5. A policy roadmap to address regional inequalities now and in the future

Chapters 2 and 3 of this report undertake a thorough analysis of regional inequality trends and drivers across OECD regions and within countries over the past two decades and conclude that these trends are heterogenous. The analysis shows a diversity of situations across OECD countries, each of which requires a diverse set of context-specific policy responses to address regional inequalities more effectively. This diversity reflects disparities in productivity resulting from differences in economic structure, the supply of skilled labour, physical capital and natural resources, and public infrastructure and strong path dependency in these spatial distributions. Such diversity may also relate to the local availability of certain amenities and is affected by labour market institutions and redistribution through taxes and benefits.

Not addressing wide and sustained regional inequalities has led to negative by-products and future remedial costs, often outweighing the costs of directly addressing those inequalities, that has become increasingly difficult, whether politically or socially, to ignore. To effectively reduce regional inequalities, policy responses are warranted to address the concerns of and improve prospects for those places that have been left behind, while sustaining the prosperity of the most dynamic regions and helping regions navigate the green and digital transitions. The chapter starts by discussing how inaction on regional inequalities can have adverse consequences on economic performance, service provision, social and political stability and the just transition in OECD countries. To encourage and guide public action, the chapter then proposes a comprehensive policy roadmap to support policy makers at different levels in their efforts to effectively address regional inequalities now and in the future.

Economic development is spatially uneven due to the differences in factors of production across regions. While cities enjoy agglomeration benefits, rural regions tend to depend highly on primary and tradeable activities. As discussed in earlier chapters of this report, pockets of economic activity and clusters tend to concentrate on space and natural resources are localised in specific geographies. Differences in factors of production translate into differences in productivity and growth potential, giving rise to unequal development patterns. Inequality in development patterns is often considered necessary or a “fact of life” of economic development. But there are important downsides to spatial inequality, especially when gaps become too high and persist over time.

This section looks at three negative by-products of regional inequalities: i) missed economic opportunities and a loss of growth potential; ii) cost implications for delivering high-quality services across the entire territory; and iii) risks of discontent and instability when they pass a certain threshold and some territories are left behind. It also examines the importance of anticipating and mitigating the potential increases of regional inequalities to deliver a just green and digital transition.

Across OECD regions, weak and strong signals of these by-products have been emerging in recent years and it has become clear that the consequences of inaction will eventually lead to even higher future remedial costs. Hence, regional policies must mitigate spatial inequality in new and better ways, moving away from quick fixes that have created dependency relationships in the past, towards a mix of muti-level, multi-sectoral policies and sound institutional and fiscal frameworks, tailored to the prospects of different kinds of OECD regions.

Some level of regional inequalities is inherent to and unavoidable in any country as the cycle of economic development and place-specific endowments of people and skills, firms and industries have led to the concentration of high-technology and knowledge-intensive sectors in some, predominantly urban, regions. According to the economic literature, several studies provide some theoretical foundations for the rise of spatial inequality:

  • Models of the New Economic Geography (NEG), the urban agenda and the new trade theory, have given important insights into explaining why economic activity and settlement patterns tend to concentrate in certain locations, which generates core-periphery spatial patterns. The model is based on a spatial equilibrium between the benefits and costs of agglomeration. Estimates predict that when city size doubles, productivity increases between 2-5% on average (OECD, 2015[1]).

  • The cumulative dynamics also apply to superstar firms and industry clusters (Alfaro, Chen and Fadinger, n.d.[2]), showing a clear hub-and-spoke structure in the geographic distribution of agglomeration patterns of industries and plants in Europe related to superstar firms, suggesting that regional policies could have a role in building superstar-centred industry clusters.

  • Studies based on endogenous growth theory and institutional economics may also reinforce these spatial outcomes. Acemoglu and Dell (2010[3]) document that about half of the between-country and between-municipality differences can be accounted for by differences in human capital and productive efficiency is determined by national factors and local institutions, such as the availability of local public goods and the security of property rights giving rise to inequality. Frick and Rodríguez-Pose (2018[4]) also find a relation between governance factors and infrastructure factors and divergence in regional growth rates. Their analysis examines the relation between city size and economic growth and finds that growth is highly dependent on adequate infrastructure and governance conditions.

  • There are also studies that show the resilience of regions and cities to economic shocks and national economic recovery also differ such as the shocks of the global financial crisis, or more recently the COVID-19 pandemic and Russia’s war against Ukraine. Duranton (2007[5]) showed that small, innovation-driven shocks lead to the churning of industries across cities. This may then lead to slower growth or decline in cities, following net gains or losses of industries.

When looking at time dynamics and the evolution of regional inequality over time, there are different scenarios:

  • The standard neo-classical growth models using capital accumulation, labour and savings (Solow, 1956[6]), Swan (1956[7]) predicts convergence to a steady state over the long run. This means that poorer regions further away from their steady-state level will tend to grow faster and thus converge, and inequalities would then eventually decline from the bottom of the distribution.

  • Williamson’s curve predicts a rise in inequality and a decline over time. It suggests that in a catching-up country, a few growth poles concentrate in regions which attract the bulk of capital, knowledge and skilled workers. As productivity rises in these regions, it will lead to faster growth and increasing disparities among regions. At later stages, as higher factor costs or diseconomies of agglomeration emerge in these regions, capital is likely to move to other regions with lower capital per worker. In addition, knowledge spillover effects may enhance the reallocation of productive factors across sectors and regions, which leads to convergence in income levels (OECD, 2012[8]).

