Scotland National Strategy for Economic Transformation: evidence paper

Executive Summary – What the Evidence Tells Us

This report provides analytical evidence underpinning the National Strategy for Economic Transformation (NSET). It is among various sources of evidence that have informed the strategy, including a public consultation exercise, views from members of the Council for Economic Transformation and their subgroups, and engagement with other economy stakeholders.

It presents evidence on the structure and performance of Scotland's economy, and the linkages between key indicators of economic performance. It identifies where the new National Strategy must take action to deliver transformational improvements to Scotland's economic performance.

The focus is on the five new policy programmes of action:

• Productive Businesses and Regions: make Scotland's businesses, industries, regions, communities and public services more productive and innovative;
• A Fairer and More Equal Society: reorient our economy towards wellbeing and fair work, to deliver higher rates of employment and wage growth, to significantly reduce structural poverty, particularly child poverty, and improve health, cultural and social outcomes for disadvantaged families and communities.
• New Market Opportunities: strengthen Scotland's position in new markets and industries, generating new, well-paid jobs from a just transition to net zero;
• Entrepreneurial People and Culture: establish Scotland as a world-class entrepreneurial nation founded on a culture that encourages, promotes and celebrates entrepreneurial activity in every sector of our economy; and,
• Skilled Workforce: ensure that people have the skills they need at every stage of life to have rewarding careers and meet the demands of an ever changing economy and society, and that employers invest in the skilled employees they need to grow their businesses.

This summary of 'what the evidence tells us' sets out the challenges identified in this evidence paper.

Scotland's Overall Economic Performance

Scotland is a small open economy with a population of 5.4 million and on-shore GDP of circa £160 billion (excluding oil), which accounts for around 8.0% of UK economy. It accounts for about a third of UK landmass, and possesses key natural resources across its land and seas. As part of the UK economy, Scotland's economy has faced a number of challenges in recent years. These include the impacts of the 2008-09 financial crisis; UK government austerity measures; the oil price shock from 2014 and early adjustment in anticipation of the UK leaving the European Union (EU) and the European single market.

These developments have impacted on Scotland's economic performance. While Scotland's economic growth performance has improved over the medium term, it has declined in comparison with Organisation for Economic Co-operation and Development (OECD) countries, with Scotland currently ranked in the 4th quartile for GDP growth. However, Scotland still compares strongly internationally. In 2019, Scotland's GDP per head (including offshore) was $48,373 at Purchasing Power Parity, ranking in the 2nd quartile of country rankings.

More recently, the COVID-19 pandemic and necessary restrictions on the economy to protect public health have impacted significantly on GDP since 2020. This was in addition to the impact of eventually leaving the EU and the European single market. Following the first COVID-19 lockdown in March 2020, Scotland's economy contracted by 23% relative to the period before the measures were introduced. While the economy has now returned to pre-COVID levels of output^[1], business resilience has been damaged across a number of sectors.

Further analyses identified the key challenges holding back Scotland's economic prosperity and opportunities for transformation. These are summarised below, along with evidence of potential of some of the projects in NSET and lessons from other small advanced economies

Productive businesses and regions

On Scotland's productivity performance and its drivers, the evidence shows that:

Overall Productivity Performance

• Scotland's productivity performance varies significantly across and within sectors, and across business size bands, with productivity growth largely occurring in higher productivity sectors (manufacturing and internationally tradable services). To shift the dial on productivity across the whole economy we need to maintain rates of productivity growth in currently high performing sectors and increase performance in the traditionally lower productivity services sectors.

Research & Development and Broader Technology Adoption

• Scotland still suffers from very low levels of business research and development (R&D) spend, although there have been recent improvements - Business Enterprise Research & Development jobs in Scotland increased by 9.0% between 2019 and 2020. Scotland also shows strong performance on higher education R&D spend.
• There is scope to improve business management practices and to build their capacity for productivity enhancing business models. This includes policies to encourage a culture of entrepreneurship within the existing business base by building experimental and innovative capacity, and facilitating peer to peer learning between businesses.
• There is need to tackle a wide range of barriers to businesses adopting and making the most effective use of existing technologies. This will go a long way in improving the productivity performance of many businesses.

