## There are both conjunctural and structural reasons to focus on business investment in the UK

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### B. Level and Growth Contribution of Business Investment in the UK
- Pre-GFC, the UK was the third fastest-growing G7 economy after the United States and Canada.
- Capital accumulation nearly halved in 2008–2010 and never fully recovered to pre-GFC levels.
- In 2016, the share of labor contribution to the UK growth exceeded 50 percent, nearly triple that observed before the GFC.
- During 2017–22, the contribution of labor declined in both absolute and relative terms, failing to compensate for weaker contributions from capital and productivity.
- UK total investment, as a share of GDP, has been 4 percentage points below (on average) compared to other G7 economies since 1990.
- Business investment accounts for about 13 per cent of UK GDP.
- Non-residential investment has been below the average for G7 peers by an average of 36 percent since 1990.
- Real business investment in the UK in 2022 was slightly lower than in 2016, while other G7 economies experienced a 14 percent increase on average over this period.
- Public investment in the UK has historically been lower than in G7 peers.
- Public capital per capita (for 2017 in constant 2011 international dollar) shows the UK stands out among advanced economies with a low capital stock.
- Literature documents complementarity of public and private capital and catalyzing effects of public infrastructure on private investment, innovation, and human capital.

### C. Drivers of UK Business Investment: Two Econometric Analyses

Fixed-effect macro panel (G7, annual, 1980–2022; non-residential investment as proxy)
- Model: growth rate of non-residential investment regressed on lagged macro variables including non-financial corporation debt, short-term interest rate, market capitalization, public investment growth, credit to households, and lagged GDP growth up to three years; time dummy for UK during 2017–2022 (Brexit) and time dummy after 2019 (Covid); time and country fixed effects.
- Main macro regression findings (selected coefficients and interpretations):
  - Lagged Debt to NFC: coefficients −0.101*, −0.127*, −0.139**, −0.139. Interpretation: higher firm indebtedness is associated with lower business investment.
  - Lagged Market Capitalization: coefficients 0.0286**, 0.0286*, 0.0247*, 0.0247. Interpretation: higher market valuation/growth expectations associate with higher business investment.
  - Lagged Interest Rate: coefficients −0.540, −0.383, −0.683, −0.683 (not statistically significant in column discussion).
  - Lagged Public Investment Growth: coefficients 0.0961**, 0.0989**, 0.0989*. Interpretation: positive and significant crowding-in effect of public investment on private investment.
  - Brexit (UK and year>2016) dummy: −4.616** and −4.616***. Interpretation: Brexit-related uncertainty has a negative and statistically significant effect on business investment.
  - Covid (year>2019) dummy: coefficients reported (not significant in some specifications); 2020 year fixed effect had a negative significant coefficient.
- Model fit statistics (by column): Adjusted R-squared 0.516, 0.484, 0.508, 0.528; RMSE 3.473, 3.671, 3.586, 3.511.

Micro-econometric firm-level (annual firm panel ~5,000 listed companies, 1984–2022; System GMM)
- Model specification: firm capital expenditure on lagged capital stock and controls including sales growth relative to historical mean, return on assets, effective interest rate, retained earnings, long-term capital; Brexit dummy (post-2016) and Covid dummy (post-2019); firm, industry, and time fixed effects as specified.
- Main micro regression findings (selected coefficients and interpretations):
  - Lagged Investment to Capital: 0.285***, 0.289***, 0.288***. Interpretation: persistence in investment behavior.
  - Sales Growth: 0.231***, 0.259***, 0.259***. Interpretation: higher expected demand drives investment.
  - Lagged Return on Assets: 0.0821***, 0.0983***, 0.0980***. Interpretation: profitability supports investment.
  - Effective Interest Rate: −0.0403***, −0.0147, −0.0145. Interpretation: higher firm borrowing costs reduce investment.
  - Retained Earnings to Capital: 0.214***, 0.200***, 0.199***. Interpretation: internal funds facilitate investment.
  - Long-term Debt to Capital: 0.0791***, 0.0807***, 0.0806***. Interpretation: access to long-term financing supports investment.
  - Brexit Dummy: −0.184***, −0.181***. Covid Dummy: −0.431***, −0.431***. Interpretation: both Brexit and Covid are associated with substantial declines in firm-level investment.
  - High-investment sectors indicator: 0.102*** when included. Sectors identified as high-investment include advanced manufacturing, transportation, communications, health services, education, research and development.
- Sample: Observations 14,263; Number of firms 2,248.

