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The Impact of Service Sector Innovation and Internationalisation on Growth and Productivity

Final Report Summary - SERVICEGAP (The Impact of Service Sector Innovation and Internationalisation on Growth and Productivity)

Executive Summary:
The main objective of the SERVICEGAP project was to investigate the role of services in various aspects of economic performance in EU countries. This involved four strands of work; an initial overview including impacts of the financial crisis, drivers of productivity growth; firm strategies in a knowledge based economy and internationalisation of services. The outputs of the project are analytical research papers containing original research, synthesis papers and policy briefs. Services sector output and productivity appear to have been less affected by the crisis than were production sectors, due mainly to lower exposure to international markets. The work on the financial sector highlighted the important role of banks in facilitating growth and the dangers of the move to smaller scale and less globalised banks, especially for smaller countries.
The research on drivers of productivity covered intangible investment, linkages between manufacturing and services and the impact of the regulatory environment. Key findings include highlighting the important role of workforce training linked with ICT, the poor training offered to older persons, the importance of intangible assets in service sectors, and the impacts of trust and fear on productivity. There is some support for spillovers from intangibles but with lower magnitudes than found in previous research. The distinction between manufacturing and services has become blurred with many firms increasingly involved in both, raising shares of services occupations in the manufacturing workforce. Increasing services inputs affecting product quality, e.g. product marketing, distribution and transport systems, have a positive impact on export market shares of manufacturing firms. Greenfield FDI projects in business services are found to depend on unit costs, corporate taxes and costs of setting up businesses. The research highlighted a significant role for business services in driving aggregate growth, given their strong linkages with other sectors, and the impacts of regulations in this sector on investment and growth. Progress has occurred in deregulation of these services but much still needs to be done.
The research on firm strategies suggests that agglomeration in high skilled sectors, international trade, lack of financial constraints and organisational capital all have positive impacts on innovation in services, especially in knowledge-intensive business services. Information technology outsourcing is particularly important for process innovation in services. Innovation in service enterprises is related to higher productivity with the link strongest for marketing innovations. Product innovation appears to generate employment growth in services, although at lower rates than in manufacturing, with little evidence of employment changes arising from process or organizational innovations.
The research on the internationalisation of services covered trade, investment and outsourcing. Trade in services is substantial and growing, although smaller than for goods. Multinational and larger firms, those that pay higher wages and more productive firms are more likely to trade and one way traders (export or import) are more prevalent in services than in manufacturing. Access barriers to trade are still very important in services, although there has been more success in removing intra EU regulations than in multilateral (GAT) agreements. International investment through mergers and acquisitions has been growing in services and tends to have stronger effects on performance of firms in services than in manufacturing. Enterprises experiencing positive productivity growth after foreign acquisition are more likely to be located in high tech sectors and in larger, less open economies. Outsourcing is found to have significant productivity effects which may counter balance any negative employment effects. Outsourcing of R&D has increased in one key sector, pharmaceuticals, with increasing presence of Asian firms along the value chain.
Overall the project suggests a key role for knowledge intensive business services in generating growth with implications for education policy, given the high skill intensity of these services, and for policy on regulation, given still very high international access barriers to trade and investment.

Project Context and Objectives:
At the time the proposal was drafted the productivity literature suggested an important role for service sectors in explaining Europe’s productivity gap with the US, driven by fast adoption of and intelligent use of information and communications technology which was concentrated in service sectors. In addition the proposal was written near the start of the financial crisis and subsequent developments highlight the importance of stimulating growth in an age of austerity.
The main objectives of the SERVICEGAP project as set out in the programme of work were to consider the academic and policy concerns that arise from the increasing importance of the market service sector and the crucial role it appears to play for differential economic performance between industrialised countries. In order to achieve these objectives the project investigated developments in productivity and its drivers within market services, linkages between services and manufacturing industries, innovation in delivery and types of services and international relationships. The overall objective of this research was to produce a comprehensive study on the impact of market services on aggregate economic growth in the EU and its comparative performance relative to competitor regions, especially the US.