  • Economic models of the NEG predict a core-periphery equilibrium but do not provide a clear prediction of the links between economic concentration and growth. These models explain why economic activities concentrate in specific geographies and sometimes benefits of agglomeration are offset by costs that arise on the concentration. The forces enhancing agglomeration typically include migration of labour, forward and backward linkages and elasticity of labour supply.

Several studies have investigated how agglomerations can benefit adjacent regions, also called “borrowed” agglomeration effects from neighbouring cities. Estimates of the benefits predict that for a doubling of the population living – at a given distance – in urban areas within a 300 km radius, the productivity of the city in the centre increases by between 1% and 1.5% (OECD, 2015[1]). Thus, evidence has shown that, more often than not, these spillover mechanisms to less-favoured regions have a more limited effect than expected. The increasing importance of knowledge-based services has also reinforced the existing advantages of large metropolitan regions over low-density and less urbanised regions (Oliveira Martins, 2021[9]).

While spatially uneven development is regarded as the price to pay for economy-wide productivity maximisation – the overarching goal being to make the “economic cake” bigger first and then distribute it –, experience over the past decades has shown that this model has in many instances exacerbated inter-personal and regional inequalities and, in fact, failed to deliver and activate development opportunities in lagging regions. Today, inaction on regional inequalities is raising different types of costs, which are discussed in the following sections.

Many lagging, lower-income regions and regions in a “middle-income trap” have levels of economic activity that are well below their potential, both in terms of employment and productivity (EC, 2022[10]; Diemer et al., 2022[11]) and are often seen as a drag on national performance, rather than as potential assets to be exploited. Yet, the OECD has evidenced that, while there will always be inter-regional gaps, those lagging regions have opportunities to “catch up” in terms of social and economic development (OECD, 2016[12]). Leaving lagging or stagnating regions behind can not only affect the regions themselves but has important consequences for national aggregates. Indeed, while individually, the impact of these regions on national growth can be relatively small, in aggregate, the contribution to national growth of all regions with catching-up potential is substantial, even at these lower levels (OECD, 2012[8]).

An exclusive focus on the leading regions is not sufficient to drive average productivity. While the productivity frontier is mostly urban, many regions with large rural populations also do well and have been catching up to the national frontier. At the same time, those regions falling behind national frontiers include many urban regions (OECD, 2016[12]). As discussed in Chapter 3, only by generating stronger growth, fuelling the catching-up machine in all types of regions in a synchronised manner and supporting the performance of the system of regions as a whole, can national economies increase aggregate productivity and reach their total output frontier.

Differences in quality and access to public services are key determinants of inequalities between regions in OECD countries, as discussed in Chapter 2. In turn, when left unaddressed, high and persistent regional inequalities challenge the capacity of subnational governments to provide people with adequate access to public services and infrastructure.

On the one hand, economically dynamic regions and notably urban areas may have difficulties maintaining infrastructure capacity and/or keeping pace with infrastructure expansion needed to cater for the large numbers of people they attract. The consequence may be shortages in affordable quality housing and congestion problems (OECD, 2015[1]). This creates a challenge, particularly for cities’ lower-skilled workers who may work in more precarious jobs and struggle with high urban costs of living, long commutes and air pollution problems.

On the other hand, lagging regions typically get trapped in a vicious cycle of decline that affects the quality of local public service provision, which becomes increasingly expensive. Regions that have suffered from long-term industrial decline have seen their unemployment rise and labour force participation decline and, in many cases, they have lost competitiveness and have not successfully transitioned into other areas of competitive advantage. As a result, public services in these regions have become stretched, are of low quality or are difficult to access, which may then be a catalyst for further outmigration of higher-skilled workers and their families. Furthermore, many of these regions are also often facing accelerated demographic changes, including population decline and ageing, pushing up the demand for health and other social services (OECD, 2022[13]).

The physical infrastructure needed to provide good quality public services can be more complex and expensive in lagging regions and attracting highly skilled people poses an additional challenge. Many rural schools, for instance, are facing or will soon face declining student numbers, generating smaller schools, class sizes and student-teacher ratios (OECD, 2021[14]). While smaller sizes can present some opportunities such as more teaching time per student, many small rural schools operate in isolation and under capacity with a limited educational offer and their principals and teachers struggle with multiple roles. The challenges are even larger in remote rural regions with low population densities. With fewer people spread over a wider area, economies of scale are difficult to achieve.

In principle, differences in relevant aspects such as population density and demographic structure translate into unavoidable higher costs of service provision in certain local units and regions within countries. These higher per-unit costs translate into lower quality services, which in turn could lower the attractiveness of the regions and incentive further drops in population and tax revenue of these places leading to negative downward spiral dynamics. Given that, across many OECD countries, national constitutions recognise health and education provision as core rights, maintaining services in these places represents a high cost and often leads to the transfer of resources across places and dependency dynamics.

Regional disparities in access to quality services, especially essential ones, can lead to increased spending on social support services and more complex healthcare issues for instance and, in turn, lower tax revenues (related to lower employment outcomes from inactivity) (OECD, 2022[15]). In education, a lack of access to quality opportunities can lead not only to lower lifelong employment opportunities, incomes and well-being but also to higher intergenerational inequalities (Hanushek and Woessmann, 2020[16]). In healthcare, a lack of access to quality care can translate into worse health outcomes, higher incidence of chronic disease, increased mortality and ultimately to a lower quality of life (OECD, 2021[14]). Migration induced by inadequate access to services can lead to brain-drain and exacerbate existing gaps in the availability of educated workers such as doctors and teachers in rural areas. Against this backdrop, ensuring the vitality of lagging places by investing in framework conditions for development or making use of technological solutions and network effects to deliver services can act as effective measures to avoid future, and potentially considerable, remedial costs.