### D. Main Results and Policy Implications
- Key empirical findings:
  - Brexit-related uncertainty appears to have been a key driver of low business investment after 2016; the pandemic added further drag.
  - There is a significant crowding-in effect of public investment on private investment (positive and significant coefficient on public investment growth).
  - UK firms with higher retained earnings or external long-term capital invested more; access to finance matters.
  - Certain sectors are more dynamic in terms of investment: advanced manufacturing, health, education, transport, communications, R&D.
  - High levels of firm indebtedness constrain investment; non-financial corporate debt is significantly below its pre-GFC peak.
- Policies the authorities have taken or announced:
  - Windsor Framework agreement with the EU and a more measured approach to reviewing retained EU laws to reduce Brexit-related uncertainty.
  - Recent budgets sought to protect near-term public investment spending, though public investment-to-GDP ratio is set to decline after 2025.
  - Options being considered to unlock the UK’s large pool of pension and insurance savings to finance high-return investments.
  - Chancellor’s 4Es strategy (enterprises, education, employment, everywhere) to target high-productivity growth areas such as advanced manufacturing, life sciences, and clean energy.
  - Three-year capital allowances introduced in the 2023 Spring budget to remove tax as an obstacle to investment.
- Recommended additional reforms:
  - Consolidate reductions in post-Brexit uncertainty through timely implementation of the Windsor Framework and careful review of retained EU laws.
  - Accelerate well-targeted public investments (e.g., green transition, network and healthcare infrastructure) to lower costs for businesses and crowd-in private investment.
  - Enhance firms’ access to external finance, ideally equity capital, by unlocking pension and insurance savings while safeguarding financial stability.
  - Improve R&D incentives, enact permanent and broader capital investment allowances, and implement measures to alleviate skills shortages to address market failures and support expansion in new industries and technologies.

*Source: Prepared by Agnese Carella, Ruo Chen, and Xiaobo Shao, extracted from the IMF chapter on UK business investment (1980–2022 analyses and firm-level evidence).*

### 1.   There are both conjunctural and structural reasons to focus on business investment in

### There are both conjunctural and structural reasons to focus on business investment in the UK

### B. Level and Growth Contribution of Business Investment in the UK
- Pre-GFC, the UK was the third fastest-growing G7 economy after the United States and Canada.
- Capital accumulation nearly halved in 2008–2010 and never fully recovered to pre-GFC levels.
- In 2016, the share of labor contribution to the UK growth exceeded 50 percent, nearly triple that observed before the GFC.
- During 2017–22, the contribution of labor declined in both absolute and relative terms, failing to compensate for weaker contributions from capital and productivity.
- UK total investment, as a share of GDP, has been 4 percentage points below (on average) compared to other G7 economies since 1990.
- Business investment accounts for about 13 per cent of UK GDP.
- Non-residential investment has been below the average for G7 peers by an average of 36 percent since 1990.
- Real business investment in the UK in 2022 was slightly lower than in 2016, while other G7 economies experienced a 14 percent increase on average over this period.
- Public investment in the UK has historically been lower than in G7 peers.
- Public capital per capita (for 2017 in constant 2011 international dollar) shows the UK stands out among advanced economies with a low capital stock.
- A large literature documents complementarity of public and private capital and catalyzing effects of public infrastructure on private investment, innovation, and human capital.

