3

Meeting the productivity challenge

The economy's productivity performance is the key to long-term growth and sustained increases in living standards. The Government's aim is that productivity in the UK will rise faster than in our major competitor countries over the next decade. To achieve this aim, it has put in place a long-term strategy built around macroeconomic stability and microeconomic reform through the five drivers of productivity growth: competition motivates firms to raise their game, innovating and minimising their costs. It rewards those firms that raise their productivity performance and reduces prices for customers; enterprise and innovation are at the heart of a dynamic business sector - new ideas for products and processes provide opportunities for productivity improvement. These chances can be exploited by entrepreneurs willing to take the risks necessary for success; investment underpins development of physical and human capital to produce productivity improvements in the future; higher skill levels not only help individuals and firms to be more productive but also encourage rapid take-up of new technologies and working practices; and alongside promoting macroeconomic stability and microeconomic reform, the Government can directly drive up public sector productivity. Improved productivity cannot be achieved by the Government alone. The sustainable improvements in opportunities and living standards that productivity growth promises can only be attained through an effort shared with managers and employees across the country, in public and private sectors alike.

THE PRODUCTIVITY CHALLENGE

Raising UK productivity

3.1 Raising productivity is one of the central conditions for meeting the Government's objective of high and stable levels of growth and employment and delivering sustained increases in living standards. This chapter sets out how and why the Government is working to increase productivity, the challenges that it faces and the environment that it is seeking to create.

3.2 Over the past three years, the Government has secured a platform of stability which provides the basis for raising productivity. The challenge ­ for business, unions, educationalists and other organisations across the regions ­ is together to tackle the productivity issue. Meeting this challenge offers the prospect of higher growth and increased employment opportunities with low inflation and low interest rates. The Government is determined not to pass up this opportunity.

3.3 The Government's strategy for productivity growth¹ is based around macroeconomic stability and microeconomic reform. It is an agenda for Government, management and employees across the economy to raise their performance and take the opportunity for sustainable higher growth.

UK productivity performance

3.4 Productivity can be defined in a number of ways. Labour productivity can be measured as output per worker or output per hour worked. Total factor productivity measures the combined productivity of capital and labour in the economy. Whatever measures are used, the UK has long displayed lower productivity levels than its major competitor nations, and continues to do so (see Chart 3.1).²

Chart 3.1

3.5 Increasing productivity growth and starting to close the productivity gap should increase trend output growth, and so deliver greater economic and employment opportunities, and better living standards. The Government set a long-term ambition in the 1999 Pre-Budget Report: that the UK will have a faster rise in productivity than its main competitors over the next decade. To further this aim, the DTI and the Treasury have a joint Public Service Agreement (PSA) target to 'improve UK competitiveness by narrowing the productivity gap with the US, France, Germany and Japan over the economic cycle'. The DTI is preparing jointly with the DfEE a paper setting out their strategy to help achieve this.

Meeting the challenge

3.6 Closing the productivity gap cannot be achieved without a broader drive from workforces and managers across the country. In October the Chancellor therefore invited the TUC and the CBI to work together on an agenda for improving UK productivity. Six particular areas were identified for joint working:

• remedying shortfalls in workplace skills and training;
• overcoming long-term under-investment;
• accelerating the use and spread of technology;
• making business more effective in adopting best practice and innovative techniques from elsewhere, and from one another;
• by benchmarking the best, making modern industrial relations more effective; and
• improving the quality of management at every level to make it genuinely world-class.

3.7 Together with educationalists and other organisations, the Chancellor invited the TUC and CBI to identify case studies of strong and poor performance. They have been asked to seek proposals from individual employers and unions for concrete improvements and to highlight issues for the Government to address. This will provide a starting point from which everyone can play a full role in raising UK productivity growth.

Macroeconomic stability

3.8 The first part of the Government's contribution to meeting the productivity challenge is to provide a platform of macroeconomic stability. Economic instability makes it difficult for individuals and firms to plan, save and invest ­ all of which are essential for productivity growth.

3.9 As Chapter 2 sets out, implementation of the Government's fiscal and monetary frameworks has provided low inflation, significantly reduced volatility in output growth and a more favourable environment for long-term investment.

3.10 UK productivity growth, slow throughout most of the 1990s, has shown recent signs of improvement (see Chart 3.2). But growth still trails that of the United States, which has seen an extraordinary acceleration in recent years (as discussed in Box 3.1).

Chart 3.2

Microeconomic reform

3.11 The Government's microeconomic reforms are focused around the five drivers of productivity growth: competition, enterprise and innovation, investment, skills and
public sector productivity. These address two issues:

• improving the quality and quantity of inputs (principally capital and labour); and
• improving the ways in which these inputs are used.

3.12 Competition drives better use of inputs. It motivates firms and individuals to improve their productivity, rewarding those who perform better and sorting them from those who
do not. The Government has a vital role to play through ensuring that the regulatory environment is right and that markets are as open as possible to the forces of competition.

3.13 Achieving these improvements requires enterprise and innovation. Entrepreneurs who are able to spot opportunities and to take on the necessary risks to achieve them are an energising force for productivity improvement. Equally, new ideas form the basis of many of these opportunities, whether innovations in processes or products.

3.14 The Government can assist the development of a more entrepreneurial culture by reducing the fear of failure and promoting the benefits of success. This intervention can be particularly effective in cities and disadvantaged areas, where barriers to entrepreneurship can be especially severe. Further, it can encourage innovation across the economy by providing incentives for companies to carry out more research and helping them to extract the best from innovations developed elsewhere.

Box 3.1: ICT, the 'new economy' and the opportunity for UK productivity The US economy has achieved an exceptional combination of high GDP growth and low inflation since the mid 1990s. This has been underpinned by strong productivity growth. In the year to the second quarter of 2000, US labour productivity grew by 5.1 per cent ­ the fastest rate since 1983. In manufacturing, productivity growth was even higher, at almost 7 per cent. Most economists agree that developments in information and communications technologies (ICT) are the principal cause of this strengthening in US productivity growth. Not only are companies that manufacture these technologies operating in a more productive way, but other sectors are investing heavily in ICT and there are 'spillover' effects from technological progress that give the broader economy the opportunity to improve. The US has led world productivity growth in recent years1. But the UK is well placed to benefit from these 'new economy' effects. A report by Merrill Lynch2 published in August 2000 rates the UK as the leading European country in terms of progress towards economic reform, and second only to the US globally. In some areas (such as mobile communications use and lack of barriers to entrepreneurship), the UK leads the US. Other new evidence shows that the UK has invested extensively in ICT over the past decade. This investment does not pay off instantly, and developments such as widespread use of the internet are too recent to have yet had a dramatic effect on productivity. But over the next few years, ICT should both give UK companies new opportunities to make productivity improvements and generate competitive pressure on them to do so. Combined with the effect of structural changes, this provides a basis for improving productivity growth in coming years, and so raising trend growth. As a recent study argued: "[T]here is now a good chance of a strong revival in productivity growth even without allowing for any special new economy effects. Adding the effects of ICT investment strengthens the likelihood of this."3

1There are, however, some important measurement issues affecting the comparative use of US data as referred to in Annex A. 2Benchmarking the New Economy, Merrill Lynch, 2000. 3'The New British Economy', Richard Kneller and Garry Young, NIESR, 2000.

3.15 The quality and quantity of inputs are both important. Sufficient investment needs to be available and it needs to be used productively. The UK is fortunate to have highly- developed capital markets. However, it has also suffered from prolonged under-investment in many areas. Despite strong growth in business investment, a cumulative investment gap with our competitors persists. The Government is working to improve this situation through ensuring that the tax framework is favourable, by promoting efficient financial markets, and by reversing a long trend of under-investment in the public sector.

3.16 Both the quality and quantity of skills available affect productivity. Addressing the barriers that keep people from developing their full potential in the labour market is not only vital to address deprivation, it is key to driving economic growth. The Government is providing new opportunities for individuals to improve their skills and for companies to make the most of their human capital. It has invested in modernising education, providing lifelong learning and addressing skills shortages to close the gap between the UK skills base and those of our major competitors.

3.17 Improvements in inputs will benefit public sector productivity as well as private sector productivity. Government has different mechanisms, however, at its disposal to motivate improvements in how these inputs are used. Achieving such improvements not only ensures better use of public money, but also increases productivity across the economy as a whole.

3.18 These five drivers are inter-related in principle: competition, for instance, not only drives improvements in the use of inputs but can also improve inputs (for instance competition between training providers). They are also inter-related in practice: policies to motivate entrepreneurship can strengthen competition, for example.

3.19 Since 1997, the Government has worked to reform and improve aspects of all five drivers (see Table 3.1).

Table 3.1: The Government's productivity reforms

Competition	Competition Act, 1998;
	Cruickshank Review of competition in banking;
	Utilities Act 2000, establishment of OFGEM to strengthen competition in gas and energy markets; and
	mergers reform, to take ministers out of merger decisions.
Enterprise and innovation	reforms to corporate tax framework; improvements to Enterprise Investment Scheme and Venture Capital Trusts;
	creation of Small Business Service;
	establishment of Regional Development Agencies (RDAs);
	Social Investment Taskforce;
	investment in research infrastructure, such as the Higher Education Innovation Fund and University Challenge Fund; R&D tax credit;
	initiatives to promote clusters, including planning guidance and funding for RDAs to co-finance business incubators;
	Enterprise Management Incentives;
	Corporate Venturing Scheme;
	promoting employee share ownership; and
	National Campaign for Enterprise.
Investment	2000 Spending Review: doubling of net public sector investment by 2003­04;
	Myners review of institutional investment; and
	reforms of capital gains tax and corporation tax (now reduced to 30, 20 and 10 pence rates) to encourage investment.
Skills	investments in education and training in 2000 Spending Review;
	national literacy and numeracy strategies;
	learndirect (the brand name for the University for Industry);
	Individual Learning Accounts; and
	work permit reforms.
Public sector productivity	Public Service Agreements setting performance targets covering every government department;
	creation of the Office of Government Commerce, to deliver £1 billion of savings on government procurement; and
	Public Services Productivity Panel, helping the public sector to innovate and deliver change.