Regional inequalities are a factor behind large regional variations in trust in government in OECD countries. Data from the 21 countries included in the OECD Trust Survey reflect variations between each country’s most and least trusting region, ranging from under 10% in Australia to a more than 30% difference in Korea (Figure 5.1). This suggests government trust deficits in many OECD countries have a territorial cleavage (OECD, forthcoming[17]; 2022[18]). Levels of trust in OECD territories have also been in flux in recent years, having declined in certain regions and risen in others.

There are a number of ways in which regional inequalities can contribute to trust deficits in certain places. Empirical evidence from OECD countries suggests that places with higher levels of government distrust are primarily: i) comparatively wealthy areas that have been in long-term economic decline (e.g. certain parts of northern Italy); and ii) middle-income areas that have been unable to sustain economic growth because they are not sufficiently innovative to compete with more productive regions (this primarily includes rural areas and small or medium-sized cities) (Dijkstra, Poelman and Rodríguez-Pose, 2020[19]). These findings reflect the growing divides between places that feel left behind by globalisation and technological change, and those that may benefit from the opportunities offered by megatrends, and even more so since the global financial crisis.

Regional disparities in trust in government reflect the differing levels of success that national and subnational governments have had in dealing with their citizens’ challenges and needs. Furthermore, citizens tend to trust subnational governments more than national ones. In 2020, for example, trust in regional and local authorities across European Union (EU) member states was nearly 10% higher than trust in national governments (OECD, forthcoming[17]).

In addition to long-term economic outcomes, there is also evidence to suggest that trust in government can be undermined by more short-term shocks to regional and local economies, such as increases in unemployment. In the United States, for instance, voters in local communities experiencing significant job losses in the manufacturing sector have shifted strongly towards anti-establishment candidates in recent years (Guriev and Papaioannou, 2020[20]). In the European Union, changes in regional unemployment rates between 2008 and 2014 were found to have a causal effect on decreasing trust in national parliaments and increasing votes for anti-system parties. An unemployment increase of 5 percentage points was associated with a drop of 3.65 percentage points in trust towards a country’s national parliament (Algan et al., 2018[21]).

While short- and long-term socio-economic outcomes are important determinants of trust, they often fail to fully explain its territorial variations. An additional factor that is thought to contribute to territorial divides in trust in government is the quality of local public service delivery. In Europe for instance, residents in a rural area or town were found to have a lower average level of trust in government compared to those living in cities, even after controlling for demographic, economic and cultural differences among cities and rural areas (EC, 2022[10]). Researchers found that a key factor behind this was dissatisfaction with local public services (notably education and healthcare) (Mitsch, Lee and Ralph-Morrow, 2021[22]). This finding is also reflected in recent OECD work in countries like Finland and Norway, where responsiveness in delivering public services has been identified as one of the most important determinants of citizen trust in national and local governments (OECD, 2022[23]; 2021[24]).

Persistent regional inequalities raise the risk that territorial divides in trust experienced by OECD countries will continue to grow and with them the risk of making the economic, social and political costs of inaction even higher:

  • Lower levels of trust have been shown to have a negative impact on long-term regional economic performance (Algan and Cahuc, 2014[25]). This is because trust deficits can limit productivity through various channels, including trade, financial intermediation, the organisation of firms and labour markets. For example, a lack of trust may inhibit a country’s performance by increasing transaction costs for businesses.

  • Lower levels of government trust may affect the willingness of citizens to accept government policies, including in a crisis situation. Evidence collected in the early part of the COVID-19 pandemic provides a stark illustration of this effect. In the European Union and the United States, for example, mobility data show that, on average, people complied with COVID-19 health restrictions on movement less consistently when they did not trust their governments (Bargain and Aminjonov, 2020[26]; OECD, 2021[27]). At the regional level, low trust in institutions was also associated with higher excess mortality in EU and OECD countries during the first year of the pandemic (after controlling for economic and demographic differences), which may reflect, at least in part, lower overall compliance with health measures in these areas (Diaz-Ramirez, Veneri and Lembcke, 2022[28]).

Persistent economic stagnation or decline in many regions of OECD countries has given rise to growing discontent and resentment of the political and economic status quo. This trend has become apparent across the OECD, as indicated by growing political polarisation, growing political fragmentation, as well as the collapse of established political parties, record-low voter turnout and the surge of new or newly reconfigured parties from across the political spectrum.

As earlier chapters discuss, megatrends such as climate and technological change are not impacting regions the same and lagging regions are often the one standing to be most affected. Persistent regional inequalities further hinder these regions’ capacity to respond and adapt to change and, in turn, jeopardise governments’ ability to make this transition equitable and just.

In the green transition, climate adaptation challenges and opportunities differ sharply across regions as some concentrate on employment and carbon emission-intensive activities. Furthermore, average wages in the key manufacturing sectors most likely to be impacted by the green transition are often higher than average wages in the economy as a whole, meaning that job loss or job transformations pose risks for wealth in regions hosting them (OECD, 2022[13]). These regions are often already lagging, implying they may have fewer economic resources to absorb shocks and take advantage of opportunities. In the European Union, for instance, the largest share of regions most vulnerable to the industrial transition to climate neutrality lag on several socio-economic characteristics, especially gross domestic product (GDP) per capita and average regional wages (OECD, 2023[29]).