### C. Drivers of UK Business Investment: Two Econometric Analyses

Fixed-effect macro panel (G7, annual, 1980–2022; non-residential investment as proxy)
- Estimated macro model: growth rate of non-residential investment regressed on lagged macro variables including non-financial corporation debt, short-term interest rate, market capitalization, public investment growth, credit to households, and lagged GDP growth up to three years; time dummy for UK during 2017–2022 (Brexit) and time dummy after 2019 (Covid); time and country fixed effects.
- Main macro regression results (Table 3):
  - Lagged Debt to NFC: coefficients −0.101*, −0.127*, −0.139**, −0.139 (standard errors shown). Interpretation: higher firm indebtedness is associated with lower business investment.
  - Lagged Market Capitalization: positive coefficients 0.0286**, 0.0286*, 0.0247*, 0.0247 (standard errors shown). Interpretation: higher market valuation/growth expectations associate with higher business investment.
  - Lagged Interest Rate: coefficients −0.540, −0.383, −0.683, −0.683 (not statistically significant in column discussion).
  - Lagged Public Investment Growth: coefficients 0.0961**, 0.0989**, 0.0989* (standard errors shown). Interpretation: positive and significant crowding-in effect of public investment on private investment.
  - Brexit (UK and year>2016) dummy: −4.616** and −4.616*** (standard errors shown). Interpretation: Brexit-related uncertainty has a negative and statistically significant effect on business investment.
  - Covid (year>2019) dummy: coefficients reported (not significant in some specifications), while 2020 year fixed effect had a negative significant coefficient.
  - Model fit: Adjusted R-squared reported as 0.516, 0.484, 0.508, 0.528 across columns; RMSE reported as 3.473, 3.671, 3.586, 3.511.

Micro-econometric firm-level (annual firm panel ~5,000 listed companies, 1984–2022; System GMM)
- Model specification: firm capital expenditure on lagged capital stock and controls including sales growth relative to historical mean, return on assets, effective interest rate, retained earnings, long-term capital; Brexit dummy (post-2016) and Covid dummy (post-2019); firm, industry, and time fixed effects as specified.
- Main micro regression results (Table 4):
  - Lagged Investment to Capital: 0.285***, 0.289***, 0.288*** (standard errors shown). Persistence in investment behavior.
  - Sales Growth: 0.231***, 0.259***, 0.259*** (standard errors shown). Interpretation: higher expected demand drives investment.
  - Lagged Return on Assets: 0.0821***, 0.0983***, 0.0980*** (standard errors shown). Profitability supports investment.
  - Effective Interest Rate: −0.0403***, −0.0147, −0.0145 (standard errors shown). Higher firm borrowing costs reduce investment.
  - Retained Earnings to Capital: 0.214***, 0.200***, 0.199*** (standard errors shown). Internal funds facilitate investment in line with pecking order theory.
  - Long-term Debt to Capital: 0.0791***, 0.0807***, 0.0806*** (standard errors shown). Access to long-term financing supports investment.
  - Brexit Dummy: −0.184***, −0.181*** (standard errors shown). Covid Dummy: −0.431***, −0.431*** (standard errors shown). Interpretation: both Brexit and Covid are associated with substantial declines in firm-level investment.
  - High-investment sectors indicator: 0.102*** when included (standard error shown). Sectors identified as high-investment include advanced manufacturing, transportation, communications, health services, education, research and development.
  - Sample: Observations 14,263; Number of firms 2,248.

### D. Main Results and Policy Implications
- Key empirical findings:
  - Brexit-related uncertainty appears to have been a key driver of low business investment after 2016; the pandemic added further drag.
  - There is a significant crowding-in effect of public investment on private investment (positive and significant coefficient on public investment growth).
  - UK firms with higher retained earnings or external long-term capital invested more; access to finance matters.
  - Certain sectors are more dynamic in terms of investment: advanced manufacturing, health, education, transport, communications, R&D.
  - High levels of firm indebtedness constrain investment; non-financial corporate debt is significantly below its pre-GFC peak (less of a current concern).
- Policies the authorities have taken or announced:
  - Windsor Framework agreement with the EU and a more measured approach to reviewing retained EU laws to reduce Brexit-related uncertainty.
  - Recent budgets sought to protect near-term public investment spending, though public investment-to-GDP ratio is set to decline after 2025.
  - Options being considered to unlock the UK’s large pool of pension and insurance savings to finance high-return investments.
  - Chancellor’s 4Es strategy (enterprises, education, employment, everywhere) to target high-productivity growth areas such as advanced manufacturing, life sciences, and clean energy.
  - Three-year capital allowances introduced in the 2023 Spring budget to remove tax as an obstacle to investment.
- Recommended additional reforms:
  - Consolidate reductions in post-Brexit uncertainty through timely implementation of the Windsor Framework and careful review of retained EU laws.
  - Accelerate well-targeted public investments (e.g., green transition, network and healthcare infrastructure) to lower costs for businesses and crowd-in private investment.
  - Enhance firms’ access to external finance, ideally equity capital, by unlocking pension and insurance savings while safeguarding financial stability.
  - Improve R&D incentives, enact permanent and broader capital investment allowances, and implement measures to alleviate skills shortages to address market failures and support expansion in new industries and technologies.