The role of regional policy

3.20 The building blocks for productivity growth are grounded in the strengths of regions, and the rural areas and cities within them. The Government is committed to a regional policy that exploits these strengths, not through top-down initiatives but through regional and local initiatives enabled by a national Government that provides the necessary flexibility and resources.

3.21 Through establishing Regional Development Agencies (RDAs), the Government has enabled regions to take a lead in developing productivity and delivering national and regional policies. The Pre-Budget Report gives RDAs more flexibility to make the most of their role as strategic leaders of regional and local economic development (see paragraphs 3.64­3.67).

3.22 To promote enterprise in our communities the RDAs will work closely with Local Strategic Partnerships (LSPs). LSPs will bring together the local authority, all service providers (such as the police, schools and health and social services), local businesses and community groups in a single coalition for a community. By developing Community Strategies they will play a key role in maximising local strengths and addressing local problems.

The European dimension

3.23 The Government is committed to pursuing economic reform within the European Union, and the goal of raising productivity is shared by all EU member states. At the Lisbon summit in March 2000, EU Heads of Government established a new strategic goal for the new decade for Europe, "to become the most competitive and dynamic knowledge-based economy in the world". To achieve this, the Lisbon and Feira summits agreed concrete action plans and deadlines in a range of areas, including venture capital, electronic commerce, financial services and telecoms liberalisation.

3.24 By monitoring performance through the use of agreed Europe-wide structural indicators, Member States are able to learn from each other and to share best practice. At the Stockholm Council in March 2001, the Government will look to build on the progress made since Lisbon.

3.25 The Government has begun to make the changes necessary to meet the productivity challenge by ensuring that markets are able to operate efficiently and providing the incentives for businesses to grow. It has established a platform of macroeconomic stability from which microeconomic reform can proceed. Now it is necessary to build on this start and to seize the opportunity. This will ensure that increases in productivity performance are sustained, securing higher prosperity for all.

COMPETITION

The importance of competition

3.26 The Government has placed competition policy at the heart of its strategy to close the productivity gap. A competitive environment plays a central role in driving productivity growth in an economy. It encourages firms to innovate by reducing slack, putting downward pressure on costs and providing incentives for the efficient organisation of production. It also reorganises market structure, by reallocating resources away from inefficient firms.

3.27 In this way, competition creates an environment within which productive firms flourish. When more productive firms gain market share and less productive firms shrink and exit the market, the overall level of productivity rises. Attempts to quantify this effect in the US and UK have led to broadly similar results, attributing 30 to 50 per cent of manufacturing productivity growth to the sorting of productive and unproductive plants.³

Creating a framework for competition

3.28 The Government has introduced a range of measures to improve competition in the economy as a whole. It has modernised the legal and institutional framework in order to ensure that market discipline acts across the economy to motivate productivity improvements and to sort the more and less productive firms.

3.29 The Office of Fair Trading (OFT) has greatly enhanced powers to tackle anti-competitive practices, due to the Competition Act 1998, and to scrutinise the competition effects of financial services regulation, in light of the Financial Services and Markets Act. The Utilities Act, now in place, enhances the competition duty for the energy regulator.

3.30 It is also important to ensure that the competition authorities have the resources and structures to use these powers effectively. The OFT received an additional £10.2 million over three years in the 2000 Spending Review, and has a new Director General in John Vickers, former Chief Economist at the Bank of England.

3.31 The regime put in place by the Competition Act 1998 is already making an impact on competition in the UK:

• the OFT is targeting its resources on detecting and deterring as much anti-competitive behaviour as possible;
• in the first eight months of operation of the new Act, the numbers of complaints are running at around two to three times the rate received under the previous legislation;
• the OFT is currently formally investigating more than 15 cases of suspected infringement and has used its new investigation powers on numerous occasions ­ including exercise of powers to enter premises under warrant;
• it has dealt with a number of requests for informal advice and guidance from business and has received two applications for leniency;
• the deterrent effects of the Act are also becoming clearer. Some cartels known about by the OFT appear to have ceased after 1 March 2000; and
• in a number of cases the mere act of complaining to the OFT has led alleged infringers to modify their behaviour to the complainants' satisfaction.

3.32 The Government is also consulting on the creation of a new board structure for the OFT. The Government believes that in view of the increased responsibilities and powers under the Competition Act it is no longer appropriate for all the body's powers to be vested in one individual. This should depersonalise regulation and broaden the basis of the decision making that informs it.

3.33 The Government has announced how it plans to reform the process for controlling mergers to deliver the objective of depoliticising decisions and making competition the sole focus of assessment in the vast majority of cases. These changes require primary legislation to be implemented fully, but as a first step towards delivering these objectives, the Secretary of State for Trade and Industry has already committed himself to accepting the Director General of Fair Trading's (DGFT) advice on whether a merger should be referred to the Competition Commission, other than in exceptional circumstances.

Ensuring competition in particular markets

3.34 The new legal and institutional framework provides a powerful basis for ensuring effective competition. In key markets where competition has broader benefits for the economy as a whole (such as telecoms and banking), or where repeated questions about competitive pressure have been raised (such as the new car market), the Government has gone further to stimulate competitive intensity.

Banking

3.35 In Budget 2000, the Chancellor announced that the Government would act upon the recommendations of Don Cruickshank's report to improve competition and services to customers in the banking industry. The Government's immediate response included:

• a commitment to legislation, opening up access to payment systems and overseeing access charges; and
• referring the supply of banking services to SMEs to the Competition Commission.

3.36 In August 2000, the Government and the Financial Services Authority published their detailed responses to the Cruickshank review. The Government announced a number of new measures, including:

• reviewing self-regulatory codes such as the Banking Code to see if they deliver real consumer benefits. The Consumer Codes Review Group is being chaired by DeAnne Julius, who currently also sits on the Monetary Policy Committee, and has members from a range of backgrounds, including those from consumer groups and the industry. The Group has been asked to report by April 2001;
• encouraging the provision of comparative information for consumers on banking products;
• agreeing to a two year review of the effect of the Financial Services and Markets Act on competition;
• introducing CAT standards for credit cards and consulting on extending CAT standards to other financial products;
• reforming the Treasury's objectives on promoting competition in financial services; and
• developing a payments strategy for all government departments to ensure a coordinated approach to e-commerce and modernising government.

New cars

3.37 Following the Competition Commission's investigation into the new car market, the Government has introduced measures to increase competition in the supply and sales of new cars. As a result, consumers have seen significant reductions in the new car prices on offer from major manufacturers.

Supermarkets

3.38 In its recent report on supermarkets, the Competition Commission found the industry to be broadly competitive. However, it raised a concern about the relationship between supermarket chains and their suppliers. The Commission made a number of recommendations which would put relations between supermarkets and their suppliers on a clearer and more predictable basis, including a Code of Practice. The Secretary of State for Trade and Industry has accepted their recommendations, and has asked the DGFT to seek appropriate undertakings from the leading supermarkets. The DGFT is due to report back at the end of the year.

Water

3.39 As the Department of the Environment, Transport and the Regions has recently announced, the Government is committed to ensuring that water consumers also benefit from the improvements in price, quality of service and choice which competition can deliver. The Government is now carrying out further work, involving the industry regulator Ofwat, on how best to implement this commitment while protecting environmental and public health standards. Options being examined include licensing new entrants for common carriage, separate licensing of different parts of the industry and how to ensure new entrants have access on reasonable terms to water resources. A full statement of conclusions will be made.

Competition in the professions

3.40 The OFT is also conducting a review of the state of competition in the professions. This is focusing on whether statutory or self-regulation unnecessarily restricts or distorts competition in key markets such as accountancy and legal services and the associated conduct of the businesses active in these sectors. The OFT issued a consultation document in May which elicited a wide range of representations. Consultants were appointed in early July to carry out a detailed study, taking into account the points raised. They have since spoken to a range of organisations, including representatives of consumer interests as well as practitioners and their regulators.

3.41 The DGFT will submit a report to Ministers on the findings of the review at the turn of the year. The Government will then need to consider what reforms may be appropriate, balancing any detrimental effects on competition with other public policy objectives, and ensuring that any restrictions on competition are both proportionate and do not go further than is necessary to deliver policy objectives.

Airports

3.42 The Deputy Prime Minister has been conducting a review of competition in the airport sector. The conclusions of this review will be announced shortly. The Government will work actively in Europe for a new slot allocation regulation that promotes competition and efficient use of capacity.

Communications

3.43 The Government is to publish a Communications White Paper later in the year on its vision and objectives for communications in the twenty-first century, including its regulation in the age of convergence of broadcasting and telecommunications. In parallel, the UK is working with its European partners to modernise and make more flexible European Union telecommunications regulation, ensuring that competition and the consumer are centre stage.