The OECD finds that the share of green-tasks jobs differs on average by 9 percentage points between the regions with the lowest and highest share (Figure 5.2). In some of these regions, workers are also exposed to poverty risk or are vulnerable on account of narrow, limited skills (OECD, 2023[30]). Regions also differ in their access to key infrastructure some of these industries will require, notably for hydrogen, carbon capture and storage and zero-emission freight transport, which is key to value chains. Addressing inequalities between regions can therefore strengthen their capacity to weather these changes and take the actions needed to ensure the success of the green transition.

Similar to the green transition, the challenges and opportunities emerging from the digital transition are uneven across regions. The opportunities being created by digitalisation differ largely due to differences in connectivity, the share of occupations amenable to remote work and the digital skills required to succeed in this new economy (OECD, 2021[31]). The rise of remote working, increasing automation and the digitalisation of services are improving productivity and well-being for many people (see Chapter 3). Remote working, for example, is redefining how and where people choose to work, proving an important opportunity to improve the work-life balance by reducing commuting times and encouraging more flexible working arrangements. At the same time, it is redefining where higher-income higher-skilled workers choose to live, which will impact the future development of regions and transportation systems, and impact carbon emission patterns.

Adapting to the digital transition requires that people and firms in regions have the right digital skills but large gaps remain. The share of people using the Internet in regions with the highest use is 10 percentage points higher than in the region with the lowest use, while, despite an acceleration since COVID-19, small and medium-sized enterprises (SMEs) trail large firms in the adoption of digital tools such as cloud computing and big data for instance (OECD, 2023[32]). This can lead to significant differences in the ability of people and firms to position themselves for the new digital environment.

The challenges posed by the green and digital transition can be turned into opportunities to boost development in lagging regions and reduce regional inequalities. Climate mitigation policies for instance can support prosperity and well-being in rural regions. This can be realised through more sustainable land management, higher valorisation of ecosystem services, making use of innovative production processes around agriculture, mining and renewable energies and new modes of transportation. Similarly, remote working can bring new growth opportunities for rural economies. Remote working holds the potential to create new job opportunities outside large cities because of more affordable and suitable housing and office spaces with better access to environmental amenities (OECD, 2022[33]).

For a long time, most policies to address regional inequalities aimed at compensating lagging regions and consisted of top-down, often short-term, subsidy interventions (e.g. for infrastructure and setting up public services) to the poorest regions. They mostly resulted in distorted markets and harmed the development chances of these regions in the medium and long terms. Such policies also often focused on keeping declining industrial sectors alive so as to protect local jobs, even when these sectors were condemned in the long term. Overall, these government responses failed to reduce inequality, generate new jobs in lagging regions or trigger a culture of economic dynamism (OECD, 2012[8]). Moreover, these actions had unintended consequences, creating a culture of dependency on the part of recipient regions, many of which are now trapped in a vicious circle of under development.

Effectively addressing and mitigating regional inequalities is no small task. These inequalities are not marginal but touch on fundamental issues in people’s lives, from access to healthcare to employment. Regions – especially lagging regions – often struggle, not just on one front but on many. This means that mitigating regional inequalities effectively cannot be done with siloed policy responses but requires taking on multiple systemic and interrelated challenges at the same time.

To guide policy efforts to address regional disparities in a way that both stimulates catching up in lagging/stagnant regions and sustains prosperity in the most dynamic regions, this section presents a policy roadmap structured around five priorities. These priorities, presented in Figure 5.3, should not be considered in isolation. Rather, policy makers should take co-ordinated and sequenced steps across all five to create equal opportunities across regions.

  • Ensuring equitable access to quality public services and infrastructure in all regions.

  • Boosting productivity and competitiveness.

  • Providing the right skills and quality job opportunities in regional labour markets.

  • Improving the quality of multi-level governance systems.

  • Strengthening capacity at the national and subnational levels.

How to address regional inequalities depends largely on local economic, socio-demographic and geographic circumstances and differs from place to place. It means that delivering on the policy roadmap requires galvanising action across a wide range of governmental and non-governmental actors at different levels. This is best done through a place-based approach, one that recognises the heterogeneity characterising OECD regional economies, in terms of place (i.e. there is a continuum of places with different characteristics and different economic specialisations), activities (i.e. manufacturing, tradeable and non-tradeable services) and firms (i.e. in terms of productivity levels and growth) (OECD, 2019[34]; 2016[12]; Barba Navaretti, 2021[35]; Iammarino, Rodríguez-Pose and Storper, 2018[36]). The following sections discuss each of the five policy priorities in detail and present concrete policy measures and experiences across OECD countries.

Improving access to quality public services can offer high social returns to investment including not only through better education and healthcare outcomes but also improved lifelong and intergenerational income and well-being outcomes. Indeed, bridging access gaps can generate higher tax revenues and decreased spending on social support services and more complex and costly health services. As the COVID-19 pandemic demonstrated, investing in reducing inequalities in service provision can also improve the resilience of systems to respond to unexpected shocks (OECD, 2022[15]).