*Source: Prepared by Agnese Carella, Ruo Chen, and Xiaobo Shao, extracted from the IMF chapter on UK business investment (1980–2022 analyses and firm-level evidence).*

### References

### References

### Academic and econometric studies
- Arellano, M., S. Bond, 1991, “Some Test of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations”, Review of Economic Studies, vol. 58, pp. 277–297.
- Arellano, M. and O. Bover, 1995, “Another Look at the Instrumental-Variable Estimation of Error-Components Models”, Journal of Econometrics, vol. 69, pp. 29–52.
- Baker, M.; J. Stein; J. Wurgler, “When does the market matter? Stock prices and the investment of equity-dependent firms”, The Quarterly Journal of Economics, August 2003, pp.  969– 005.
- Bernanke Ben S., 1983, “Irreversibility, Uncertainty and Cyclical Investment,” Quarterly Journal of Economics, 97 (1983), 85–106.
- Blundell, R.W. and S. Bond, 1998, “Initial Conditions and Moment Restrictions in Dynamic Panel Data Models”, Journal of Econometrics, vol. 87, 115–143.
- Faccini R., E. Palombo, 2021, "News Uncertainty in Brexit United Kingdom" American Economic Review: Insights, 3 (2): 149–64.
- Leitner, Y. “Stock Prices and Business Investment”, Federal Reserve Bank of Philadelphia, Q4 2007 Business Review, pp. 12–18.
- Myers, Stewart C. "Capital Structure Puzzle," Journal of Finance, Vol. 39, No. 3, July 1984, pp. 575– 592.
- Xu, Xiaoming, and Y. Yan. Does government investment crowd out private investment in China? Journal of Economic Policy Reform 17, no. 1 (2014): 1–12.

### Brexit, UK-specific, and working papers
- Baker, S.R., N. Bloom, and S. J. Davis, 2013, “Measuring Economic Policy Uncertainty,” Stanford University and University of Chicago.
- Górnicka, L. 2018, Brexit Referendum and Business Investment in the UK. IMF WP No. 18/247.
- Thwaites, G.; P. Mizen; P. Bunn; N. Bloom; S. Chen; P. Smietanka, 2019, The Impact of Brexit on UK Firms. NBER Working Papers No. w26218.
- McCafferty, Ian, 2014, “Achieving a sustainable recovery: where next for business investment?” speech at The Nottingham Business School on January 22, 2014.

### IMF, World Bank, and policy reports
- Commission on Growth and Development, 2008, The Growth Report: Strategies for Sustained Growth and Inclusive Development.
- International Monetary Fund, 2014. "United Kingdom: Selected Issues Paper," IMF Staff Country Reports 2014/233, International Monetary Fund.
- International Monetary Fund, 2020. “Public Investment for the Recovery”, IMF Blog October 5, 2020 Public Investment for the Recovery (imf.org).
- International Monetary Fund, 2023. " Disentangling the Post-Pandemic Decline in Labor Force Participation in the UK" IMF Selected Issue Paper.
- World Bank, 2007, Fiscal Policy for Growth and Development Further Analysis and Lessons from Country Studies, March 28, 2007.

*Source: sipea2023050 - References*

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_Source: https://www.imf.org/-/media/files/publications/selected-issues-papers/2023/english/sipea2023050.pdf_