There is no doubt that productivity growth is central to achieving sustainable growth. In the longer term productivity growth is crucial to the EU achieving the Europe 2020 objectives. Therefore it is important to understand the drivers and barriers to productivity growth. The research undertaken for workpackage 2 of the SERVICEGAP project builds on previously funded EC projects such as EU KLEMS ( and INDICSER ( that pointed to the importance of service sectors in driving differences in productivity performance between the EU and the US. In industrialised countries, the service sector has steadily gained importance during the past few decades. In the EU 27, market services now comprise about 42 percent of employment.
Innovation is well recognised to be a key driver of productivity and growth. The EU 2020 target is to have 3 per cent of GDP to be spent on Research and Development (R&D). Most EU countries, however, still operate at a lower level than this. While the determinants and impacts of innovation in the manufacturing sector are already well studied, there has been a lack in evidence and understanding of the innovation mechanisms in services. The research carried out for workpackage 3 of the SERVICEGAP project attempts to fill this gap by focusing on the determinants and impacts of innovation.
International trade and investment in services have been growing in importance in recent decades. Technological advances have led to the reduction of transport and communication costs which in turn have enabled a greater fragmentation and internationalisation of the production of services. Liberalizing cross-border trade and foreign direct investment (FDI) in services has run up against many access barriers, mostly national regulations. Understanding barriers to trade and FDI in services implies uncovering the nature and economic rationales of domestic regulation that hinders or prevents foreign trade or FDI. In line with the increasing importance of the services sectors especially in developed countries, trade in services has increased substantially since the mid-1990s. This is due to direct trade in services but also the increasing importance of the services that accompany the delivery of goods by manufacturing enterprises. Despite this evidence on patterns of trade and characteristics of trading enterprises in the services sectors is still limited. An increasingly important activity in the European service sector is international investment, especially through cross-border mergers and acquisitions and in recent years, there has also been a growing outsourcing and offshoring of services. Understanding these international dimensions is the main aim of workpackage 4 of the project.
The project was divided into three main work areas, a preliminary workpackage that was concerned with setting the context and the implications of the financial crisis and a workpackage concerned with synthesis and policy implications. The detailed objectives of the workpackages were as follow:
WP1: Overview of developments in service industries
This work package was designed to provide background and context for the core research workpackages (WP2-WP4). It aimed to investigate general trends in the performance of services in the EU with a particular focus on financial markets and consequences of the current financial crisis. It also aimed to produce literature reviews for the research to be carried out later in the project.
WP2: Productivity drivers in service industries
This aimed to examine productivity trends in more detail. It focused on a number of dimensions that are vital in understanding the drivers of productivity and apply different analytical methods. These include:
An examination of the assumptions underlying conventional measures and econometric analysis of productivity, with a focus on ICT;
Investigating the extent to which low levels and growth in productivity in the EU relative to the US in market services is driven by lack of investment in intangible assets;
Analysing the interrelationship between service and manufacturing sectors both on the output and input side;
Investigating the competitive and regulatory environment of service industries in the EU and their impact on productivity, innovation, technology and employment.
WP3: Firm strategies in the knowledge-based economy
The objective of this work package was to analyse various strategies of knowledge creation supposed to enhance innovativeness, productivity and growth and thus to support competitiveness in EU industries and countries. The research carried out for this workpackage aimed to:
Consider internal sources of knowledge and analyse the interrelationship between investments in ICT and in intangibles such as organisational capital as firm strategies to enhance productivity;
Examine the role of external knowledge acquired by sourcing out service functions to specialized suppliers and analyse its importance for productivity and innovation;
Investigate investment in innovation activities as a strategy of knowledge creation for productivity and employment growth.
The analysis was based on models of innovation and productivity and on large-scale firm-level data for different EU countries. The most important database used for the econometric analyses is the Community Innovation Survey (CIS). Some of the studies rely on data from country-specific surveys. Based on the empirical results policy implications in the context of Europe 2020 are derived. Among the determinants analysed in WP 3 are agglomeration, internationalisation, financial constraints and IT outsourcing. Moreover, information technologies (IT) and organisational capital are factors widely discussed as enabling factors of innovation and productivity. Finally, since innovation itself can make production processes more efficient and thereby can affect employment the impacts of innovation on productivity and on employment were analysed.