ENTERPRISE AND INNOVATION

3.44 A dynamic environment with opportunities for enterprise and innovation is vital to improving economic performance. The Government wants to make the UK the most attractive environment for business in Europe, removing obstacles to entrepreneurship and promoting the development and spread of new ideas. Productivity improvements thrive in a climate of new ideas, new businesses and new opportunities.

3.45 The Government is particularly concerned that these opportunities are open to everyone. If entrepreneurship is confined to a narrow segment of society, not only are many people denied the chance to succeed, but also the economy wastes a valuable resource for fulfiling its potential.

Improving the tax system

3.46 To provide the right incentives for enterprise, the Government has undertaken radical reforms of the tax framework for businesses, including:

• reforming corporation tax, making the UK main rate of corporation tax the lowest among major industrialised countries;
• reducing corporation tax for SMEs, with a starting rate of 10p which is the lowest in the EU. The average corporation tax bill of a small company has been reduced by nearly 25 per cent since 1997;
• introducing a capital gains tax taper reducing the effective tax rate on business assets to 10 per cent after four years; and 40 per cent first year capital allowances for SMEs, made permanent in Budget 2000; and
• reforming the double taxation relief system, introducing for the first time in the UK a new system of on-shore pooling. This removes the incentive for mixing profits in an offshore holding company and makes it available in non-abusive situations to all UK companies.

3.47 In this Pre-Budget Report, the Government is announcing further initiatives to make the UK the best possible environment in which to do business. Building on announcements made in Budget 2000, it is:

• planning to abolish from April 2001 the requirement to withhold tax on interest and royalties between companies within the charge to corporation tax. Subject to consultation on the details, legislation will be introduced in Finance Bill 2001. This follows the announcement of the abolition of withholding tax on bond interest and other payments in Budget 2000;
• launching the next stage in the reform of the taxation of intellectual property, goodwill and other intangible assets. More than 80 responses were received to a Technical Note setting out the options, which was published by the Inland Revenue in June 2000, and the Inland Revenue is publishing alongside this Pre-Budget Report a further Technical Note setting out how a new regime could operate in light of these responses. The Government intends to legislate in Finance Bill 2001;
• easing the impact of VAT on SMEs (see Box 3.2);
• proposing to extend the on-shore pooling rules to allow relief for eligible unrelieved foreign tax, even if it arises at several levels in a chain of companies overseas. In addition, the Government will be acting in Finance Bill 2001 to ensure that the calculation of foreign tax applies in all cases as originally intended;
• publishing proposals to simplify and modernise the legislation concerning corporate debt, financial instruments and foreign exchange gains and losses in an Inland Revenue Technical Note; and
• considering responses to the proposals for simplifying National Insurance contributions for employees issued as a Technical Discussion Paper by the Inland Revenue in June. These responses have been generally supportive and have given some guides to further areas of interest. The Government will respond in detail.

Box 3.2 Easing the impact of VAT on SMEs The Government is proposing to introduce a major package of measures from April 2001 to allow small and medium sized enterprises (SMEs) to manage their entry into the VAT system, reduce their VAT administration burden and improve their cash flow. The package will include: extending the benefit of the cash accounting scheme to 40,000 traders by expanding the turnover limit from £350,000 to a new consolidated SME turnover level for VAT of £600,000. This will help more SMEs manage their VAT, while easing their cash flow burdens; allowing at least 100,000 more businesses to benefit from lower compliance costs through the ability to file VAT returns on an annual rather than quarterly basis. The upper turnover limit for qualification will be raised from £300,000 again to the new consolidated SME turnover level of £600,000; providing better advice for SMEs, through launching a lifelong business support programme and a national contact centre for general enquiries, extending the national importers and exporters programme and developing e-business measures; increasing the VAT threshold in line with inflation, keeping the UK threshold at the highest level in Europe. This will ensure that another 8,000 businesses will be entitled to operate without the need to charge VAT; and consultation on rationalising the frequency of VAT payments due from traders under the annual accounting regime and introducing a lower SME turnover limit of £100,000, under which these SMEs will be able to: use a "flat rate scheme". Within this scheme, SMEs will be able to calculate their VAT liabilities as a percentage of their turnover and avoid having to account internally for VAT on all of their purchases and sales. The scheme would be designed to generate broadly the same amount of VAT payable, but would be simpler to use; and enter the annual accounting regime immediately rather than having to wait until they have completed a year of VATable trading.

Encouraging enterprise

3.48 The right tax framework can make a critical contribution to achieving an environment in which enterprise and innovation flourish. The Government will continuously review the tax system to ensure that it is meeting this goal. But there is more that the Government can and has done to improve the situation for business.

Reforming insolvency and business rescue

3.49 The fear of failure can act as a powerful disincentive to potential entrepreneurs considering starting their own businesses. Inefficient or inappropriate treatment of businesses in difficulty may stifle entrepreneurs who could otherwise have turned their situation around. The Government is examining the possibilities for reforming corporate rescue and insolvency and the report of a review group on this subject was published on 2 November.

3.50 The report recommends that the Inland Revenue and Customs and Excise should adopt a more commercial approach. In response, a new Inland Revenue/Customs and Excise unit is being set up to consider proposed rescue plans put forward by businesses. The unit will ensure that from April 2001 rescue proposals put forward by businesses (so-called Voluntary Arrangements) receive individual consideration. The unit will consider proposals in the same way as commercial creditors considering the full range of discretion available, and recognising that helping a business through a difficult period is often the best way to secure repayment of debts. New and strict timetables for dealing with vulnerable businesses will be published and adhered to.

3.51 A consultation is now under way in relation to a number of other recommendations and options for change. These include:

• a "single gateway" procedure for trading companies, simplifying the currently wide range of options by allowing the courts to make a temporary administration order when a petition to wind up a trading company is presented;
• the development of a simple financial health check for small firms which will encourage them to raise the standard of their financial and business management;
• the removal of the right of a floating charge holder to veto the making of an administration order; and
• a change in the law to ensure that the extent of a fixed charge over a company's book debts be determined at the date of the company's entry into either a Voluntary Arrangements moratorium or administration.

Limited Liability Partnerships

3.52 The Government has modernised the legal framework for business in the UK by introducing Limited Liability Partnerships (LLPs). Designed to appeal particularly to the professional business community, this arrangement allows members to limit their liabilities but structure their activities as a partnership. LLPs will be available from 6 April 2001.

3.53 In order to ensure that the commercial choice between using an LLP or a partnership is not distorted, the LLP will be treated for tax purposes as a partnership. The Government is concerned to ensure that the new structure is not used to create an unfair advantage through tax avoidance and the Inland Revenue is publishing alongside this Pre-Budget Report its proposed way forward and inviting comments.

Encouraging employees to share in success

3.54 Employee share ownership can help to align the incentives of all those in an enterprise. In order to encourage employees to take a stake in the success of their companies, the All-Employee Share Ownership Plan (AESOP) was introduced in Finance Act 2000. Over 160 companies have applied to set up a new AESOP, with 20 company schemes (covering more than 30,000 employees) already approved. By 2005, half a million more employees are expected to have shares in their companies through schemes of this type, bringing the total number who have a stake to over 2.5 million.

3.55 To encourage further employee shareholding and foster a more enterprising and productive relationship between firms and their employees, the Government extended in Finance Act 2000 the more generous business assets rate of capital gains tax taper relief to all disposals of shares held by employees in their companies where the companies were wholly (or almost wholly) trading. So that more companies and employees can benefit and to reduce their compliance costs, the Government is proposing to extend the benefit of the business assets taper to include employees of a range of non-trading companies from 6 April 2000. The Government will consult regarding the appropriate level of revenue protection.

Employer NICs

3.56 Since 6 April 1999 National Insurance Contributions (NICs) have been payable by both the employer and employee on the gains arising when share options are exercised outside an Inland Revenue approved scheme, if the shares are readily convertible into cash. The rapid growth in the stock market since April 1999 has led to concerns by companies with volatile share prices that their exposure to an unpredictable NICs liability could endanger their investment strategies and damage their future growth by deterring investors.

3.57 The Government announced on 19 May 2000 that it was introducing legislation in the Child Support, Pensions and Social Security Act to allow the employer's NICs to be recovered or transferred to the employee, following agreement between companies and their employees. This will solve the accounting problem and help smaller start-up companies with limited cash flow.

3.58 Having addressed the concern over share options issued after 19 May 2000, new legislation will be introduced to cover share options issued between 6 April 1999 and 19 May 2000. Under these rules, companies will have the option of removing all uncertainty through settling their NICs liabilities on those options based on market values at the time of this Pre-Budget Report. This will remove future growth from the charge to employer's National Insurance. Together with the option of transferring liability to the employee, this will solve the difficulties for those high growth firms.

Encouraging SME financing and growth

3.59 A thriving small and medium sized business sector is important to driving productivity growth. In particular, the creation and growth of new firms promotes the exploitation of new ideas and opportunities, and sharpens competition.

3.60 Smaller, high risk companies often experience problems recruiting and remunerating key employees, and, in acknowledgement of this, the Government introduced in Budget 2000 tax-favoured Enterprise Management Incentives. This allowed the individual company to issue up to £100,000 of tax-favoured share options to up to 15 key employees. This has proved popular and, since the launch in July, over 100 companies have notified the Inland Revenue that they have granted options to a total of over 500 people, and it is estimated that 2,500 companies will use EMIs over the next three years.

