, Welsh regions are either catching up or falling behind.

To make matters worse, Wales is set to receive a real term cut to its capital budget over both the Spending Review period and the parliament. In addition, the Welsh Government’s borrowing limit was not uplifted in the Spending Review, further constraining public investment.

The unimpressive outlook for public investment in Wales highlights the importance of prioritising a productivity-focused policy agenda that crowds-in private investment.

“We are grateful to Fergus for presenting this analysis in Wales. It highlights the importance of addressing Wales’ productivity challenge for the future sustainability of public service delivery, especially in the face of societal challenges such as population ageing”.

– Professor Melanie Jones, Academic Lead for the Wales Productivity Forum.

“What stood out to me in the conference was how closely discussions on productivity and fiscal policy relate to the well-being of future generations in Wales. Both are key to achieving longer-term social and environmental outcomes.”

– Dr Fari Aftab, Research Associate for the Wales Productivity Forum.