Raising productivity is a key Treasury objective. Productivity is defined as output per worker hour. Skills is one contributory factor to increasing it.
Understanding how the Treasury thinks about productivity and how it thinks skills contributes to raising output per worker hour is critical for stakeholders in the post-16 sector to grasp if they are to win extra resources.
In January, Campaign for Learning published a blog to make a start in explaining the Treasury view of the contribution of skills to productivity. The further insights here will assist the post-16 sector as it makes the case for skills in the run up to the general election.
A recap
Economics is known as the dismal science with productivity being one of the most esoteric aspects to the generalist.
There are three contributors to total productivity.
The first is capital deepening and refers to both more investment in physical assets and greater use of existing physical assets. Importantly, this can be measured by economists.
The second is labour composition and refers to the skills of the workforce. This too can be measured.
And third is total factor productivity and relates to what productivity is left after the first two are measured. It is attributed to the quality of management and use of new technology and is not directly measurable.
As part of the November 2023 Autumn Statement, the Treasury published data showing the productivity gap between the UK and the US, France and Germany. It is primarily explained in terms of lower capital deepening and total factor productivity (see Box 1). It shows the labour composition in the UK was higher than its competitors and so the gap was not due to the skills of the workforce.
Box 1
Chart 4.1: Decomposition of the UK’s output per hour worked gap with selected economies, 2019 cited in Autumn Statement, HMT, November 2023
In the same Autumn Statement, the Treasury also cited research commissioned by the Department for Education that shows productivity has fallen between 2001 and 2019, but the contribution of skills (labour composition) has been positive and constant (see Box 2). Indeed, during 2014 and 2019, the only source of productivity growth was labour productivity.
This explains why, in the short-term at least, the Treasury views the main challenge to productivity is increasing capital investment and spreading innovation, rather than skills development.
Box 2
Skills and UK Productivity, Department for Education, 2023
Further insights into Treasury thinking
In this context, there are two additional aspects of Treasury thinking on skills which are important for the post-16 sector to appreciate. The first is that the Treasury has what we might call a traditional analysis of productivity. The second is that it uses earnings of workers of the highest qualification level held as a proxy for the contribution of skills to productivity.
A traditional approach to productivity
We should remember that economists find that labour productivity cannot be fully explained by capital deepening and labour composition. The residual is total factor productivity growth, although this is a balancing item rather than a measurable variable.
The Office of National Statistics undertakes a more granular analysis of labour productivity by using a ‘multi-factor’ productivity approach. Estimates are made of how skills and capital together raise productivity and in so doing adds to the potential contribution skills can make.
So far, however, the Treasury appears to be following the traditional approach to productivity decomposition.
An earnings/highest qualification level approach
There are three aspects that make up the way the Treasury measures the contribution of skills to productivity.
First, qualifications are used as a proxy for skills of the workforce. Second, analysis focuses on the highest qualification held by each worker. And third, earnings are used as a measure of the value of achieving the highest qualification held.
Qualifications are used as a proxy for skills. The measurement of the contribution of qualifications to labour composition and productivity is in terms of the highest qualification held. Analysis focuses on holding a Level 2, Level 3 and so on, and whether at each level the qualification is academic or vocational.
Earnings reflect that an employer has recruited a worker with a given skillset – measured in terms of highest qualification for productivity purposes – and what an employer has decided to pay them.
Earnings reflect the ‘realised preferences’ of employers. Employer-stated preferences may be different. What employers do rather than what they say is important, both in qualifications and in pay.
Economists model earnings and productivity on the basis that employers will continue to add workers until the output of the last one they take on is barely profitable – earnings being equivalent to the 'marginal productivity'.
This is a simplification, but a useful way of thinking about the problem.
Economists measure the rate of return to education using what is known as the ‘Mincer equation’. In its classic form, earnings are the result of the number of years in full-time education and the number of potential years of experience - usually the length of time between leaving full-time education and retirement age. In this form, one can compare the return to an additional year of education across countries.
The measurement of skills to productivity takes the form of the earnings of workers linked to the highest qualification level held, and academic and vocational qualifications held at the highest level.
Average rates of financial return are the difference between no qualification and the highest qualification held. Marginal financial rates of return are the difference in earnings between one qualification level – say Level 3 – and the next – say Level 4 - although often it is Level 6 that is used.
Treasury support for qualifications with the highest earnings
Given these approaches to skills and productivity, we should not be surprised about the qualifications that the Treasury likes best: highest qualifications which deliver the highest earnings return. From a productivity angle, this means first degrees at Level 6 and post-graduate degrees at Level 7-8 (see Box 3) particularly given the data for 2014-2019 (see above).
Box 3
Department for Education, February 2023 (https://www.gov.uk/government/publications/skills-and-uk-productivity).
Underestimating the contribution of skills
Yet, there are many reasons why the Treasury might be underestimating the contribution of skills to UK productivity. And these reasons are important to appreciate when negotiating a better deal for skills.
Multi-factor productivity
Skills maybe making a far greater contribution to productivity through the interaction between capital deepening and labour composition. It is how capital and skills interact together which raises productivity. At the same time, increasing capital deepening – such as a rise in investment – and total factor productivity – such as quality of management – drives up demand for skills.
Reskilling and highest qualification held
The concept of highest qualification held limits the contributions of skills to productivity to upskilling, namely the achievement of a Level 2, Level 3 and so on. It does not capture the contribution of reskilling, where a worker with a Level 6 reskills at Level 4 or Level 3 or Level 2, such as a qualification in supervision or first-line management. Nor does the approach capture the contribution to productivity where a worker reskills by gaining a vocational Level 3 but holds an academic Level 6.
Problems with earnings for highest qualification held as a measure
The use of earnings as a measure of financial rates of return to the highest qualification held is also less than perfect.
Use of no qualifications as a baseline is problematic because the number of workers with no qualification in the UK workforce is now very small and they are predominantly highly experienced (older). Another problem is that the national minimum wage legislation is pushing up the earnings of workers with no or low qualifications. As a consequence, rates of return to mid-level and higher qualifications have dropped, relative to the no qualifications base.
In most cases, what people need to consider is the earnings path they would get over their career if they did the qualification, compared with what they would get if they did not start on the qualification. Economists call this the ‘counterfactual’. There are few people coming into the FE system with no qualifications at all, so a no qualification baseline is likely to be problematic.
Decent earnings returns at below Level 6
We know the Treasury likes Level 6-8 qualifications because of the higher lifetime earnings they generate. Even so, there are positive returns to many qualifications at below Level 6 (see Box 4 and Box 5). The post-16 further education sector must continue to point out that significant financial returns flow from workers achieving qualifications at vocational and academic qualifications at below Level 6 (see Box 4 and Box 5).
Box 4
Social Mobility Commission, February 2023 (https://www.gov.uk/government/publications/labour-market-value-of-higher-and-further-education-qualifications-a-summary-report).
Box 5
Social Mobility Commission, February 2023 (https://www.gov.uk/government/publications/labour-market-value-of-higher-and-further-education-qualifications-a-summary-report).
Granular earnings returns from the FE Outcomes Dashboard
Stakeholders in the post-16 sector should also raise awareness within the Treasury of the fast developing granular data contained in the FE Outcomes Dashboard published by the Unit for Future Skills (see Box 6). This shows the earnings trajectory for those in work, and the proportion of people in employment or learning after completing qualifications – academic and vocational – from Level 2 to Level 6.
Box 6
Paul Bivand is a Labour Market Analyst