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Background Analysis to the Framework for Economic Development in Scotland

3. Policy to Promote Economic Development

3.1 The Sources of Economic Growth

The primary challenge in the Scottish economy is to establish an accelerated and sustainable rate of economic growth. Growth is, in part, determined by the levels of investment and the availability of people engaged in productive work.

More importantly, however, increases in the long-term economic growth rate will be secured through sustained increases in our competitiveness in international and domestic markets. This competitive edge will itself fundamentally depend on raising the underlying productivity of enterprises. This, in turn, will hinge on enhancing the quality of capital investment and the quality of the workforce. It will also rest heavily on the rate of technical progress: namely, the rate at which new and existing knowledge are captured in the production process.

Enterprise productivity rests on a range of critical determinants, some integral to the enterprise itself and others within the broader economic environment in which the enterprises are operating. The Framework for Economic Development targets these key determinants of productivity, notably:

• The generation through R&D of knowledge that can drive productivity;
• The rate of innovation and technical advances in productive processes;
• Capital investment, especially where it provides a vehicle for technical progress;
• Investment that enhances the equality of human capital - the education and skills;
• The quantity and quality of the physical and electronic capital infrastructure;
• The effectiveness and efficiency of resource use in production and distribution;
• The environment in which enterprises are seeking to flourish.

There are, therefore, many channels through which increased productivity can be achieved. The level of investment in R&D activity within both the educational and enterprise communities can result in the acceleration of the rate of innovation. Continued investment in physical capital can provide a vehicle for the more rapid introduction of more productive methods. The quality of human capital can be continuously enhanced through lifelong learning and improvements in the quality of the basic education infrastructure, leading to higher skill levels in the aggregate labour force; this in turn can stimulate product development with the introduction of increased expertise within production and management processes. Finally, the overall physical and electronic infrastructure will have an impact on the overall unit cost of production, via transport links and access to markets, and therefore the overall value added that can be achieved.

The critical point in the context of the devolved Scottish government's Framework is that this analysis of the key drivers of economic growth implies an important role for government in influencing the rate of technological progress and productivity and, thereby, economic growth.

The remainder of this document spells out the strategic approach to this challenge that the Executive has adopted in order to play its part in driving growth in collaboration with the private sector.

3.2 The Scale of the Challenge

The scale of the challenge is evident from the present size of the productivity gap between Scotland and many of the advanced economies of the world. While there are various definitions of productivity and there are familiar difficulties in measurement, the data all tell a similar story: namely, that the UK lags behind its major competitors and Scotland lags behind the UK.

The table below demonstrates the magnitude of the challenge on the basis of one critical measure, GDP per hour worked. The gap in Scottish productivity is long-standing and it is clear that it has widened over the period of 1999-2002.

Table 3.1 GDP per hour⁴worked, 1996-2002 (UK = 100)

Source: ONS.

3.3 The Role of the Private Sector

Private-sector enterprise will be the primary driver of economic growth. While the public sector has an important facilitating role, it is private-sector entrepreneurs and managers themselves who are generally better equipped in determining where productive investment might best be undertaken and how productivity can be driven up in order to establish dynamic and competitive enterprises. Entrepreneurs are critical for the economic development of Scotland as they generate prosperity by developing new products, new methods of production or new vehicles that give access to new markets.

Sustained investment in capital, both human and physical, and technology creates an environment which leads to a long-term improvement in the overall economic performance. The level of investment in R&D activity within the enterprise community is crucial. Ultimately, this can lead to a greater rate of innovation and technical advances, as it is recognised that sustained investment in the innovation process accounts for strong growth performance. The continued improvement and investment in skills is an important factor in achieving a higher quality of human capital. This should lead to increasing knowledge and expertise in the production and management processes which stimulate innovation and product development.

3.4 The Role of Public Policy

The private sector and economic markets are generally better able to make efficient decisions about the conduct of economic activity than the public sector. However, where markets do not operate effectively, there is, in principle, a role for the public sector to improve the outcomes of the market system.

Public policy can raise efficiency if it remedies market failures that otherwise would lead to the private provision of goods and services being set at an inefficient level. A significant share of Executive expenditure, however, is not primarily concerned with raising efficiency but with providing equal access to services like education and health. This type of expenditure, while not immediately aimed at raising efficiency, contributes in very important ways - albeit less directly - to raising Scotland's growth potential by maintaining a well-educated and healthy workforce.

