Understanding the drivers of productivity: Capital

This blog is the second in our new series on the drivers of productivity. The drivers of productivity include skills, capital, innovation, enterprise and competition, and land. This blog focuses on capital, and complements the blogs on GVA and productivity published in summer 2024. 

This series adds to our Understanding core concepts in local economic growth series, and is aimed primarily at those working in local and central government. The series provides deep-dives into various components of economic growth, and some key concepts to consider when thinking about local economic growth. 

What is capital? 

Capital refers to durable inputs used in the production of goods and services. ‘Durability’ distinguishes capital from intermediate inputs that are used up in production (such as steel, timber, cotton or sugar). Capital can be tangible or intangible:  

• Tangible capital – Physical assets such as machinery, buildings, and broadband cables. 

• Intangible capital – Non-physical assets such as software, intellectual property, and branding. 

Capital can be private or public.  

• Private capital – Assets owned by individuals or businesses, used to produce goods and services. Examples include machinery and warehouses. Private capital is excludable (i.e. it can only be used by, or with the permission of, its owners) and rival (i.e. it cannot be used by more than one person or business at the same time without reducing availability to others).  

• Public capital – Assets provided and maintained by the government for societal benefit. Examples include roads, hospitals and schools. In contrast to private capital, public capital is non-excludable (i.e. everyone can use it) and non-rival (i.e. it can be used by multiple individuals or businesses at once without reducing availability).  

Capital is usually measured as a stock at a specific point in time (for example, the value of machines in a factory or of infrastructure within a city). 

Capital stocks can be increased or improved through investment. Investment can be financed in different ways, including from retained income or profits, borrowing from banks or other financial institutions, issuing equity or through grants or loans from the public sector. Investment can refer to investment in both private and public assets.  

Why do we need to think about capital?  

Capital is an important driver of productivity. Productivity measures how efficiently inputs (resources, or factors of production) are converted into outputs (goods and services). If businesses want to improve productivity, they might invest in new machinery to speed up production, or new software to tackle more complex and higher value tasks. The amount of machinery or technology available to each worker and the efficiency of machinery or technology can increase output per worker or reduce costs, increasing productivity.  

Increasing productivity through investment in capital might have a substitution effect on other inputs. For example, new machinery might replace (substitute) jobs in the short-term, increasing unemployment. This was the case of businesses investing in personal computers in the 1980s and 1990s, reducing the need for staff in a typing pool. In other cases, investment in capital may have a complementary effect on other inputs. For example, offices that invested in computers in the 1980s and 1990s needed IT teams to resolve  issues.  

Public capital investment can also have powerful and lasting effects on productivity. For example, investment in roads, rail, ports, energy grids, and broadband reduces costs and time for businesses, boosts efficiency, access to markets, and connectivity.  

How can we improve capital? 

Businesses are more likely to invest in capital when the economy is stable, funding is available, and borrowing costs are low. They invest when they see low risk and expect that the benefits will outweigh the costs. When individual businesses will not invest (for example, due to high costs or low returns) or will not invest enough (for example, when collective returns outweigh individual ones), central government can support investment, with policy options including loans or grants (for example, through British Business Bank) or providing public investment that complements private investment and increases returns. 

Local government also have a variety of policy levers that can help increase investment in capital:  

• Evidence-based economic strategies – Longer-term strategies can provide certainty to businesses, align public investment with local economic priorities (such as green growth, housing, transport, digital infrastructure), and identify ways to encourage private investment. 

• Planning and permitting processes – Streamlining processes can make it easier, faster, and less risky for businesses to invest. 

• Business advice programmes – Support for businesses to improve business plans, or to scale up, can help increase the returns to investment.  

• Financial readiness programmes – Support for businesses to prepare plans for borrowing for banks can increase the probability of businesses receiving the funding they need to invest. 

• Access to finance programmes – Grants and loans increase the funding available and can reduce the cost of the investment. Given local authorities have limited resources, the emphasis may need to be on promoting uptake of national schemes rather than developing local schemes. 

• Public investment in infrastructure – Businesses are more likely to invest when the public sector has laid the foundation (for example, roads, utilities, tech parks). 

What to consider when thinking about capital? 

• Both the quality and quantity of investment matters – Poorly targeted or inefficient investment in capital can lead to low returns and wasted funds. Some businesses struggle to access finance because it’s a high-risk proposition or their business plan isn’t strong. If a project is driven by speculation rather than real value creation, it can divert investment (and other resources such as labour) away from more productive uses. 

• Be realistic about the impact of investment by individual businesses on the wider economy – Businesses in an area often compete for sales, and thus investment in capital by one business may have negative effects on another. This is a particular problem for non-tradeable businesses serving local markets.  

• Consider deadweight – Some businesses that access public grants or loans would have been able to invest even in the absence of government support. This is particularly true of larger businesses.  

• Not all debt finance is used for investment – Evidence from the British Business Bank suggests half the time businesses seek finance for working capital (the funds a business needs to be able to operate from day to day). Only one-quarter of businesses are seeking finance to purchase fixed capital or invest in business growth. 

• Investment payback periods vary across projects – For example, investment in a new production line can have high upfront costs and a long payback period, whereas upgrades may have shorter payback period. Some sectors – such as pharmaceutical R&D or film production – require large upfront investment that must take place in advance of revenue generation, while in many other sectors investment can be more incremental.  

• Public investment affects the returns on and costs of private investmen –. Public investment can crowd in private investment by reducing risk and creating enabling conditions (for example, public investment in ports or roads can reduce transport costs or open new markets for businesses, incentivising private investment). Public investment can also crowd out private investment, with increases in public sector spending competing with private sector spending in the same geographical area, to the detriment of the private sector (for example, subsidised housing projects, which offer rents below market rates, can affect private market rents, reducing developer returns, and discouraging them from investing in new housing units).  

• Additional costs to maintain capita –. Investment in public capital (such as roads) usually requires continued expenditure on maintenance to keep the capital working efficiently. Consider those costs and how they would be funded when thinking about public investment. 

• Distributional effects of investment – Capital investment may affect specific demographic groups, businesses or areas, but not others. Assessing who benefits and who does not can help mitigate negative effects. 

Where can I learn more about capital? 

• What Works Growth evidence briefing on assessing the impacts of improving access to debt finance on local economic growth, and our evidence review on access to finance.  

• Boosting productivity: why doesn’t the UK invest enough?, a blog from the Productivity Institute. 

• The Department for Business and Trade’s small businesses survey includes data on access to finance (and many other topics). 

• Boosting growth and productivity in the United Kingdom through investments in the sustainable economy, a policy report by Dimitri Zenghelis, Esin Serin, Nicholas Stern, Anna Valero, John Van Reenen and Bob Ward.  

The next blog in our drivers of productivity series will be on innovation. Sign up to our newsletter to get an update on our next blogs, briefings and events.