The Links Between Sectoral and Regional Investment and Sectoral, Regional, and Aggregate Productivity in the United Kingdom

As is well known, UK productivity growth has been extremely slow since the global financial crisis, both relative to the past and to similar advanced economies. But is this aggregate picture masking differences across sectors and regions? Are one or two specific sectors and/or regions driving the slowdown in productivity either because of their relative size or because of their importance in providing inputs into other sectors and regions or both? And to what extent will investment in human and physical capital in particular sectors lead to higher sectoral, regional and aggregate productivity growth? In this project, we aim to develop a disaggregated model of the United Kingdom including both sectors and regions within which we can examine how investment in human and physical capital within a particular sector and/or region can affect aggregate UK productivity and how aggregate productivity growth can be stimulated by policies aimed at specific sectors and/or regions.

Our starting point is the National Institute’s Sectoral Model (NiSEM) in order to examine these issues. The model is described in Lenoel and Young (2021), although we plan to use a different sectoral split within our updated version of this model in order to bring it line with our monthly GDP tracker. In particular, we consider the sectors Agriculture (A), Mining and quarrying (B), Manufacturing (C), Electricity, gas, steam and air conditioning (D), Water supply, sewerage, waste management and remediation activities (E), Construction (F), Distribution, hotels and restaurants (G and I), Transportation, storage and communications (H and J), Business services and finance (K, L, M and N) and Government and other services (O, P, Q, R and S). We assume that output in each sector is driven in the short run by the demand for that sector’s output, both from final consumers and from other producers to use as intermediates. In the long run, supply in each sector is determined by sector-specific production functions where intermediate inputs are assumed to be in fixed proportion to gross output and value-added is given by a sector-specific CES function of capital (physical and human) and labour in that sector. The parameters determining the shares of sectoral inputs in each sector’s gross output are calibrated based on the Supply and Use Tables whereas those governing value-added production are estimated.

We then move to the regional level by using data on the regional shares of different sectors as well as data on regional employment and capital (recently uploaded to the Productivity Lab) to link up sectoral output and productivity with regional output and productivity.

Once the model is in place, we can examine the effects of sectoral and/or regional supply shocks. The main interest here is the extent to which the slowdown in UK productivity growth can be explained by a slowdown in productivity growth in particular sectors or regions or rather whether the slowdown is common to all sectors and regions. Particular sectors can matter for aggregate productivity either because they are large relative to other sectors (eg, real estate activities or wholesale and retail trade) or because their outputs are used as input by many other industries, affecting their productivity (eg, manufacturing or financial services). By calibrating the model based on the microeconomic data (including the supply and use tables), we will make sure to capture these channels.

Within the model, we can also examine the effects of a fall in demand in particular sectors and/or regions, eg, lower foreign demand affecting manufacturing in the West Midlands or a Covid-type shock leading to lower demand in the ‘Distribution, hotels and restaurants’ sector in London, in particular, assessing the extent to which such shocks could lead to lower productivity throughout the economy.

Most important for the project, we will use the model to examine the effects of increases in investment in human and physical capital within individual sectors and regions on productivity in other sectors and regions and the United Kingdom as a whole. Armed with those results, we can then examine the effects of sector and/or region-specific taxes and investment/employment subsidies on productivity at the sectoral, regional, and aggregate level as a way of beginning to think about possible policy options.