In addition, the public sector can facilitate the development of institutional networks that are not always generated spontaneously within the private sector. These networks can promote the flow of information, knowledge and collaboration that contributes to the lowering of the costs of doing business and opens up opportunities for further advances in productivity.

At the micro-economic level, the Executive will, in principle, wish to become involved in economic development for one of two reasons:

• the promotion of economic equity, or
• the objective of improving economic efficiency.

Efficiency-led policies could be said to have the objective of increasing overall output in an economy, and these can take the form of:

• productive efficiency - in which the output of the economy is being produced at the lowest cost.
• allocative efficiency - in which resources are being allocated to the production of the goods and services the society most values.

Equity-led policies focus on distributing or shifting output within an economy. These interventions will not be first and foremost directed at increasing overall national output, but at changing the distribution of this output. But even in equity-led policies efficiency objectives have to be pursued. There are many ways in which government intervention can improve economic fairness but they are not equally efficient - output has to be distributed in such a manner that consumers would not wish to achieve the same level of redistribution in a different way.

The degree of selectivity to adopt in determining policy to promote economic activity is one of the central issues for public policy. The support of the Executive will focus on:

• the national environment: with a focus on the macro-economy, the national infrastructure, the national educational system and the like - that is, non-selective with respect to specific enterprises or sectors of the economy;
• the enterprises themselves: with a focus that is more selective of specific enterprises, whether self-selected (subject to pre-determined eligibility criteria) or selected by government;
• the sectoral level: with a focus on particular sectors or clusters of enterprises, however defined. Assistance here might, for example, entail either support for enterprises within the sector or infrastructural support focussed on a geographical grouping or concentration of enterprises.

The Framework recognises that all three of these foci have a place in promoting economic development, although the principal role of the public sector is in the promotion of a broad economic environment in which private sector entrepreneurs are stimulated and empowered to compete effectively in both existing and new markets.

Where the public sector takes on the role of direct provider - as in the health, education, criminal justice system, etc. - the key question is how government can ensure and maintain technical and allocative efficiency. Creating value for money has to be at the forefront of the Executive's approach when implementing policies to achieve its commitments and targets.

3.5 Choices and Trade-Offs

With finite resources available, any public or private organisation faces difficult choices between competing demands. First, different policy decisions may have far reaching effects that impact on the progress towards many other objectives. Second, success in achieving a given target may have implications for the meeting of other objectives.

When considering the overall outcome objectives of this Framework, there will always be the prospect of some mutual benefit or trade-off between the objective of growth and efficiency, and other goals regarding distribution and equity.

The challenge that must be explicitly addressed in the conduct of public policy within this Framework is to minimise or mitigate the ill-effects of otherwise benign techniques and approaches upon other objectives, or to seek alternative approaches that are less costly in their side-effects. In order for this to be achieved, the decision-making process should consider that:

• policy decisions should be driven by an explicit understanding of the priorities and pre-requisites that are needed for an objective to be successfully met and achieved;
• policy makers need a sophisticated understanding of the broader impacts that their decisions have - positive and negative - beyond the effect on the immediate prime objective;
• where policies reinforce the progress towards more than one objective then this should be outlined in order to be effectively evaluated against all final outcomes;
• where a policy appears to have negative or conflicting side effects upon other objectives, there needs to be a rigorous analysis of how these might be avoided, whether other mitigating measures are required, or whether this is a cost that is acceptable, in order to meet the priority commitment;
• cost-effectiveness and value for money of all spending plans must be monitored.

The Framework therefore proposes that there should be a more explicit consideration of:

• a wide range of alternative options that could help deliver a given particular objective;
• a clear impact analysis of the options on the Executive's primary goals.

These steps, in conjunction with the explicit consideration of the rationale and objectives of the intervention, would inform and enhance the decision-making process with regard to the most effective means of pursuing any specific goal and, moreover, the decisions on how to allocate the constrained resources between different objectives. Chapter 5 explains in more detail the Executive's approach to appraising options and ensuring efficiency in public spending.

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