3.61 However some companies have commented that they would like more flexibility, including the opportunity to issue these options to all their employees. The Government will therefore consult on replacing the limit on the number of employees with a total amount of tax-favoured options that the company can allocate in the way best suited to its business. In addition, rather than keeping the limit at the current level of £1.5 million, the Government will consult on raising the limit to £2.5 million. These two changes will increase the benefits of EMIs and make them available to more employees.

3.62 The Government has introduced a wide range of measures designed to boost the supply of risk capital finance to SMEs with growth potential, which might otherwise be under-supplied by the market. In particular, to improve the supply of equity to smaller, higher-risk companies, the Government has improved the Enterprise Investment Scheme (EIS) and Venture Capital Trust (VCT) scheme. Total investment to date is around £750 million for EIS and £1 billion for VCT. Encouraging a different source of capital for smaller companies, the Government has introduced a corporate venturing tax relief scheme from April 2000. This is designed to promote mutually beneficial investment by corporates in smaller higher risk trading companies.

Box 3.3: The Small Business Service To maximise the opportunities for start-ups and small businesses, the Small Business Service (SBS) was launched in April 2000. With the recruitment as Chief Executive of David Irwin, founder of Project North East, one of the UK's leading enterprise and economic development agencies, the SBS is a strong voice for small business at the heart of Government. The SBS will make Government support for small business simpler and more coherent, and help small firms deal with regulation. In its first six months of operation, the SBS has: commenced a research programme to ensure a detailed understanding of the needs of small businesses and to establish performance measures; launched a Small Business Investment Task Force in September 2000 under the chairmanship of Sir David Cooksey to advise on ways to stimulate the supply of SME finance, including the establishment of regional venture capital funds. An extra £100 million for these purposes was announced in Budget 2000; launched the UK High Technology Venture Capital Fund in July 2000. The Fund has now raised well over £100 million towards its target of £125 million and is already making investment commitments to UK-based specialist technology funds; and started to transform the existing Business Link partnerships into a slimmer, fitter, higher-quality network, by selecting new local franchises to be operational from April 2001. To date, 39 of the existing Business Links have been awarded franchises on the quality of their applications, in five areas other operators have been selected, and the SBS is currently out to tender on the final area. The SBS has recruited nine Regional Managers from the private who will be based in the Regional Development Agencies from April 2001. With £30 million funding from the Invest to Save Budget and Budget 2000, the SBS is also currently building up its 'Gateway' ­ to provide high quality information and advice on-line and via call centres to 3 million businesses, compared with the 600,000 that currently access Business Link support. The SBS is committed to promoting enterprise across society and particularly among disadvantaged groups, including women who currently originate only 30 per cent of new business start-ups in the UK. In the November 1999 Pre-Budget Report, the Government allocated £30 million to the Phoenix Fund to invest over three years in promoting better access to business support and finance in disadvantaged areas. This funding was more than trebled in the 2000 Spending Review. The SBS manages the Phoenix Fund, the results of which include: 500 volunteer business mentors have been appointed, with a further 500 to be in place by April 2001; bids for a £3 million fund for new and existing community finance initiatives are now being evaluated ­ the fund has been seven times oversubscribed and a second bidding round will take place by autumn 2001; over 200 bids to the £12 million (over three years) Development Fund are now being evaluated. The Fund was set up specifically to promote innovative enterprise support in disadvantaged areas; and the Inland Revenue is working with the SBS to identify how the Revenue's Business Support Teams can support new and small businesses in disadvantaged areas. It will have agreed plans in place for April 2001.

Box 3.4: An Urban Renaissance: successful towns and cities The Government is committed to maximising the potential of all towns and cities ­ to build on success and ensure that thriving places continue to prosper, while helping those places that are currently falling behind. Successful towns and cities have always been at the heart of economic development and the creation of prosperity. The national economy depends on their success. The forthcoming Urban White Paper will set out, for the first time in 20 years, a comprehensive strategy for improving the performance of all towns and cities, while the National Strategy for Neighbourhood Renewal will set out how the Government intends to narrow the gap between the most disadvantaged communities and the rest. The Government's strategy is to create attractive places for individuals and business ­ places that create and share prosperity, and that provide good quality services that meet the needs of everyone. It builds on the challenge set to the Government by Lord Rogers' Urban Task Force, to create an environment which people and business find attractive. All towns and cities should: aim to be places where people want to live and businesses choose to locate ­ through efficient land use, quality design, modern infrastructure and sustainable use of resources; provide employment opportunities and support wealth creation by building on their economic assets and encouraging enterprise and innovation, promoting private investment and access to capital, providing economic opportunities for all and supporting lifelong learning, and adapting to the challenges of the modern economy; and provide high quality public services delivering decent homes, substantial reductions in crime, good schools and healthcare and efficient transport, to attract and retain dynamic people and enterprises. To ensure success, government at all levels needs to work with the people who know their towns and cities best. The White Paper will set out a coherent framework for delivering improved performance through national policies, regional strategies and local community action. For example: at the national level, the substantially increased resources provided by the 2000 Spending Review will from April 2001 help to reduce crime, boost employment and improve education, health and housing ­ especially in the most disadvantaged areas (supported by Public Service Agreements ­ see Chapter 5); in the regions, an enhanced role for Regional Development Agencies (RDAs) will enable them to use their substantially increased budgets and increased funding flexibility and single cross-Departmental budget from April 2002 to focus their help on underperforming towns and cities; at the local level, modernised local authorities will help to develop Community Strategies for their local areas and promote Local Strategic Partnerships (LSPs); and in every community, the forthcoming Action Plan for Neighbourhood Renewal will help to galvanise action. In order to improve their performance, less successful cities and towns need to build a better understanding of their economic strengths and capitalise on their assets. Many are already doing so ­ and there is a major opportunity to learn from what works both elsewhere in the UK and internationally. One key constraint to exploiting markets in underperforming areas is access to capital. The Bank of England will shortly publish the first in a new series of reports on finance for small businesses in disadvantaged communities. Building on this, the Government will: fund the RDAs to work with Local Strategic Partnerships and others on City Growth Strategies, which will map the economic asset base and develop detailed action plans for business growth in a number of key cities over three years; and sponsor with the private sector the Inner City 25, which will showcase some of the fastest growing, unquoted companies in the most under-invested inner-city areas. The Government plans to introduce a package of measures to help regenerate the most disadvantaged communities and relieve pressure on the countryside by encouraging more development on brownfield land. For example: at the national level, the package includes a stamp duty exemption for the most disadvantaged communities, accelerated payable tax credit for cleaning up contaminated land, a package of VAT measures to reduce the costs of residential conversions and tax relief for creating new flats from underused space above shops. The Government will be working with the European Commission to introduce these measures consistent with EU state aids guidelines (see Chapter 6); at the local level, consulting on business rate relief for small businesses; town improvement zones financed by supplementary business rates; tax increment financing, to allow local authorities to retain and invest some of the additional local tax revenue resulting from successful regeneration; and the reform of planning obligations, including the option of impact fees; and at the community level, the Community Investment Tax Credit and Community Development Venture Fund recommended by the Social Investment Taskforce (set out below).

3.63 To take advantage of this increased supply, more SMEs with growth potential need greater understanding of venture capital and specialist advice on how to structure business plans to secure external equity finance, to make themselves 'investment ready'. There is evidence of a gap in this market, akin to the classic 'equity gap'. The Government has therefore asked the SBS, working with the Regional Development Agencies and in consultation with the Small Business Investment Taskforce and market practitioners, to make early progress in identifying measures to bridge this gap, with a view to harnessing the expertise of the private sector as rapidly as possible.

Regional Development Agencies

3.64 Regional Development Agencies (RDAs) are at the heart of the Government's agenda for promoting sustainable regional economic growth, enterprise and regeneration. They provide a key element in the delivery of the Government's strategy for improving UK productivity.

3.65 In the 2000 Spending Review the Government announced that RDAs would have a strengthened role as strategic leaders of economic development, with a key role in promoting innovation and enterprise in their regions. They are to have a substantial increase in resources and a significant increase in flexibility on how to use those resources. The RDAs' overall budgets will rise from £1.2 billion this year to £1.7 billion in 2003­04. Within this overall sum, RDAs will be subject to the same rules as other government programmes. From April 2002 the separate budgets from DETR, DfEE and DTI will be brought together in a cross-departmental Single Budget.

3.66 The Government welcomes the RDAs' enthusiasm in developing the Single Budget and has decided to take a major step towards this with significantly increased freedom from next year:

• more budgetary flexibility: with this RDAs will be able to target resources more effectively by doubling their flexibility to switch resources between programmes. RDAs may transfer up to 20 per cent out of any programme, with no limit on the amount that may be transferred into any programme, so long as it is consistent with delivery objectives; and
• a new Strategic Programme: RDAs will be able to switch resources into the new Strategic Programme for innovative schemes that meet their economic and other strategic aims. This Strategic Programme will be a test-bed for the Single Budget with new project and appraisal processes.

3.67 As part of this increased flexibility, through consultation RDAs will be asked to provide stretching outcome and output targets to ensure their activities deliver their strategic goals, matching flexibility with greater accountability. These measures give RDAs increased flexibility to spend where they can have the greatest impact in delivering national and regional policies next year, promoting enterprise, innovation and growth. Increased flexibility next year will ensure a smooth transition to the Single Budget the year after.

The Social Investment Taskforce

3.68 The Social Investment Taskforce (SIT), led by leading venture capitalist Ronald Cohen of Apax Partners & Co, reported to the Chancellor in October. Its report, Enterprising Communities: Wealth Beyond Welfare, recommended a five-point programme of action aimed at stimulating enterprise, investment and wealth creation in under-invested communities.