WP4: Internationalisation of services and growth
The aim of this research was to analyse the extent of internationalisation of services in the European Union and its effects on enterprise productivity, employment and growth. In particular it aimed to:
Analyse the extent of international trade in services and its effects on productivity and employment. This research examined obstacles to international trade in services, the extent to which service enterprises engage in import and export markets, and the effects of international trade on enterprise productivity and employment in EU countries:
Examine the effects of international investment in services on productivity and employment. This research analysed determinants of foreign acquisitions in services and its effects on enterprise productivity and employment in EU countries:
Investigate international outsourcing of services. This research provided a comprehensive analysis of determinants of international outsourcing of services and its effects on enterprise productivity, employment and innovation in EU countries:
Investigate the operation of global value chains.
WP5: Synthesis of research results and policy analysis
The main objectives of this workpackage were to bring together the research results to provide a prospective analysis indicating the constraints and opportunities relating to service sector performance and its impacts on economic growth. In addition this aimed to review current and future policy options relevant for the service sector and discuss the implications of the research results for these options.
The objectives of the project were met primarily by quantitative economic analysis. The results of the project provided a comprehensive knowledge base on the potentials of service industries and on how these potentials can be reaped for strengthening productivity, growth and employment in the EU in order to meet the Europe 2020 objectives.

Project Results:
The primary outputs from the workpackages were analytical papers and summary/synthesis papers. These outputs are summarised below by workpackage.
WP1: Overview of developments in service industries
The paper ‘Growth and Productivity in EU Services Sectors‘ by Mary O’Mahony presents an overview of productivity developments in the EU compared to the US, describing trends in market service sectors, including the years after the onset of the financial crisis. It highlights the importance of market services in explaining the poor productivity performance of the EU relative to the US from 1995 to 2007, and the importance of the distributive trades and business services in contributing to this difference. It suggests this productivity performance gap in services persisted into the era of the financial crisis, but services were less affected by the downturn than production industries.
Literature reviews were delivered on five separate topics. The first three related to the work programme for workpackage 2 including intangible investment, links between manufacturing and services and product and labour market regulation. The review paper Intangible Capital and Productivity Growth: A Literature Review with a Special Focus on the Service Industry by Felix Roth, Anna Thum and Mary O'Mahony first discussed the most recent papers using both growth accounting methodology and growth econometric approaches. It then examined individual types of intangible capital, namely computerized information, innovative property and economic competencies. This review showed that the use of intangible capital was particularly important for the service sectors. The second literature review, Linkages between Services and Manufacturing in EU countries by Martin Falk and Elena Jarocinska examined linkages between manufacturing and services both on the input side (i.e. use of services occupations in manufacturing, use of intermediate service inputs) and on the output side (i.e. service turnover in manufacturing). This found that, on the output side, manufacturing firms generate an increasing proportion of sales from services activities, while on the input side direct and backward linkages between manufacturing and services increased in the last few decades which occurred simultaneously with an increase in service occupations in manufacturing. Overall, the distinction between manufacturing firms and service firms has become more blurred over time. The third review paper, Regulation and Economic Performance: Literature Review by Ana Rincon-Aznar, Nikolaus Graf, Iain Paterson, Wolfgang Schwarzbauer, Richard Sellner, Stan Siebert and Canan Yildirim first discussed the main theoretical channels by which regulation can have an impact on economic outcomes, such as productivity, investment, innovation and employment. It then reported the main empirical findings on this topic with particular emphasis on professional services and financial services. It highlighted some important channels through which de-regulation can have impacts on performance but concluded that the channels underpinning associations between regulation and performance in service sectors remain largely unexplored.
The remaining two literature reviews underpin the research programmes for workpackages 3 and 4. The first of these, The Role of Information Technology for Service Sector Performance, by Irene Bertschek, Benjamin Engelstätter, Krzysztof Szczygielski presented an overview of the role that information technology (ICT) plays in the innovation process, including ICT as a driver of product and process innovation, ICT-based firm strategies, in particular service outsourcing, and the impacts of innovation on productivity and employment. The focus was on empirical work from a microeconomic, firm-level perspective. It suggested the need for research to differentiate between manufacturing and services when considering ICT and that it is necessary to take account of both human and organisational capital when evaluating the benefits of this technology. The paper also recommended distinguishing service industries with different “technological regimes” when examining innovation in services. The review paper Internationalisation of Services, Productivity and Economic Growth: Literature Review by Holger Görg, Stefanie Haller and Iulia Siedschlag discussed recent theory and empirical evidence on the internationalisation of services and its effects on firm performance. It suggested that there is a lack of solid empirical evidence on the extent and determinants of the internationalisation of services in the European Union and its effects on productivity, employment growth and competitiveness. The paper concluded with a research agenda to address the existing gaps in knowledge.