The provision of basic services such as primary care remains essential in keeping the need for more specialised services at bay. OECD countries have striven to bridge access gaps in places lacking other options, including through innovative and digital solutions, such as expanding telemedicine and developing digitally based sharing mobility services. These strategies however often need to be accompanied by substantial transversal investments to tackle rural-urban gaps in (digital) skills and connectivity (OECD, 2022[15]).

The costs of service delivery not only depend on density or absolute or relative distances but also a wide range of other factors including economies of scale and scope. Policy efforts have focused on pursuing integrated and flexible approaches to the provision of services, notably by offering different types of related services in a single location, in order to broaden access, reduce costs and improve outcomes, especially for underserved communities in rural or remote regions.

This is especially important at a time of high labour demand and staff shortages, especially in the care sector. Policy measures to address this challenge typically focus first on improving the attractiveness and working conditions in these professions, including working hours, pay, job security and access to training. Specific support for workers interested in moving into the care sector can also be part of the solution, for example in the form of career guidance and training. Additional incentives – financial or otherwise – can then help encourage professionals to take up work in underserved locations (OECD, 2016[39]). This can take the form of special scholarships to obtain certain qualifications and could be combined with return-of-service obligations, one-off payments for those moving to underserved areas and to support their installation, or recurrent bonuses (OECD, forthcoming[40]).

Stagnating productivity growth and its consequences for well-being contribute to social and political polarisation (see discussion earlier in the chapter). Inversely, more productive regions tend to offer better jobs that translate into better wages and incomes for households, and more balanced development within countries. These places are also more likely to generate the tax revenues necessary to finance public services and infrastructure, such as health, education, transport and social support (OECD, 2020[42]; Tsvetkova et al., 2020[43]).

As discussed in Chapter 3, operating in global markets exposes regions to practices of the global productivity frontier and makes them less constrained by country-specific limitations (e.g. technological, financial and related to market size) or equilibria (e.g. when frontier regions already dominate the local markets) (OECD, forthcoming[40]). An advantage of healthy tradeable sectors – especially tradeable services and manufacturing – is that they can enhance productivity in all types of regions – i.e. predominantly urban or rural – although tradeable subsectors and mechanisms in place might vary depending on the type of area (OECD, 2016[12]).

The impact of the war in Ukraine on GVCs has created a renewed focus on reshoring and nearshoring critical industries in regions. This is part and parcel of a broader trend of the macro-regionalisation of supply chains since the global financial crisis, which has been further accelerated by the COVID-19 crisis, albeit recognising that diversified supply chains can also be a source of resilience (see discussion on sectoral specialisation and diversification in Chapter 3). Regions must navigate and make the most of this new global environment and the OECD Programme on Regions in Globalisation provides an analytical framework to help examine and understand subnational drivers of attractiveness to key international target groups (Box 5.1).

Transport infrastructure can contribute to leveraging agglomeration economies of metropolitan regions and expand the benefits of well-functioning cities to other lower-density regions, including in terms of knowledge and innovation diffusion and links to financial institutions, which are crucial to entrepreneurship, firm growth and public infrastructure investment. To help create new economic activity in lagging regions, transport infrastructure investments call for complementary policies supporting the (re)activation of unutilised resources, such as coupling FDI attraction policies with investment in major international transport hubs (OECD, 2020[45]).

Developing transport infrastructure that maximises the accessibility of opportunities for people and firms requires accounting for functional relationships across space that often go beyond administrative boundaries. A functional approach to transport infrastructure accounts for the diversity of scales and can thus help fit transport infrastructure to the needs of people and workers living in a place (Dijkstra, Poelman and Veneri, 2019[46]). This approach has important governance implications and requires incentives to work (see the following section on multi-level governance).

A functional approach is especially important to leverage rural-urban interlinkages through inter-regional transport infrastructure, inter-municipal co-operation, urban-rural partnerships, etc. Accessibility to metropolitan areas (through distances or driving times) is a powerful determinant of the “agglomeration economies” that rural areas can borrow from urban areas (Fadic et al., 2019[47]) and thus of the productivity growth potential that governments can leverage through better transport infrastructure. The functional approach is also behind the OECD definition of functional urban areas (FUAs) for instance, which delineate metropolitan areas’ boundaries through labour market interactions between cities and their surroundings (OECD, forthcoming[40]).

Economic diversification is important to boost productivity and competitiveness, especially in lagging regions where innovation creation and uptake often lag behind metropolitan regions, weighing down on aggregate productivity, income levels and overall well-being (OECD, 2022[49]). Focusing on labour-augmenting innovation that improves job opportunities and wages can contribute to dynamically stimulating lagging regions and bend the trend of high-paying jobs concentrating in certain, often metropolitan, regions (Storper, 2023[50]).

A broad approach to innovation consists in promoting technology and non-technology-driven innovation, building innovation competencies of SMEs, better connecting regional innovation actors and stronger engagement with regional innovation cluster organisations, creating a stronger regional innovation ecosystem and linking innovation with broader regional development goals. It also means supporting innovative entrepreneurship to generate economic and industrial diversification and, through this, diversify innovation potential (OECD, 2021[51]). The OECD has developed a self-assessment toolkit for regions that allows national and regional policy makers to implement up-to-date assessments of bottlenecks for innovation diffusion in different regions. The toolkit provides a regional innovation profile (relative to other OECD and EU-27 regions), quantifies the strength of different innovation diffusion channels in the region and allows policy makers to engage local stakeholders to gather their views on actions for improvement.