3.69 The report's five main recommendations were:

• a new Community Investment Tax Credit to encourage private investment in both not-for-profit and profit-seeking enterprises in under-invested communities;
• a new Community Development Venture Fund ­ a matched funding partnership between Government on the one hand and the venture capital industry, entrepreneurs, institutional investors and banks on the other;
• disclosure by individual banks of their lending activities to businesses in under-invested communities and the creation of a rating system to reward excellent performance. The SIT believes this should, if possible, be done on a voluntary basis, but if not, then legislation should require disclosure;
• greater latitude and encouragement for charitable trusts and foundations to invest in community development initiatives; and
• support for Community Development Financial Institutions, which provide finance and business support to enterprises just outside the margin of conventional finance; and the appointment of a high ranking "champion" for community development finance, with strong links to government.

3.70 The Government welcomes this innovative report and endorses its central conclusion, that enterprise and wealth creation are vital to building sustainable communities. The Government is already supporting the growth of community development finance for businesses in under-invested areas. In response to the SIT report, the Government will now do more:

• the Government believes that a tax incentive for community investment could prove effective in helping to bring more investment and expertise to the economic renewal of disadvantaged communities. The Government will consult widely on the proposal for a Community Investment Tax Credit, with a view to taking it forward as early as possible;
• the Government will work closely with the venture capital industry and others on setting up the first Community Development Venture Fund;
• the Government attaches great importance to making financial services available to all. To provide greater transparency, the Government will encourage banks to disclose their individual lending activities to businesses in under-invested areas. The Government will look at what obligations should be laid on banks in the context of the overall requirements being asked of them, for example in relation to Universal Banking Services;
• the Government welcomes the Charity Commission's plan to produce early next year new guidance on when charities can make programme related investments, and to issue further subsequent guidance on the role which charities can play in community development finance; and
• the Government believes that the Taskforce has set out very clearly the challenges that lie in front of the community development finance sector in the UK, if it is to achieve its potential. It must be a matter for the sector to respond to those challenges, but the Government will continue to play an active role in support, for example through assistance with training. The Government also recognises that there may be a role for an informal "champion" and will consider how to take this suggestion forward.

Promoting an enterprise culture

3.71 Positive attitudes to enterprise, business and risk-taking are fundamental to an entrepreneurial economy. Often, the UK has been compared unfavourably with some of its rivals on this score⁴. The Government is addressing the need for a more pro-enterprise climate.

3.72 The Government is supporting 'Enterprise Insight', which was launched by the Prime Minister in May 2000. The campaign, led by Chief Executive Oonagh Mary Harpur, aims to create over the next 5 to 10 years a more enterprising culture across the UK, by:

• highlighting the contribution enterprise makes to jobs and wealth creation;
• promoting SMEs as much as big businesses;
• encouraging innovation, change and risk-taking; and
• celebrating successful entrepreneurs and growth companies.

3.73 The campaign will be spearheaded by the Ambassador Programme, where hundreds of entrepreneurs and business people will take part in a range of nationwide enterprise activities, including discussion forums with young people and mentoring young entrepreneurs.

3.74 The Government is helping to foster a spirit of enterprise among young people by providing £10 million this year to boost enterprise activities in schools. This money is being used to:

• improve the quality of the national network that brings schools and businesses together, in readiness for April 2001, when the new local Learning and Skills Councils will be the focal point in the regions for closer school-business liaison;
• increase the scale of enterprise programmes in schools, such as Young Enterprise and Understanding Industry; and
• improve the quality of work experience for pupils and business placements for teachers.

3.75 In Budget 2000, the Government announced the New Entrepreneur Scholarships to provide budding entrepreneurs in disadvantaged areas with the management and business skills they need to turn their business ideas into reality. Three pilot schemes in Manchester, Greenwich and Plymouth have been launched, with more than 30 participants.
The programme will run nationally from September 2001, when 200 places will become available.

Encouraging innovation

3.76 The successful exploitation of new ideas is a crucial component for productivity growth. The UK needs world-class research in universities and the private sector, and the ability to capitalise upon the innovations it produces. But it has not always performed to its full potential in this field. Research and development intensity in the UK, for instance, is lower than in the US, France, Germany or Japan. Since 1997, the Government has reinforced the innovation base and worked to ensure that the economy makes the most of good ideas. Analysis for the pharmaceutical task force has shown that the UK pharmaceutical industry is the most productive in the world, as measured by patents per amount invested.

3.77 To encourage research and development by SMEs, the R&D tax credit has been introduced. This raises the tax relief for qualifying current R&D spending by SMEs from 100 per cent to 150 per cent. The enhanced relief will reduce the cash cost of research and development by 30 per cent where the company pays the small companies rate of corporation tax. Firms not yet in profit can take the relief as a (discounted) cash payment, reducing their costs by 24 per cent.

3.78 The Government will be evaluating the efficacy of the R&D Tax Credit for SMEs once sufficient information on its take-up becomes available. The Government will also be examining the case for complementary measures aimed at boosting R&D across business, drawing on existing analyses and on the research of the CBI, the Engineering Employers Federation, and other interested parties.

3.79 The Small Business Research Initiative (SBRI), announced in the Science White Paper, will encourage more high-tech small firms to start up, or to develop new research capacity. It will open up to SMEs R&D procurement programmes from departments and Research Councils worth up to £1 billion. It has the target of procuring £50 million of research under these programmes from small firms. Each participating department will aim to procure at least 2.5 per cent of their R&D from small firms, with Research Councils moving to meet the target over time.

Making the most of the radio spectrum

3.80 The radio spectrum is an essential raw material for many of the UK's most promising industries of the future. But the amount of spectrum available is finite ­ and ensuring that it is used efficiently is essential if the growth of these industries is not to be impeded.

3.81 The Government has taken steps in recent years to improve the UK's spectrum management regime ­ to provide that spectrum users face the right incentives to use it efficiently. It has introduced administrative pricing and auctions as spectrum
management tools.

3.82 The auction of spectrum for third generation mobile services earlier this year demonstrated the importance of spectrum to commercial operators. It also demonstrated that auctions are a very effective way of ensuring that spectrum is assigned to those who value it most.

3.83 The next decade will see significant growth and innovation in wireless communications. The UK has been successful in making spectrum available for new services but it is essential that the framework for spectrum management keeps up with the pace of change if the UK is to remain at the forefront of the information revolution. To help it move forward in this area, the Government will commission an independent review of spectrum management, to report to the Chancellor and to the Secretary of State for Trade and Industry. The review will advise Government on the principles which should govern spectrum management and what more needs to be done to ensure that all users, including non-commercial users, are focused on using their spectrum in the most efficient way possible. In doing so, it will consider the use of spectrum management tools such as spectrum valuation, pricing and trading.

Taking advantage of ICT

3.84 The Government is acting to ensure that the UK takes advantage of the possibilities offered by ICT (see Box 3.1). It is encouraging investment in ICT, access to and use of the internet, and the development of ICT. Initiatives to date include:

• providing tax incentives ­ such as 100 per cent first year capital allowances for small enterprises investing in ICT for three years from April 2000;
• launching UK Online for Business ­ to help UK small businesses exploit the benefits of ICT by raising small business awareness and understanding and providing advice and signposting. An expert call centre advice service will be developed;
• promoting competition in telecoms ­ by supporting Oftel's plans for the the unbundling of the local loop and the successful auction of third generation mobile telephony;
• reforming the legislative framework ­ through the Electronic Communications Act which provides for legal recognition of electronic signatures;
• developing a network of 6,000 UK Online Centres where people will be able to access the internet ­ to include around 1,000 ICT learning centres, of which over 600 have now been funded;
• £1 billion investment in schools' ICT over three years; and
• £1 billion over three years to get government services online.

3.85 The Government has set targets for the UK to be the best place to do e-commerce by 2002, and, by 2005, for everyone who wants it to have internet access and all government services to be online. It has already beaten its target to have 1.5 million SMEs online by
2002 ­ 1.7 million are already online.

3.86 But getting business online is only the first challenge. Ensuring e-commerce brings real business benefits is the next step. A recent DTI study found that businesses representing 27 per cent of UK employment are trading online, putting the UK on a par with the US and Canada and ahead of Germany and Sweden. The Government is aiming to increase from 450,000 to 1 million the number of SMEs trading online by 2002.

3.87 The DTI study concluded that the last year had seen good progress by small and micro businesses but that more is required in some respects before they can be considered up with the best in the world. For example, the UK is fifth on the measure of micro businesses trading online with 14 per cent, compared with Germany the best performer at 21 per cent.

Making the most of UK universities

3.88 UK universities are a vital economic resource, nationally and regionally. If they are to play a full part in improving the UK's economic performance the universities need the resources to sustain a world-class science base and the incentives and framework to encourage greater interaction with business. Since 1997, the Government has introduced a number of initiatives to improve universities' contribution to closing the productivity gap.

3.89 The Higher Education Innovation Fund, announced in the Science and Innovation White Paper, is designed to build on universities' potential as drivers of growth in the knowledge economy. Worth £140 million over three years, it seeks to encourage knowledge transfer and help universities in their efforts to promote productivity and competitiveness in small firms. It incorporates the existing Higher Education Reach Out to Business and the Community (HEROBC) fund, tripling existing funding by the third year. The last round of HEROBC funding, in August, allocated £22 million to 50 bids from universities and colleges.

