Vivid Thoughts: Revamping Government Appraisals for Levelling Up Part 3
Smart incentives for productivity enhancing investments
In the budget, the Chancellor announced a series of spending commitments on infrastructure, including road, rail, broadband and housing. It contained few hints about the Government’s plans for freeports, which are currently under consultation, with business rates, enhanced capital allowances, R&D credits, stamp duty and national insurance all levers being reviewed. In this final instalment, I consider how an improved set of guidelines can be used to design freeport incentives which support new, productive investment in disadvantaged areas in line with the Levelling Up agenda.
Part 3: Smart incentives for productivity enhancing investments
The UK finds itself at a time of high employment, but sluggish growth in productivity and sharp regional imbalances. Underlying this has been years of lacklustre business investment in human and physical capital. To combat this trend, the UK has just begun formal consultation on its plans to establish 10 freeports. Freeports, also known as free zones, are a type of special economic zone designated outside the domestic customs territory. This allows companies to import goods without paying VAT or duties, store them and use them in manufacturing processes, and either reexport them, or bring them into the domestic economy (at which point duties become due).
This ‘basic‘ model has been enhanced by Governments around the world, with many freezones also offering exemptions from corporate income tax or enhanced allowances on certain expenditure, access to concessional finance, as well as fast-tracked permissions and subsidised infrastructure. In the UK, business rates, stamp duty, enhanced capital allowances, national insurance and R&D tax credits are all being considered.
Our experience has shown that such incentives are common but are rarely well thought through, both in their design and in the way they are offered. Governments often lean towards tax exemptions, such as the enhanced capital allowances provided in the UK’s Enterprise Zones. Yet these offer the biggest subsidies to those businesses making the most profits, increasing the risks of deadweight (handouts to investment which would have gone ahead in any event), rather than encouraging truly additional investment by boosting the returns to marginal or more risky investments. One reason is that government accounting and public opinion make it far easier to forgo future revenues than hand over cash today,
Internationally, we’ve seen incentives come in the form of subsidised rent for factory space, such as Lesotho’s industrial parks. The value of these incentives increased with the size of the factory, and was relatively more important for companies with low value-addition per square-meter of floorspace. This promoted space-hungry, low value production, such as cut-make-trim apparel manufacturing. They do little to incentivise capital investment or more productive jobs, meaning investors did not make long term investments and Lesotho was not shifting up the value chain. These lessons are important when considering reduced business rates in the UK.
Smart incentives can encourage productivity enhancing investment, in capital, research and development, and training costs for highly skilled workers. Incentives that are offered proportionally to regionally weighted economic benefits can tackle imbalances between the Southeast and North.
Although the Green Book sorely needs updating to better reflect the objectives of society, as I discussed in my previous post, we nonetheless believe that it presents the right framework for appraising potential inward investments, and designing and handing out incentives which increase their impacts. These need to be enhanced with the use of dynamic models are required to understand the long-term benefits to productivity of investments. We’ve supported zone regulators, using our investment appraisal model (IIM), to assess which investors are likely to have the biggest social impacts.
Incentives should be weighed against the ability of businesses to deliver societal benefits and contribute to economic objectives. Critically, the additionality of offering incentives needs to be considered: will providing a tax exemption be the difference between the investment proceeding in the UK or not? And if so, are we incentivising the right sort of behaviour? Additionality can be tested by looking at the impact of incentives on business models. The most profitable business models are likely to go ahead with or without a tax break. For some internationally mobile investment, incentives may still be important for closing any gap with even more profitable investment locations. For more marginal investments, incentives can make the difference and push the rate of return above minimum thresholds.
The Chancellor has a perfect opportunity to revisit the rules for appraising public expenditure ahead of the establishment of freeports. Improving, rather than replacing the S-CBA framework at the heart of the Green Book is the right approach. If he succeeds, other countries should follow his lead.
All views are those of the author and do not necessarily represent the views of Vivid Economics.