Analysis - Productivity puzzle to tax UK election victor

By David Milliken LONDON (Reuters) - Less than two weeks away from a knife-edge election, Britain's biggest economic problem, stagnant productivity, has barely surfaced in the political debate. Whoever wins on May 7 will struggle to keep their promises unless Britain can find a way to follow up on the strongest job creation in a generation by getting people to produce more once they are in work, generating more profits and tax revenues. After an initially slow recovery from financial crisis, Britain last year had the fastest growth rate of any major advanced economy. This could slow sharply if firms do not make products and deliver services more efficiently. Prime Minister David Cameron, seeking to break ahead of the opposition Labour Party in the polls, touts his economic successes. But Britain's reliance on ever more people joining the workforce is unsustainable in the long run and will not automatically raise living standards. Productivity fell in other countries too after the crisis but has mostly recovered, while in Britain productivity in 2013 was almost a third lower than in the United States or Germany. Conservative finance minister George Osborne used his pre-election budget address to extol Britain's recovery in comparison to France's. But in terms of productivity, the French have easily outstripped their British counterparts, albeit at the cost of jobs. Higher revenues from higher productivity are crucial both for Cameron to deliver on his plans to bring down Britain's budget deficit and for Labour leader Ed Miliband, who has pledged to spend more on public services. The difficulties stem partly from Britain's reliance on oil and gas production, hampered by declining North Sea reserves, and financial services, more rule-bound since the crisis. But productivity growth also comes from new, innovative firms expanding fast - and here Britain faces a challenge too. Invertek Drives is a small, high-tech company based in rural Wales, which makes electric motors that power lifts, air-conditioning pumps and industrial machinery, 90 percent of which are exported. It has to look overseas for staff. Sales manager Nick Thorne says it is often easier to hire an engineer from China than Britain. "We get lots of CVs of the right calibre from people further afield, and not really in the UK," he said. Although Invertek is able to train assembly workers from the local area, its 20-strong research and development team includes staff from China, Russia, Spain and the Czech Republic. SKILLS SHORTFALL The Bank of England says productivity remains "puzzlingly weak" after falling 1.4 percent over the past three years, and that if things do not improve, the result could be slower growth or higher inflation. Skills shortages are now the biggest problem facing British industry, according to Terry Scuoler, head of the EEF manufacturers' association. The ease of hiring and firing workers in Britain brings big advantages in creating jobs, but compared with other parts of Europe it gives firms less incentive to invest in training and more efficient production methods. "We have a flexible labour market here, and that encourages us perhaps more to take on staff rather than invest in plant, equipment and technology," he said. While Invertek spends around 10 percent of its nearly 25 million pound ($37 million) turnover on research and development, overall British corporate R&D spending is just 1 percent of gross domestic product (GDP), half the rate in the United States and Germany. Scuoler said some British manufacturers were also too ready to sell their firms to foreign competitors, rather than build them up through productivity increases to the scale needed to compete on international markets. Late last year the government's official budget forecasters predicted that if productivity growth failed to return to its past average of nearer 2 percent, annual economic growth was likely to slide to less than 1 percent. Britain's public debt, fed by regular budget deficits, would then keep rising faster than national income, potentially forcing a future government to cut spending or raise taxes. London School of Economics professor John Van Reenen said Britain was also suffering from government inaction over infrastructure such as high-speed broadband, roads and airports. Partly this reflected Britain's complex planning laws. But it was also due to efforts to economise since 2010. "We have underinvested in many of the long-run investments that you need for improvements in the productivity level," said Van Reenen, who was a senior government policy advisor from 1999 to 2001. Polling company ComRes found more than two thirds of Conservative and Labour lawmakers viewed low productivity as 'very' or 'extremely' important, making it the economic issue with the greatest degree of cross-party consensus. But on the election trail, while Labour leader Ed Miliband gave one speech where he called low productivity "our biggest economic challenge", the two parties have mostly stuck to partisan themes of deficit reduction and inequality. "They are trying to keep messages simple," said Tom Mludzinski, ComRes's head of political polling. "It's not the most sexy of areas or one which gets much voter interest." (Editing by William Schomberg/Ruth Pitchford)