3.90 The University Challenge Fund enables commercial initiatives to be developed from university research to a point where they can raise venture capital. So far, 37 institutions have been involved and 80 projects have received investment from the fund. The first round of funding totalled £45 million, and there will be a second round of funding worth £15 million.

3.91 The Science Enterprise Challenge provides funding to teach science, engineering and technology graduates entrepreneurial skills. In addition to the £29 million already allocated, the 2000 Spending Review added £15 million to its funding. 40,000 students will benefit from the scheme by 2004.

3.92 The Joint Infrastructure Fund, announced in the 1998 Comprehensive Spending Review, allocated £750 million to start reversing years of underinvestment in the science infrastructure. The Wellcome Trust provided £300 million of this money.

3.93 The Science Research Investment Fund, announced in July, continues this partnership with the Trust and will invest a further £1 billion in 2002­03 and 2003­04. The Wellcome Trust will contribute £225 million.

3.94 The potential of public sector research establishments, which have produced innovations such as the liquid crystal display, has often not been fully exploited. A report commissioned from John Baker recommended a range of measures. In response the Government has established a £10 million fund for commercialisation of public sector research. It has made changes to civil service rules to give government scientists better incentives and rewards, and Partnerships UK will be advising research establishments on the exploitation of their research.

Box 3.5 Universities and productivity - a key challenge Universities contribute to productivity in two key ways: generating skills ­ through their output of trained graduates and postgraduates; and generating knowledge to underpin innovation ­ through their research and in their direct engagement with business. On both counts UK universities have been highly successful. The annual output of graduates has doubled in the last two decades, yet economic returns to higher education both for graduates themselves and the wider economy have stayed high. UK research punches above its weight: with 4.6 per cent of world science spending, the UK accounts for 8 per cent of science publications and 9 per cent of citations. Of 152 fields of research, the UK is a world leader in 26. Finally, the contribution to business growth and creation is growing at regional and national level, with universities active in commercial spin-outs, business incubation and other forms of knowledge transfer. The regional role of universities is increasingly clear ­ especially as collaborators with business and as centres of growing clusters of high-tech firms. Productivity in the knowledge economy will increasingly depend on the ability to innovate and deploy skills, so the underpinning role of universities will remain vital. But to fulfil this role, universities will need to respond to major technological and market change ­ in particular: the increasingly global market for top academic talent; and the growth of web-based learning and research, which offers new delivery channels and new market opportunities ­ but also threats ­ for universities. With a view to these challenges, the Government has since 1997 made significant real terms increases in university funding. It has started to reverse a huge backlog of capital investment in university research and, through schemes like University Challenge and Science Enterprise Challenge has given universities new incentives to engage with business, commercialise their research and become more entrepreneurial. The Government aims to achieve 50 per cent participation of those aged 18-30 in higher education by 2010. In the coming years, the challenges for the Government will include: getting the funding right: ensuring that universities have the resources they need, and from the right sources ­ with taxpayers, graduates and students paying their fair shares; getting the incentives right: ensuring that government funding mechanisms promote excellence and innovation, without stifling diversity; promoting world class institutions ­ nurturing the UK's best universities, while ensuring that the sector as a whole thrives; and delivering on the commitment to widen access to higher education. But the challenge is not just for the Government: universities will have to become more dynamic and business-like to compete. In an international market they will need to understand and exploit their comparative advantage; and businesses will need to do more to exploit the wealth of skills and knowledge in universities.

INVESTMENT

Investment in the UK

3.95 The UK has, historically, suffered from problems of under-investment. The greater economic stability now being achieved will promote investment. Low and stable inflation and sound public finances provide individuals and businesses in the UK with the confidence to invest, and attract internationally mobile capital flows in greater volumes and at lower cost. UK long-term interest rates, and hence the cost of capital, have fallen. Business investment, as a proportion of GDP, reached record levels in 1999 which are being maintained this year.

Encouraging investment

3.96 To encourage investment, the Government has reformed the tax system by:

• cutting corporation tax rates to 30, 20 and 10 per cent, their lowest ever levels. The 10 per cent rate, in particular, allows small and growing companies to retain more of their profits for re-investment and growth;
• introducing a capital gains tax taper, reducing the effective tax rate on business assets to 10 per cent after four years; and 40 per cent first year capital allowances for SMEs, made permanent in Budget 2000; and
• expanding the scope of the consultation on the taxation of disposals of substantial shareholdings to consider the issues surrounding a deferral relief regime in more detail and, as part of a wider discussion on competitiveness, whether alternative approaches, including the possibility of a form of exemption regime, might be appropriate. The Inland Revenue is publishing a further Technical Note alongside the Pre-Budget Report.

3.97 A stable macroeconomic climate and the right tax framework are vital. But it is also necessary to ensure that funding for investment is available to those who need it and can best use it. This means making sure that capital markets are able to work efficiently in allocating investment across the economy.

The Myners review

3.98 In Budget 2000, the Government asked Paul Myners to conduct a review of UK institutional investment. As part of his ongoing review, he has written a letter to the Chancellor and the Secretary of State for Social Security outlining two proposals. These are summarised in Box 3.6.

Business angels and financial promotion

3.99 Individual investors in smaller growing companies ("business angels") provide a key link in the financing chain, helping enterprises to become 'investment ready' for subsequent venture capital funding. Business angels can also bring additional finance and industry expertise to venture capital funds.

3.100 To reduce the time and cost involved for both SMEs and venture funds in raising capital from private investors, the new Financial Services and Markets Act will exempt communications to a defined class of high net worth or sophisticated individual investors from the normal financial promotion rules. The draft Financial Promotion Order, which should come into effect by July 2001, proposes to define high net worth investors as those with annual income above £100,000 or net financial assets above £250,000.

Box 3.6: The Myners review of institutional investment In Budget 2000, the Government asked Paul Myners, of Gartmore Investment Management, to lead a review of institutional investment in the UK. The Myners Review issued a consultation document in May 2000 covering a range of issues related to life assurance and pension funds, which has received more than 200 responses from a wide range of bodies. The review team have held further discussions with many industry participants, and will report in time for Budget 2001. Mr Myners has today written an an open letter to the Chancellor and the Secretary of State for Social Security, available on the Treasury website (www.hm-treasury.gov.uk). This sets out two proposals, the first on the Minimum Funding Requirement (MFR) and the second on the regulation of investment in limited partnerships. The Minimum Funding Requirement The letter responds to the joint DSS/HM Treasury consultation now under way on the MFR. In considering the issue, Mr Myners has had in mind twin objectives: to ensure proper protection for members of defined benefit pension schemes; and to examine and seek to ameliorate distortions in investment decision-making. The letter argues that the MFR is seriously inadequate and should be replaced, because: it increases the cost of providing defined benefit pensions by distorting asset allocation. This is due to its use of a set of reference assets to calculate discount rates for liabilities; and it does not provide necessary or effective protection. It only records the state of a fund at one point in time, despite the fact that financial markets and economic conditions change constantly, and it is not designed to protect against fraud. The interim conclusions of the Review also suggest that the MFR encourages the move from defined benefit to defined contribution pensions, and, due to its use of standard and fixed assumptions for calculating assets and liabilities, may give trustees a spurious sense of certainty about funding. The letter argues that the MFR should be replaced by an enhanced compensation scheme for fraud, mandatory arrangements for safe custody of pension fund assets, and transparency and independent review of pension funds' finances and plans. Each defined benefit fund would produce a 'transparency statement'. This would set out how it planned to invest its assets to enable it to meet its obligations to pay pensions. This statement would be made publicly available, so that members of pension schemes were able to see for themselves the state of the fund and its future plans. Trades unions, pensioner support groups, the personal finance media and the creditors and shareholders of the sponsor company would also have an interest in the plans and would be able to comment. Members of the pension scheme would be able to raise any concerns with trustees, and if sufficient numbers of beneficiaries voted in favour, the fund would have to commission an independent report on its plans. The Occupational Pensions Regulatory Authority (Opra) would be expected to take an interest in funds where an independent report was produced and would if necessary be able to use powers to disqualify trustees. Members of smaller funds, where routine scrutiny might be less wide, would have an additional safeguard that trustees would have to obtain a statement certifying their investment assumptions as reasonable. The proposed solution aims to improve institutional decision-making by making it more skilled, transparent, well-informed and better debated, with greater engagement by trustees, in line with the wider principles of the Review. The letter argues that this approach will provide more effective protection for members of defined benefit schemes without creating major additional regulatory burdens or costs. At the same time, it will help the major capital flows controlled by defined benefit pension funds to be allocated in as rational and well-informed a way as possible. It is preferable to alternatives such as an insurance-based scheme (which would create additional costs, and might be distortionary), using a prudential regulator (which would place too great a reliance on the judgement of those regulating), or a central discontinuance fund (which raises similar issues to insurance). Private equity and financial services legislation The Review also argues for reform of the law regarding investment in limited partnerships whose purpose is to undertake investments in private equity. It believes that pension funds are discouraged from investing in such limited partnerships by the prohibition on unauthorised persons carrying on investment business. The letter to the Chancellor and the Secretary of State for Social Security sets out a solution to this problem. Government response The Government welcomes the proposals of the Myners Review on the MFR as an important contribution to the consultation process which continues until January 2001. The Government also welcomes the proposal on private equity investment and intends to incorporate changes in secondary legislation under the Financial Services and Markets Act, subject to the consultation on draft legislation already underway.