Smaller urban areas are increasingly being seen as potential motors of regional development and catching up, although they are extremely heterogeneous in terms of development trajectories and underlying driving factors. They hold great potential to enable more polycentric development and greater territorial cohesion through a more balanced diffusion of activities and opportunities across space while helping boost broader territorial development by providing services and amenities to surrounding territories.

In this respect, intermediary cities can offer an attractive alternative to large metropolitan areas, especially to people looking for more affordable housing and better environmental quality and, in turn, boost well-being and reduce many of the negative externalities often presented by larger metropolitan areas, including urban sprawl and pollution, whilst also helping to preserve natural resources and landscapes.

In some OECD countries, urban strategies and programmes are no longer limited to addressing urban challenges characteristic of large metropolitan areas but also encompass specific visions and measures for smaller and medium-sized towns with the aim of increasing their innovation capacity and transition potential and preventing them from losing their socio-economic function.

Geographic inequalities in the number and quality of jobs available are large. Many policy responses to regional inequalities have given priority to distributing job opportunities more equally across regions, addressing regional skill imbalances, improving regional labour market outcomes and forecasting skill needs at the regional level to alleviate risks associated with structural change, such as industrial transitions.

In the context of the knowledge economy and as skills become more important to innovation and growth, the availability of a skilled workforce is increasingly important to firms’ decisions to locate, remain and/or expand in a locality or region. In regions where quality job opportunities are rare, workers and young people have lower incentives to invest in their human capital and to increase labour market participation (OECD, 2020[54]). Meanwhile, businesses that lack qualified staff are unlikely to innovate and create good-quality employment. Wages and productivity are low and higher-skilled workers and innovative employers have the incentive to move to economically more dynamic areas leaving behind a low-skilled workforce and high unemployment (OECD, forthcoming[40]).

Flexible training, education and employment services are required to proactively respond to skills gaps that may act as barriers and obstacles to business growth and expansion. Providing workers with training in place-sensitive skills, which are relevant in the local context, can be one solution. For example, while the demand for basic digital skills will likely grow in all places, demand for more specialised skills may be more regionally concentrated. However, in addition to training workers, employers need to create the corresponding job opportunities to make sure that qualified workers can be retained and that their skills are put to good use. It is also essential to increase the visibility of learning and training offers and raising awareness among firms and potential learners to facilitate their participation.

In some cases, longer-term skills strategies are devised, such as for growing industrial sectors, which can increase the relevance of the training offered. However, regions and localities need to be careful to avoid overspecialisation and “lock in” to a limited rage of sectors. To ensure lifelong learning becomes a reality, local education and training systems also need to better adjust to the needs of workers, for example by offering flexible learning modules and after-hour classes (OECD, 2014[55]).

Access to quality information on regional skill needs is the first step to steer investment towards in-demand skills. Skill forecasting and intelligence at the regional level can be effective particularly if it brings together local stakeholders such as industry organisations, and education and training providers, with national and regional authorities. Skill anticipation, however, should also fit into a national framework to prevent fragmentation.

Investment in the supply of skills alone will not be sufficient to improve job quality and the resilience of regional economies. The degree to which employers are demanding and using skills also has to be taken into account. There are considerable variations in the supply and demand for skills at the regional and local levels (OECD, 2014[55]) and these may very well increase as megatrends accelerate. Some regions can fall into a vicious circle known as “low skill equilibrium”, i.e. it does not pay for people to invest in skills when skills are not valued by employers. At the same time, those who do not attain skills move away to better-quality jobs elsewhere. In such regions, skills policies need to be embedded in a broader drive to support economic development. This can include helping existing firms to move towards more skills-intensive, higher-value product market strategies.

Policy makers also need to pay attention to regions and places which are experiencing persistent problems of unemployment, in particular youth unemployment and labour market exclusion. Immediate barriers to work can include a lack of affordable childcare, poor transport links and complex welfare arrangements that make reconciling work and benefits difficult (OECD, 2014[55]). In the longer term, living in areas which are isolated from the labour market and ill health can become more persistent barriers to employment. As the employment barriers experienced by individuals become more complex, a joint approach is often needed to tackle them, involving employment service providers, vocational education and training institutions, economic development agencies and social welfare organisations.

Skills development and retraining are vital to ensuring that workers have the right skills to prosper in a changing world of work and are a prerequisite for making the green transition a “just transition”. New skills will be needed throughout the economy, whether it is retraining construction workers on environmentally friendly materials and techniques, or reskilling workers in automotive for electric vehicle production. The jobs and skills needed will differ geographically: some regional and local labour markets will have people with skills that can be easily redeployed and others not (OECD, 2023[30]).

In the context of rapidly transforming labour markets, workers with skills that are becoming outdated or obsolete require early support. Demographic trends, coupled with industrial transitions, including through digitalisation and automation, will likely bring about major changes in the skills supply and demand in local labour markets. In the past, some regions that underwent such heavy structural change experienced high numbers of layoffs with long-lasting negative consequences (OECD, 2018[58]). Helping workers affected by structural transformation avoid unemployment is better for their employment prospects, earnings trajectories and human capital development, and it is less costly for the public budget than providing support after dismissal (OECD, 2013[59]). Still, across the OECD, at-risk workers are less likely to participate in training or use guidance services than other workers (OECD, 2021[60]). One effective solution for identifying workers with potentially outdated skills can be to target specific groups of workers, for example at firms or in sectors facing declining demand or high risk of automation.

