00Executive summary

The development of the new economy is central to the development of the national economy

The ‘new economy’ encompasses emerging knowledge-intensive sectors like FinTech and advanced manufacturing that are at the forefront of new technologies and innovations. It is important for improving the UK’s productivity and prosperity and a central pillar for the future success of the whole economy.

The new economy is made up of manufacturing and services activities

This report contains two main findings that are relevant for policy. The first is that the new economy – defined as 47 technologically advanced sectors – is made up of both services and manufacturing businesses. As well as robotics and autonomous vehicles, it includes Internet of Things, telecommunications and gaming to name but a few. This is important because much of the thrust of innovation policy designed to foster such activities has focused on product innovation (goods) to a much greater degree than process innovation, which applies more to ways of working and services.

The new economy clusters in cities

The second finding is that while the new economy is located across the country, it is disproportionately based in cities, and city centres in particular. In fact, 59 per cent of firms cluster in the 9 per cent of land covered by the 63 largest cities and towns.

The further a location is from the centre of a city, the less popular it tends to be. City centres are at the heart of this clustering; despite accounting for just 0.1 per cent of land, they are home to 13 per cent of new economy firms. While this holds for both services and non-services, it is particularly true for activities such as FinTech and Software as a Service. In contrast, deep rural areas (defined as those beyond a commutable distance to a city) account for 52.9 per cent of land, but accommodate just 8.6 per cent of new economy businesses.

Clustering also occurs on business parks in the suburbs of cities, but these are much less popular outside of cities. They play a different role to city centres, and this is reflected in the types of businesses they attract. While the city centre new economy is dominated by services companies, these parks have a higher share of non-services activities, in particular those specialising in sensors and advanced materials.

This happens because of the inherent benefits an urban location offers innovative new economy businesses. Cities provide access to large numbers of skilled workers and a network of similar companies with which to share information and knowledge. This does come at a cost – businesses pay a premium to get access to these benefits through the higher price of commercial space. For those focused on services, access to these two benefits in city centres is particularly important. For non-services companies, the greater relative preference for a suburban location suggests that while access to knowledge is slightly less important to them (although again this varies – it is more important for AI than net zero companies), access to lots of skilled workers still means they mainly locate in cities.

Cities in the Greater South East have more new economy firms than those elsewhere, with large cities in particular punching below their weight

This makes cities very important for the success of the UK economy, even with recent increases in remote working. The challenge for policy is that some cities offer these benefits much more effectively than others. Those in the Greater South East – most notably London but places like Milton Keynes and Reading too – provide plenty of access to skilled workers and knowledge, which has proven attractive to both services and non-services new economy businesses. Most cities elsewhere, particularly large cities outside London, such as Birmingham, Glasgow and Manchester, cannot do this to the same extent, which impacts the size of the new economy within them. The analysis in this report shows that while they are undoubtedly centres of new economic activity, they have fewer new economy businesses than our modelling suggests they should. This is likely to be a key reason why they have lower levels of productivity than their European peers.

Policy has focused too much on specific sectors and too little on place

Rarely is this geography acknowledged in policy designed to support and commercialise innovation, particularly by the new economy. Most policies have been national in focus even if they have played out differently across the country. One example is public funding for research and development (R&D) – it has been driven by assessments of the quality of universities’ research, but the geography of the best performing institutions means that it has concentrated funding in the Greater South East.

Recent Government policy has looked to take a much greater spatial approach, which is welcome. February’s Levelling Up White Paper committed to increase R&D investment outside the Greater South East by 40 per cent, and was deliberately selective in choosing Birmingham, Manchester and Glasgow as the sites for three new Innovation Accelerators. There is, however, no clear plan for how and where this extra investment will be spent – a strategy setting this out was cancelled – nor a clear sense of what the Innovation Accelerators will do.

Policy has also focused too much on particular sectors. It is right that, where possible, it encourages the development of businesses at the frontier of the economy, but being overly specific ignores the clustering of related industries in certain places. It also leaves it inflexible to supporting the growth of new activities when they emerge.

While some sectors may have specific needs, the barriers holding back one are likely to affect others. For this reason, industrial policy should support the ever-changing new economy and make sure places are offering what this cohort of businesses requires, for example through R&D tax credits, competition policy and intellectual property rights, rather than being too narrowly defined.

What needs to change

After the introduction of the CHIPS and Science Act in the USA, which states that $10 billion will be spent to increase innovation in 20 places, the UK should follow its recent decision to prioritise Birmingham, Glasgow and Manchester by going much further. It should create a £14.5 billion growth package for these three cities over 10 years to help achieve the Levelling Up White Paper’s ambition of making them internationally competitive. This should include:

• Allocating a total of £1 billion of the annual £7 billion R&D uplift the Government has promised to spend outside of the Greater South East to be shared amongst the leading university in each of these cities.
• A £500 million investment in each place to improve how attractive their city centres are to new economy and other high productivity businesses, funded from the Strategic Programmes budget.
• Extending the City Region Sustainable Transport Settlement beyond 2026/27 for a further five years for Greater Manchester and the West Midlands (an additional £1 billion each), plus a similar commitment to Greater Glasgow, and giving all three places Transport for London-style powers so they have more control over services and can invest revenues in their systems.
• The Scottish Government establishing and working with a new Greater Glasgow combined authority to provide a single departmental-style spending settlement for the city region in the way the UK Government has committed to explore for Greater Manchester and the West Midlands. Legislation should be amended to allow all areas to introduce local taxes, such as a tourist tax.

To support the new economy in other places the Government should also:

• Set out a spatial strategy for how the remaining uplift in public R&D will be spent. It should be driven by the geography of the new economy, with a particular focus on improving innovative activities in places that are lagging behind their potential.
• Extend the Strength in Places Fund to maintain specific support for innovative activities across the country, with funding continuing to come from the Strategic Programmes budget.

A lot of policy has focused on the low levels of public R&D spending relative to other countries, but this has been concentrated on factors that influence mainly product innovation in manufacturing. However, the UK has a much broader business investment problem. To address this, policy should increase R&D spending while encouraging investment in other areas by:

• Increasing the R&D target from 2.4 per cent of GDP to at least the OECD average of 2.7 per cent, by 2027.
• Expanding the R&D tax credits to expenditures associated with innovative services. Including data and cloud computing in the R&D definition in 2021 was a step in the right direction, but the Government should broaden this to cover innovative services activities that depend on software and other intangibles.
• Reversing the cuts to public skills spending seen over the past 12 years and setting a target to increase spending from 5 per cent to 7 per cent of GDP, as is currently the case in Sweden.
• Introducing a human capital tax credit to match the R&D tax credit, which would attempt to reverse the decline in business investment for training.
• Designing future changes to the apprenticeship levy to encourage further business investment in skills.

Finally, to address the UK’s skills problems and to reflect the role that a diverse workforce plays in companies that innovate, the Government should expand the period of the ‘graduate visa’ from two to five years and guarantee the policy will not be reverted in the next decade. This would make the post-work visa more competitive compared to international peers like Australia.