Investment

• Recently, Scotland has performed well at attracting foreign direct investment projects, and has a strong angel investment market due to 'the Scottish model' of business angel syndicates investing alongside the public sector.
• Scotland's capital investment, measured by Gross Fixed Capital Formation (GFCF) as a share of GDP is low by OECD standards. However, Scotland's public sector investment as share of GDP is higher than the UK's, and compares favourably to other OECD countries, although there remains a gap to close on the better performing countries like Norway.
• Scotland's business capital investment rates are lower than comparable countries. The pandemic may have exacerbated this problem due to impact on business balance sheets and ongoing economic uncertainty.

Digital Infrastructure and Technology

• While there has been progress to support digital transformation through enhanced broadband and mobile coverage via programmes like Reaching 100 (R100) and the Scottish 4G Infill (S4GI) Programme, Scotland's levels of connectivity still lag behind many other European countries, particularly when considering full fibre
• The adoption of most key digital technologies, such as mobile technologies and cloud computing, has increased in recent years. However, the digitisation of Scottish businesses is relatively low on average and there is scope to increase further the adoption of many digital technologies to improve economic performance.
• Barriers to digital adoption and readiness exist, particularly in digital skills development, meaning many businesses are not fully embracing digital technologies to enhance their productivity. This is important as digital adoption is a continuous process where deployment of modern technology and development of skills should be a constant of business evolution.

Transport

• Overall, Scotland's transport system performs well in enabling economic activity. However, there remains opportunities to improve transport connections within and between certain areas. The main challenge is with respect to public passenger transport, largely improving satisfaction with services and encouraging switch from the car to public and active travel.

Fairer and More Equal Society

Scotland's economy needs to do more to deliver on wider prosperity. Scotland also faces challenges with respect to:

• low growth of earning from employment and low pay, with a significant although reducing proportion of the workforce earning below the 'real living wage'. While this is partly explained by productivity levels, the evidence from other countries suggest that labour market structure, business models and policy could be important determinants of wages.
• deep seated regional inequalities in economic activity with many communities in Scotland facing significant social challenges linked to poor economic performance, as evidenced by high-levels of deprivation or child poverty in regions with low economic performance.
• significant economic inequalities exist for disadvantaged groups (gender, ethnicity and disability). Tackling these is not only important for maximising the benefits from Scotland's economic prosperity, but it improves overall economic performance.

New Market Opportunities

• Scotland has demonstrable strengths in many of the industries of the future, with high potential for economic transformation if it can make progress in establishing industries to serve new markets linked to net zero transitions and wider technological developments.
• Evidence from offshore wind energy developments suggests that Scotland has not always maximised on opportunities. Supply chain development has not matched the opportunities available in Scotland, the rest of the UK and internationally. It is important therefore that Scotland's approach to other emerging or new markets draws lessons from offshore wind developments where there are now efforts to bolster Scotland's supply chains capacity. This will require investment in skills, private capital, infrastructure and innovation to grow capacity and competitiveness.
• While Scotland has grown its international exports over the past 20 years, their value as a share of GDP has remained broadly static and remains low relative to comparable small advanced economies.
• Scotland's exports are heavily concentrated. Our top five sectors account for 69% of export value. Scotland outperforms its peers in a few sectors. Scottish export performance differs across regions due to the geographic distribution of exporting businesses.