The extent to which employees and regional economies are capable of diversifying depends, to a large extent, on the success of reskilling and re-education programmes. In the context of the green transition, local, bottom-up organised training to leave high carbon emitting (“brown”) industries is necessary to help the most affected workers transit into new career opportunities, make the human capital needed for the green transition available and include more disadvantaged groups in new emerging sectors. Furthermore, the transition to a low-carbon and resource-efficient economy as well as the effects brought by other megatrends require a workforce capable of acquiring skills throughout their lives. Effective and inclusive adult learning systems can help workers remain employable and productive throughout their life cycle, despite changing skills needs. If such systems are in place, the green transition can be delivered effectively and benefit most workers. Otherwise, skills shortages may hinder its implementation and inequality will likely increase. In turn, effective adult learning systems can become a comparative advantage that regions can leverage to attract investment from green businesses (OECD, 2023[30]).

Jobs are not just created in the private sector. The social economy and social entrepreneurship can also play an important role in generating employment. In some regions, percentage growth in employment in the social economy has usually outpaced that of the private sectors in recent years (OECD, 2013[62]). The social economy also brings the added benefit of being embedded in communities and offering jobs to the most excluded in the labour market, either by providing training and work experience opportunities or by offering direct employment.

Net job creation is typically led by a small number of young firms. While much industry now operates globally, new firms are strongly dependent on the local economic contexts in which they emerge, with most high-growth firms developing in regions with high population density and high levels of tertiary education. Despite their positive contribution to the local economy, high-growth firms are faced with barriers to development, including a lack of access to investment. Governments can help by putting in place strategies to build regional entrepreneurial ecosystems, where new firms can learn through knowledge-sharing networks and through inputs from more experienced managers.

In some OECD countries, business accelerators have been developed to provide a variety of support. OECD countries have also supported entrepreneurs build the skills required for their success. Common approaches are to embed entrepreneurship training into the curriculum in schools, vocational training and university-level courses and to develop stand-alone training for entrepreneurs and “would-be” entrepreneurs (OECD, 2023[65]). Other approaches are to support coaching and mentoring relationships and to develop peer learning programmes (OECD, 2014[55]).

Designing and implementing policies to address regional inequalities is a responsibility shared by national and subnational levels of government and involves diverse policy sectors. A key issue for policy makers to consider is how to manage this mutual dependence through effective multi-level governance arrangements. It requires clarifying how responsibilities are assigned across levels of government, ensuring efficient co-ordination across levels of government, sectors and jurisdictions as well as strengthening administrative and fiscal capacities, especially at the subnational level (see following section) (OECD, 2014[67]; 2019[68]).

How effective policies are at reducing regional inequalities depends, in part, on how national and subnational governments manage the functions they share. In practice, the question is not of a clear-cut allocation of responsibilities but rather of how to manage these shared responsibilities. The challenge comes from the fact that functional responsibilities – i.e. financing, regulating, monitoring – within each policy area are often not clearly defined or inconsistent (OECD, 2019[68]). The lack of clarity in the assignment of responsibilities is an important obstacle in ensuring overall institutional efficiency and local political accountability, which in turn is also linked to lower levels of trust in government (OECD, forthcoming[17]).

Over the past decades, an overall trend in the OECD has been in favour of decentralisation as a way to manage mutual dependence between national and subnational levels of government to achieve common objectives. Today, 40.4% of public expenditure in OECD countries is undertaken at a subnational level (OECD, 2019[68]). The forms and extent of decentralisation vary greatly from one country to another – and even within the same country. There are also varying degrees of upward and downward accountability and central government control. The trend has also been towards more differentiated (or asymmetric) governance systems at the subnational level in certain countries, with different responsibilities assigned to regional and local governments – at the same level of government, depending on their capacity, population (urban or metropolitan areas), and certain characteristics like geographic characteristics (e.g. islands) (OECD, 2019[68]).

Scale matters and it is functional areas rather than administrative boundaries that are important to the implementation of many policies for addressing regional inequalities. The OECD has empirically documented the productivity penalty that results from administrative fragmentation in metropolitan areas and has shown that strengthening urban-rural linkages can generate economic, social and environmental dividends for both urban and rural residents alike and contribute to bridging urban-rural divides (OECD, 2015[69]).

Across the OECD, inter-municipal, inter-regional and cross-border co-operation, metropolitan governance arrangements and “regionalisation”, i.e. the strengthening of regions (OECD, 2022[70]; 2019[68]) have been leveraged for physical infrastructure provision where the efficient scale often exceeds the boundaries of individual regions or localities, and for investments in human capital development and innovation where administrative and functional boundaries may not coincide. Co-operation among subnational governments is important also for subnational public service delivery, especially in the case of small or lagging regions with limited resources. However, co-operation rarely occurs spontaneously, hence the need for national governments to provide the right incentives for this co-operation to happen.

Poor government effectiveness at the subnational level severely limits the prospects of regions (OECD, 2019[68]). The capacity of subnational governments to design and implement policies and public investments effectively and to fund and deliver the public goods and services for which they are responsible, is crucial for them to be meaningful partners. Unfortunately, there is wide heterogeneity in the level of capabilities of subnational governments in OECD countries and, often, subnational capacities suffer from significant limitations, be they in investment financing, policy design and implementation, or governance more broadly (OECD, 2019[71]).