SKILLS

3.101 Since labour (alongside capital) is one of the key inputs to production, the quantity and quality of skills are crucial to raising productivity. Yet skill levels in the UK are lower than in many of our main competitors. For example, a lower proportion of people in the UK have intermediate skills than in France or Germany. When international adult literacy was last surveyed between 1995 and 1997, the UK came tenth out of twelve countries, lagging behind the US, Canada and Germany. One in five of the UK adult population continues to suffer from very low skills in literacy and numeracy.

3.102 In November 1997, the Secretary of State for Education and Employment announced his intention to establish a National Skills Task Force. The Task Force reported earlier this year, and identified three core components to a National Skills Agenda:

• an action plan for changes in post-16 education and training to produce the required improvements in the skills 'supply side';
• an approach to the continuing management of post-16 education and training that shapes both the demand for, and the supply of, skills over time so minimising skills shortages and gaps in the future; and
• targets for improvements in skill levels, plus measures of performance in managing the match between supply and demand, to raise public confidence, drive progress and monitor success.

3.103 The Government is considering its full response to these findings. It has already endorsed this conception of the National Skills Agenda, and outlined its strategy for addressing this agenda. The key elements of this are:

• strengthening the links between what people learn and the jobs they will have in the future;
• creating excellence in vocational learning for all to reach their potential;
• reaching out with basic skills training and beyond to adults who the system failed first time and building a flexible system of lifelong learning for all; and,
• working with employers to give everyone the chance to boost skills and productivity.

3.104 The level of basic skills and the ability of ­ and opportunity for ­ members of the workforce to adapt to changing technology and working practices are all important. The Government has pledged to reduce the number of adults with literacy or numeracy problems by 750,000 by 2004. Significant extra resources were allocated in the 2000 Spending Review towards this aim, increasing spending from around £240 million in 2000­01 to over £400 million in 2003­04.

3.105 Ensuring that Britain's young people enter the workforce with a high level of skills is essential to raising Britain's long-term productivity performance. This means starting from an early age to increase levels of educational attainment and encourage young people to realise their full potential. Chapter 5 explains how education is an important influence on children's life chances. The Government is working to reverse the record of under-investment and under-achievement in Britain's schools, and provide all children with the skills they need to succeed in the modern economy. It has:

• established the Sure Start programme to ensure that all children start school ready to learn (see Chapter 5);
• developed strategies for teaching literacy and numeracy in primary schools; and will set demanding targets for literacy, numeracy, science and ICT at
  age 14;
• invested in connecting schools to the internet. The Government is well on course to ensuring that all schools are connected to the internet by 2002: 98 per cent of secondary schools and 86 per cent of primary schools in England are now connected. By 2004, there will be one computer for every five pupils in secondary schools;
• begun to modernise the comprehensive school system through the introduction of specialist schools. Independent studies have shown that specialist schools show significant attainment gains, and almost one third of secondary schools will have specialist status by 2004; and
• provided for AS-level options at 16, enabling students to study a broader range of subjects for longer.

Raising the UK skills base

3.106 In addition to raising standards in primary and secondary education and ensuring that young people leave school with a foundation of essential skills, the Government intends that by the end of the decade 50 per cent of the UK's young people will have the opportunity to benefit from higher education by the time they are 30. There they can gain the professional, technical and managerial skills on which a strong and successful economy relies. The 2000 Spending Review provides funding for more places in higher education, including:

• a reversal in the decline of funding per student, with real funding per student set to increase in 2001-02 for the first time in 15 years;
• initiatives to widen access, with additional resources for institutions that have students from disadvantaged areas; and
• two year foundation degree courses, designed to provide focused and vocational higher education for a broad range of students.

Investing in lifelong learning

3.107 The dynamic and ever changing nature of the modern economy means that lifelong learning must be at the forefront of education policy ­ both providing opportunities for adults who have missed the chance to develop basic skills earlier in life, and providing the opportunity and encouragement to individuals and firms to adapt existing skills and gain new ones. This has the potential to produce dramatic benefits for both the individual in terms of greater flexibility and adaptability and the opportunity for higher earnings, and for employers and the wider economy in terms of higher levels of productivity.

3.108 This autumn, learndirect (the brand name for the UfI) is rolling out its ICT-based learning portal and services nationally, opening up a new avenue through which adults can add to basic skills or build on higher skills. This is enabling training to reach further to groups of people unable to take advantage of more formal training opportunities. Users can learn at home, in the workplace or in one of over 700 learndirect centres which are now up and running across the country. A total of 38,000 users have so far registered on an average of two courses each. Early signs are that as many as 40 per cent of learndirect users have not engaged in learning in the past three years.

3.109 In addition, over 600 new ICT learning centres were announced in September 2000, with more to follow in the spring and autumn of 2001. These centres, located across the country, will enable people with low or no skills to acquire basic ICT skills. As well as significantly improving employment prospects, this will open the way to the acquisition of other skills, often through progression to the UfI. Through the inclusion also of ICT access points in libraries, there will be 6,000 UK online centres by 2004.

3.110 As part of its goal to create a highly skilled and adaptable workforce, the Government has also launched a national system of Individual Learning Accounts (ILAs). In England ILAs are available to all people aged 19 or over, but are being particularly targetted at those between 19 and 30, those returning to work, the self-employed, and non-teaching school staff. Learners can benefit from a package of incentives including £150 for the first million account holders to book eligible learning, provided they contribute £25. With almost 400,000 accounts opened so far, the Government is well on course to meet its target of 1 million account holders by March 2002.

3.111 To examine some of the key ongoing issues related to workforce training (see Box 3.7), the Performance and Innovation Unit in the Cabinet Office, working with stakeholders inside and outside government, will shortly start a project to identify the extent, nature and causes of under-investment in workforce development. In the light of this analysis, it will make proposals for solutions.

Improving management skills

3.112 High quality management and leadership skills are an important element of raising the productivity of the UK economy. The Skills Task Force found evidence of both skills shortages and skills deficiencies in UK management and leadership. To examine how management and leadership can be improved, the Government has established the Council for Excellence in Management and Leadership under the chairmanship of Sir Anthony Cleaver. The Council is due to report its interim findings in April 2001. The Government will consider the Council's conclusions and recommendations.

Tackling skills shortages

3.113 The Government is committed to ensuring that the UK competes for the best skilled workers in the world market. The arrangements for work permits have therefore been reviewed and the commitments made in Budget 2000 are being delivered.

3.114 The 'innovators' scheme was launched in September to attract budding entrepreneurs (especially those who plan to set up high-tech companies) to the UK. A range of IT jobs have been included in the shortage category list to make it easier for employers to obtain work permits for such workers.

Box 3.7: Adult basic skills and workplace training A skilled workforce is essential to increasing the UK's productivity performance. At present, however, the UK has significant comparative weaknesses in basic and vocational skills for adults. For instance: Sir Claus Moser's 1999 report on basic skills estimated that 20 per cent of the adult population had reading and writing skills below that of an 11 year old ­ and considerably more might have similarly low numeracy; and the Skills Task Force found that the UK has just one third of the proportion of 25-28 year olds with level 3 vocational qualifications as Germany. Addressing these weaknesses is crucial in a knowledge economy with a declining proportion of jobs for genuinely unskilled labour. A more skilled workforce will allow the advantages of new technologies to be exploited more effectively and will improve the introduction of new working practices. It will ensure that firms have flexibility to innovate and develop new products and services. A firm basis in numeracy and literacy is crucial to developing further skills. Adult basic skills The UK's weakness in adult basic skills is largely the legacy of social exclusion and historic failings in the education system. The Government's challenges are: to motivate those lacking basic skills to take the training opportunities available and to make an impact on their skills. Those with the lowest levels of skills can be difficult to engage, and the qualification rate needs to improve; to mobilise employers, in particular challenging the view that basic skills problems are solely the Government's responsibility. This is important in encouraging workplace training more generally; and to mobilise the public sector fully, as employers and as gateways to learning. To start to meet these challenges, the Government is substantially increasing funding for adult basic skills. It has set a target, supported by over £240 million this year, rising to over £400 million in 2003-04, to reduce the number of adults without basic skills by 750,000 by 2004. Workplace training While figures suggest that the amount of workplace training undertaken in the UK has increased by 50 per cent since 1986, it is likely that both employers and employees under-invest in some areas of workforce development. For example employees with lower qualifications tend to receive far less training from employers than those with higher level skills. There are several reasons for this, which need to be overcome, including: both the actual cost of training and the opportunity cost of training time. This is especially important for small firms which also have less access to finance than their larger competitors. The Skills Task Force found that only 36 per cent of firms with fewer than 25 employees carry out some form of off-the-job training; firms' fears that trained employees will leave, thus depriving the firm of the benefits from the training in which they invested; and a lack of information for employers and employees of the returns from workforce development. Recent work by the Institute of Fiscal Studies1 concludes that, in fact, there are considerable returns for both the employer and the employee from training. It estimates that increasing the number of workers trained by 5 percentage points would provide a 4 per cent increase in productivity and a 1.5 per cent increase in wages. 1'Who Gains When Workers Train?', Institute for Fiscal Studies, 2000.

3.115 It is now far easier for those overseas students whose skills are needed to obtain permission to work on graduation. The Overseas Labour Service has revised the definition of skilled workers to include all those with degrees ­ allowing employers to obtain work permits for graduate recruits. The Home Office has recently changed its procedures so that prospective university students will not be denied student visas on the basis that they wish to switch into work permit employment on completion of their studies ­ and applications from students to switch their immigration category will be normally be approved. The Government will be publicising these new measures widely to universities and employers.

3.116 Burdens on business have been reduced, with work permits now running for up to five years rather than four, and extensions and changes of employment are no longer subject to a labour market test.