Entrepreneurial people and culture

The evidence shows that Scotland's entrepreneurship is improving from a low base, but there needs to be a step-change in order to be truly transformative. There remains significant scope for improvement in a number of areas, as follows:

• Scotland has a relatively small but growing business base. Growth has largely been among micro and small businesses, and Scotland still lags behind comparable economies on indicators of entrepreneurial dynamism – start-ups, business survival rate and high growth businesses.
• Scotland has a deficit of high-growth firms when compared with other countries, and there is evidence of constraints to business growth in the wider enterprise ecosystem.
• There is recent evidence of significant improvement in business start-ups in the younger age groups that Scotland can build on. The business start-up rate amongst ethnic minorities is also significantly higher than in the rest of the population, demonstrating the value of immigration to Scotland's economy. There is, however, a distinct gender gap in Scottish entrepreneurship; there is need to increase female entrepreneurs.
• Growth of registered businesses has been strongest in 'internationally tradable services' and 'infrastructure and support' sectors,^[2] although the domestic services industry still accounts for the largest share of registered businesses.

Skilled Workforce

Scotland has performed well in post school education and has one of the highest shares of the workforce with at least tertiary education in Europe. However, the economy still faces a wide range of challenges with respect to skills, including:

• general skills shortages as measured by prevalence of 'skills shortage vacancies'. The skills challenge has grown as economic activity has recovered following the pandemic and with impacts of EU exit on migration;
• an aging population, which is also translating to an aging workforce. There is evidence the working life is getting longer with increasingly more people working beyond the retirement age. Latest projections suggest that these trends are long term and will continue. This highlights the importance of investing in lifelong learning.
• While Scotland has depended on migration to meet skills and workforce requirements – especially in some sectors; its share of foreign-born population is much lower when compared to other OECD countries. Brexit will have reduced this further.
• Despite having challenges with respect to skills and general labour shortages, around one in five of Scotland's working age population is inactive. The most common reason cited for labour market inactivity in Scotland is temporary or long-term health problems in the workforce. The share of inactive workers reporting that they are discouraged or not interested in work is extremely small (1 per cent).
• To mitigate against growing skills mismatch in the economy, there is need to ensure skills provision adapts to changing skills requirements as the economy transforms with modern technologies and new markets. This requires ensuring that a more coherent lifelong learning offer is complemented by increased employer and industry investment in skills and training.

Potential Impact of the Strategy

Economic modelling suggests that the economy could be 4.9% (£8 billion) larger in 2032 than it would otherwise have been if NSET projects to increase openness and productivity were implemented successfully. An increase in exports through improved access to existing and new international markets benefits trade. Productivity improvements provide a further boost to the economy by increasing economic capacity and through improved competitiveness at home and abroad.

Lessons from Comparable Advanced Economies

The evidence suggests that successful small advanced economies that Scotland could emulate have strengthened their economic competitiveness through investing in human capital and supporting innovation. They have chosen their areas of outward activity through careful development of existing strengths and targeting of potential international markets.

Prioritising Innovation and Human Capital: they demonstrate strong, sustained investment in knowledge, innovation and human capital. High performing economies, such as Switzerland and several Scandinavian countries, perform particularly well on the Global Competitiveness Index's innovation and business sophistication measures.

Strategic Coherence: they demonstrate a high degree of policy coherence in their approaches; demonstrate flexibility when responding to shocks and structural changes. For example, the Scandinavian nations and Switzerland all have flexible labour market policies, but also strong social insurance systems to protect their workforce and mitigate the risks that come with labour flexibility. Following the 2008 crisis, the countries that recovered quicker tended to have an increased focus on:

• building economic resilience and an increased awareness of economic risk;
• deliberate efforts to boost productivity, either through structural reform or other policy levers, increased business investment and encouraging innovation; and,
• strategies to diversify international footprints, either through trade agreements or through supporting firms to expand internationally.

Active International Engagement: they also tend to have active international engagement, which lets them access larger markets. Their business base has more large companies per capita, which helps with access to global markets. External relations policies—whether that takes the form of trade agreements or a skills focus on enterprise and international expansion—support this international engagement.