Can policy boost productivity in the UK’s services-based economy?

The UK has long struggled with slow productivity growth. One key reason is comparatively low levels of investment – not least in the intangibles of R&D, design, software and human capital that are so important to the performance of an economy dominated by the services sector.

As part of this year’s celebrations to mark 300 years since the birth of Adam Smith, it has often been asked what he might have to say about today’s economic challenges. How would he comment on a government that sought to rebalance the economy away from services and towards making things once again? Would the father of economics, who is widely understood as arguing that the invisible hand of market forces leads to the most efficient outcomes, support government intervention to reshape the economy?

The Industrial Revolution of the late 17th and 18th centuries transformed Britain into the world’s first industrial nation, captured in Smith’s seminal work, The Wealth of Nations. By the 20th century, deindustrialisation meant that the UK economy had shifted away from industry and towards services. Today, major economies are predominantly services-based – the sector accounts for around four-fifths of UK national output.

On the tercentenary of Smith’s birth, the UK economy is struggling with slow productivity growth. And it is not alone, with many countries confronting the same challenge. So, it seems a good time to revisit this question about the role of government in shaping the economy to try to raise productivity and standards of living.

When countries industrialise, they move out of agriculture and into manufacturing, which has higher productivity or output per worker and thus generates higher wages. Industrialisation is how countries throughout history became middle class and prospered.

Deindustrialisation then follows. In advanced economies, manufacturing starts to become less important as a share of output once they become richer. Services in the business, retail and finance sectors begin to dominate the economy, and employment shifts from factories to offices or stores. This is in relative terms, since in absolute terms the UK remains one of the top ten manufacturing nations in the world – with sales worth £400 billion in 2021.

Figure 1: UK GDP composition by sector, 1901-2011

Source: Herrendorf et al, 2014

Still, manufacturing has declined from contributing a quarter of national output in the UK in 1980 to a fifth in the 1990s and under an eighth in the 2000s. The 2000s saw a financial crisis that dented productivity growth. But the slowdown in productivity goes back several decades.

This raises the question of whether services-based economies can grow well. It is not just a question for advanced economies but also for developing countries, some of which are experiencing premature deindustrialisation. This is when the economy moves from agriculture to services without becoming industrialised first.

The crucial question is whether state intervention can be effective. One area where the UK lags other major economies is investment. When research and development (R&D) and other intangible investments were included, estimates of US GDP increased by 3%. The OECD estimates that intangible investment, including in education (human capital) and software, is as important as investment in tangible machinery and equipment in the UK.

Figure 2: Productivity growth contributors, 1770-2067*

Source: Office for Budget Responsibility, 2018

There is a strong argument for the UK government to act to bolster investment in general, and specifically in services, particularly since a great deal of value-added in manufacturing is based on service inputs such as design and R&D.

By targeting investment, which should be feasible, government need not favour certain industries and instead could give businesses incentives to invest efficiently. This would be more aligned with Smith’s famous observation that: ‘It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.’

Figure 3: Nominal vs GDP share of research and development spending, by country

Source: OECD, 2022

It’s worth mentioning that Smith didn't favour the services sector as it was in his day. He believed that it was comprised of ‘buffoons, opera singers, and musicians’, whose output could not be traded. Consequently, it did not add to national output in the same way as manufacturing.

Smith was, of course, a product of his times. On the tercentenary of his birth, the services sector is now vastly different since a digital download of music is as tradable as a widget. If services can produce lasting value and public intervention can avoid distortions, Smith might be persuaded that governments should try to shape the economy to boost growth.

Where can I find out more?

The Productivity Institute: A UK-wide research organisation exploring what productivity means for business, workers and communities – how it is measured and how it contributes to increased living standards and wellbeing.
Programme on Innovation and Diffusion(POID): A project based at the Centre for Economic Performance (CEP) that conducts research on how to improve productivity through nurturing innovation – ideas that are new to the world – and then diffusing these ideas across the economy.
The UK's productivity gap: What research tells us and what we need to find out: ESRC report from 2004 written by Romesh Vaitilingam.