3.117 Processing times for work permits have already gone down significantly ­ and by April 2001, the Overseas Labour Service aims to process 80 per cent of completed applications within a week. Employers will soon benefit from electronic application forms ­ which will be introduced in December 2000 ­ and the Government is already piloting a scheme to allow employers to issue their own work permits.

3.118 At the turn of the year, the Government will launch a pilot scheme to attract people of outstanding ability from around the world. The scheme, which will seek applicants initially for up to six months, will allow particularly skilled individuals to enter the UK to seek work in their field of specialism. In order to gain entry, applicants will need to satisfy three of the following four criteria:

• a PhD or equivalent qualification;
• five years graduate level experience (three years if a PhD is held), of which two years should be at a senior level position;
• a salary of at least £40,000 in the last year (or the equivalent in their country of origin);
• evidence of significant achievement in their field of specialism.

Within a year of entry, each applicant will need to show evidence of employment at a level warranted by their skills base

PUBLIC SECTOR PRODUCTIVITY

The role of the public sector

3.119 The Government is working to provide the best framework and the right incentives for businesses to close the productivity gap with our international competitors. But it is also changing the way it works itself, ensuring similar disciplines are in place so that the public sector works to improve its own productivity⁵.

3.120 The Government is seeking to bring this about in three complementary ways: by defining clearly the key outcome targets for each department and who is accountable for their delivery; by improving performance management based on clear strategies for delivery; and through a major investment for change programme supported by the right incentive structures and increasing managers' flexibility to innovate.

3.121 The Public Service Agreements (PSAs), first published after the 1998 Comprehensive Spending Review, and updated and improved as part of the 2000 Spending Review, are the single most ambitious attempt internationally to set targets for policy outcomes and service improvements that the Government is committed to. The new set, published in July, have been slimmed down to bring out more clearly the single-sentence aim, high-level objectives, and concrete targets that each main department and cross-departmental programme is working to. The 160 targets that result are an understandable, precise and accountable statement of the Government's priorities. Clear commitments have been made on key issues of concern. For example the Government will:

• reduce preventable deaths from cancer and heart disease;
• increase pupil attainment at GCSE level, especially in the most disadvantaged localities; and
• cut domestic burglary, especially focusing on the areas with the worst rates.

3.122 Many of these improvements can only be achieved by co-ordinated action by several parts of government. A feature of the 2000 Spending Review was the 15 cross-departmental reviews. As a result around 30 of the PSA targets are held jointly by more than one government department and they are jointly accountable for their delivery.

3.123 Setting clear priorities is only the first step towards delivery of improved services. The new Service Delivery Agreements (SDAs), published earlier this month, make clear the programmes and actions that departments will be working on in order to deliver the high level targets including the specific contributions departments are making to deliver joint targets. The SDAs also provide a guide to management priorities and value-for-money reforms in government departments. Parliament and the public will be kept informed regularly and in detail about performance against the targets, in departmental Annual Reports. The next reports are due in spring 2001. In addition the Government is preparing to provide more regular progress reports on PSA target delivery on the internet. The detailed public reporting provides a strong incentive to deliver the commitments contained in the PSAs, and the Cabinet Committee on Public Services and Public Expenditure (PSX), supported by the Treasury, rigorously monitors departmental performance, assessing progress against agreed milestones.

3.124 PSAs underpin the approach to clarifying accountabilities throughout public sector organisations. Being clear about expectations and putting the emphasis on results rather than procedures gives a sound foundation on which to build effective systems of public sector performance management. By targeting appreciable improvements in key services that the public value, the real enthusiasm of individuals within public sector organisations to serve the public can be tapped and engaged. In this way each individual can accept realistic but challenging objectives and be held accountable for them.

3.125 The Public Services Productivity Panel, a team of top private and public sector change management experts including chief executives and trade unionists, is a central part of the Government's strategy to improve public sector performance. One its first outputs was a new framework for performance management which has been adopted as the new business planning structure for the whole of central government as part of the Civil Service Reform programme. All departments are now required to establish independent quality assurance for their planning systems on a three year cycle.

Public investment

3.126 The Government is committed to significantly improving the public sector's capital stock as an integral part of improvements to public services. The 2000 Spending Review allocated £43 billion of additional funding to deliver significant improvements in key public services ­ an investment for change underpinned by clear targets and a process of modernisation and reform. As part of this, net public investment is set to double to £18 billion a year by 2003­04. High quality capital investment in public services will make a valuable contribution to raising their productivity.

Chart 3.3

3.127 To ensure best use of this significant increase in investment, the Government has introduced a series of incentives to increase the productivity of the existing public sector asset base and new investment. The National Asset Register brings accountability to existing asset holdings. The Government has introduced resource accounting and budgeting, which ensures financial planning takes account of the annual cost of holding public assets, not just the purchase price. Departmental Investment Strategies, to be published shortly, set out how departments will deliver value for money in their investments. In addition, departments are allowed to recycle receipts from the sale of redundant assets to fund assets that are needed. As part of the Government's commitment to improve productivity in new capital investment, the Capital Modernisation Fund is a source of finance for innovative capital projects that look at new ways to enhance public service delivery such as delivering services on-line.

3.128 The public sector has not always been quick to innovate in the past, with the consequence that productivity is held back as systems fail to adapt sufficiently to changed circumstances. With clear accountabilities for outcomes and results, there is a case for reviewing inhibiting rules on systems and procedures. Under Modernising Government, steps are being taken to encourage innovation by increasing managers' flexibility to act. These include a requirement for all initiatives to undergo a regulatory impact assessment to minimise the level of bureaucracy experienced in implementation, greater 'bottom up' input into policy making through a regional co-ordination unit, over £230 million allocated for the first three rounds of the Invest to Save Budget allowing local managers to identify new ways of improving productivity, and a pilot of local PSAs (see Chapter 5) enabling central and local government to agree new freedoms and flexibilities to achieve new stretching targets in specific areas.

3.129 Accountabilities will be effective only if tangible consequences are associated with success and with under-achievement. Opportunities to innovate will only be taken up if there is a genuine entrepreneurial culture, where rewards are not reserved for those who play safe. Setting the right incentives is therefore the third interlocking piece of the Government's strategy.

3.130 The Government is committed to modernising public sector pay to ensure that it provides appropriate incentives for the delivery of PSAs, including a much greater use of performance-related pay. The four large national networks (the DSS, Inland Revenue, Customs and Excise and Employment Service), are preparing for the introduction of team-based performance awards directly linked to the delivery of PSA targets, a major recommendation of the Public Sector Productivity Panel in its report Incentives for Change. All other departments will review by April 2002 their current pay systems to determine how best to ensure that in future they underpin more effective service delivery and greater productivity.

3.131 The Public Sector Productivity Panel has, in its first year, recommended a wide range of ways to help deliver better services including improved team-based performance incentives, a new approach to the comparative measurement of police efficiency, ways to achieve greater customer focus in the delivery of services and a number of practical steps to improve NHS services. The Panel's joint report, Public Services Productivity: Meeting the Challenge, published in August 2000 stressed that a good performance management system embedded in the culture of an organisation is essential to deliver consistent top class performance.

3.132 The Panel has recently been expanded, and is currently developing its programme for the coming year. The Panel intends to focus its work on helping secure better ownership for the delivery of services through improved accountabilities, incentives and motivation of staff. As before, the Panel will be working on the ground to help the public sector deliver real change to improve the productivity and performance of public services for all users.

Partnerships UK

3.133 Public-Private Partnerships (PPPs) are a cornerstone of the Government's policy to modernise and improve the quality of public services. But PPPs bring with them new challenges which require specialist skills and expertise.

3.134 Partnerships UK has been established as successor to the Treasury taskforce. By combining private sector skills and disciplines with a strong public sector mission it will help the public sector to get the best deal from Private Finance (PFI) and PPP transactions.

Reforming government procurement

3.135 The Government is a major purchaser of goods and services. Making sure that it is a good purchaser not only improves value for money, but also encourages best practice amongst its suppliers.

3.136 To this end, the Government established the Office of Government Commerce (OGC), bringing together procurement from across Government. Following recommendations from a review of public procurement, the OGC is on track to save £1 billion across departments within three years through modernisation, skilling, e-tendering and strategic partnerships. All government procurement will be sent and received electronically by 2002.

¹ The Government has published alongside this Pre-Budget Report a separate paper setting out its strategy for raising UK productivity: Productivity in the UK: the Evidence and the Government's Approach, HM Treasury, November 2000.

²Comparative data on national productivity performance are collated by the Organisation for Economic Cooperation and Development, and adjusted by the Department of Trade and Industry to take account of the latest figures for the UK and US. Due to the introduction of the System of National Accounts there have been revisions to the GDP estimates for several countries, hence the data used in this Report are updates of those incorporated in Budget 2000.

³For the US see 'Aggregate Productivity Growth: Lessons from Microeconomic Evidence', L Foster, J Haltiwanger and CJ Krizan , NBER Working Paper 6803, 1998; and for the UK 'Productivity in the 1990s: Evidence from British Plants', J Haskel and M Barnes, Department of Economics, Queen Mary, University of London, Draft Working Paper, 2000 available at http://www.qmw.ac.uk/~ugte153.

⁴For instance Executive Report, Global Entrepreneurship Monitor, 1999.

⁵The Government will be publishing a separate paper in due course on public sector productivity, to complement the week's paper on productivity in the wider economy published alongside the Pre-Budget Report.