Although measuring government quality is notoriously difficult, it has become increasingly clear that many regions that are either lagging or declining have much weaker institutional systems than more developed ones (Charron and Lapuente, 2013[72]). Some research has demonstrated that weak institutions, in general, and poor-quality government in particular constitute a crucial obstacle to development (Rodríguez-Pose, 2013[73]). Poor institutions affect essential growth-promoting factors, such as the returns on European Cohesion Policy (Rodríguez-Pose and Garcilazo, 2015[74]) and competitiveness (Annoni, 2017[75]). Poor-quality institutions can also curtail the prospects of economic development progress because regions cannot seize economic opportunities as they arise.

Sustained investment in fiscal capacity at the subnational level is essential to strengthen incentives for local policy makers to support a proactive approach to development while being accountable for the results achieved. Fiscal autonomy and reliance on own source revenues appear to help the catching-up regions more than those above the national average (Blöchliger, Bartolini and Stossberg, 2016[76]). This requires limiting unfunded and/or under-funded mandates to ensure subnational governments have the requisite resources to invest, provide services or manage policies, and ensure they are properly staffed (Rodríguez-Pose and Vidal-Bover, 2022[77]).

Most OECD countries have developed fiscal equalisation systems to mitigate regional differences in fiscal capacity and expenditure needs, each of them with different specificities. With the overarching goal of achieving fiscal equity among jurisdictions, fiscal equalisation aims to offset differences in revenue-raising capacity and/or public service costs with the purpose of allowing subnational governments to provide similar public services with a similar overall tax burden. However, evidence indicates that, while fiscal equalisation can effectively create a level-playing field in the fiscal arena across subnational jurisdictions, it is not typically designed to reduce regional income inequality, whether GDP per capita or adjusted household income per capita. However, there is considerable scope to leverage complementarities between fiscal equalisation policies and regional development policies to achieve better fiscal and economic outcomes (OECD, 2022[78]).

Building more qualitative strategic and administrative capacity is a fundamental dimension to improving subnational government quality. This refers to skills and competencies in strategic planning, policy and programme management, budgeting and finance, project appraisal, regulation, infrastructure investment, procurement, data management, stakeholder engagement, partnership building and monitoring and evaluation. Well-developed competencies in these areas allow regional and local authorities to design and deliver public services and carry out administrative procedures effectively. Several OECD countries have invested in dedicated strategic capacity-building initiatives to boost subnational capabilities.

Strengthening subnational capacities in the broad sense requires commitment from all levels of government as well as from public sector staff to continually develop skills. It also requires fostering a learning culture, including providing knowledge exchange opportunities and encouraging continuous training, experience-sharing, learning-by-doing and innovation. Such efforts should be targeted and incremental, including with pilots and experiments, so as to avoid burdening subnational authorities, especially those with limited human and financial resources (JRC, 2022[81]).

Economic development policies, labour market policies, policies to support entrepreneurship and social entrepreneurship, and education and training policies all have a role to play to reduce regional inequalities. Integrated approaches can be built across these policy areas to help foster inclusive growth. Yet often this does not happen and policies are delivered “in silos”.

In some cases, this is because of institutional inertia and the organisational challenges of working together. However, there can also be trade-offs between meeting national policy objectives and fostering regional development and resilience. The search for efficiency in the delivery of national policies and programmes can sometimes lead to a lack of attention to the negative effects that a “one-size-fits-all” approach can have in certain regions.

Furthermore, interaction effects across regions need to be accounted for. An intervention that addresses a given challenge in one region – say expanding the affordable housing stock and improving transport infrastructure in a rapidly growing metropolitan area – may have unintended consequences elsewhere, e.g. a further loss of skilled workers in less dynamic non-metropolitan regions nearby. And in some cases, the investments required to stabilise relative incomes in economically lagging regions may be so large that they may not represent a good use of the available resources (OECD, forthcoming[40]).

While there is no simple policy prescription to mitigate regional inequalities, the policy roadmap presented in this chapter proposes five priorities for public action to help boost both balanced development and inclusion. Importantly, advancing on all five priorities requires implementing complementary measures in parallel that can reinforce each other and for which sequencing matters. For example, regions will only manage to develop high-value-added industries if they can offer employers a skilled workforce. But good job opportunities alone will not be enough to attract and retain skilled workers and their families: access to good-quality and affordable public services, notably housing, childcare, schooling and healthcare, equally matter.

Capitalising on the positive linkages presented in Table 5.1 that exist across the five priorities of the policy roadmap can offer a double dividend in terms of socio-economic progress and individual well-being. Furthermore, if smartly combined, actions across the five priorities can counteract a race to the bottom among regions within a country. Rather than having regions trying to undercut each other, for example, at the expense of tax revenues or environmental and labour standards, a combination of these priorities offers regions a productive way to compete with each other and better function in a “system” of regions, while lifting the economic performance of the entire country (OECD, 2019[34]).

Going forward, the OECD Recommendation on Regional Development Policy adopted by the OECD Council at the Ministerial level on 8 June 2023 will serve as a compass to guide governments’ efforts at different levels to promote and implement effective place-based regional development policy that improves the contribution of all regions to national performance and reduces inequalities between places and between people (OECD, 2023[84])

The Recommendation is articulated around ten pillars that are well-aligned with and can serve to reinforce the five priorities of the policy roadmap presented in this chapter, as illustrated in Figure 5.4. As such, the Recommendation can further support efforts by OECD governments to ward off persistent divides between regions.


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