The third task of workpackage 1 was to analyse the impact of the financial crisis on growth. The first paper to emerge on this task, The impact of financial stress on sectoral productivity: A panel cointegration analysis by Georgios Efthyvoulou attempted to use econometric time series modelling to test if there are differences in the impact of financial stress between production and services sectors. Data constraints meant that the analysis was only possible up to 2007, i.e. before the current crisis. The paper took the view that an analysis on impacts of past crises, which are the norm rather than exceptions, could be informative on the sectoral location of these effects. The research found significantly higher imfluences of financial stress on economic performance in production industries but these arose mainly from international channels. In market services, internal national sources of financial stress had a greater impact. Possible explanations include higher capital intensity and greater costs of undertaking innovation in production sectors than in services.
The second paper produced under task 3 The Banking Sector and Recovery in the EU Economy by Ray Barrell, Tatiana Fic, John Fitzgerald, Ali Orazgani and Rachel Whitworth, examined the impact of the crisis directly on the banking sector. This used a micro data set to investigate the impact of size on banks’ Net Interest Margin and showed that larger banks lowered borrowing costs for firms, raising sustainable output. Before the financial crisis the trend was towards larger and more international banks but this has been reversed since 2008, with banks becoming smaller and moving back into their home territory. The research investigated the impacts on output in large and small countries and showed that the effects were generally larger in small countries, and also larger in economies that are more dependent on bank finance for their business investment decisions. The authors conclude that if recent increases in sovereign spreads propagate into the banking system they will cause a sharp slow down in activity in Greece, Spain and Portugal and also in Ireland and Italy.
WP2: Productivity drivers in service industries
While there has been ample growth accounting evidence of service productivity growth in Europe and the US, there was so far little effort to address its drivers in the context of growth theory. A paper titled ICT, Intermediate Services and Growth: Stylized Facts and Theoretical Considerations by Anne Jurkat, Marianne Saam and Thomas Niebel investigated how this could be done, focusing in particular on intermediate services. The growth accounting literature identified two important engines of these growth differentials: market services and the production and use of ICT. Extending previous theoretical research, this paper develops a set of stylized facts that can be used to set up a four-sector growth model with ICT production, other manufacturing, distribution services and knowledge-intensive services. When it comes to calibrating the model, a critical element is the assumed future productivity growth rate in knowledge-intensive services. Long-term evidence does not suggest that knowledge-intensive services, in particular business services and finance, have a high potential for productivity growth. This could on the one hand lead to the conclusion that experiences of high growth in these industries in some countries between 1995 and 2007 were the result of a bubble. More optimistic observers would on the other hand argue that the ICT revolution has taken off only recently and that the higher growth rates in knowledge-intensive services are a sign of a regime change that has lasting effects on the innovation possibilities in these industries. The main empirical conclusion from a stylised calibration exercise in this work is that the contribution of MFP growth in intermediate services to GDP growth does not exceed the aggregate contribution of ICT capital deepening unless one assumes much higher services shares and service productivity growth than were observed over the past two decades. Considering only ICT-based services, their aggregate contribution is much lower than the aggregate contribution of ICT capital in the steady state of the model.
Intangible Investments
This component of the work programme builds on two previously funded FP7 projects, Coinvest and Innodrive, that sought to measure intangible capital across a range of countries and its impact on growth. The resulting estimates have recently been combined in a consistent manner and posted on a new web-site INTAN-Invest ( While these projects were focused on the aggregate market economy, the research on intangible investments in SERVICEGAP is concerned with the impact of this important asset at the sector level. The sectoral estimates were produced as part of the INDICSER project.
A first paper Workforce Training, Intangible Investments and Productivity in Europe: Evidence from EU KLEMS and the EU LFS by Mary O’Mahony and Fei Peng, on the impacts of intangible investments on productivity focused on one component of organisational capital, workforce training. This paper employed industry by country estimates of intangible training capital developed for the INDICSER project in a production function framework. It investigated both direct impacts from training and indirect effects through links with ICT. The results using ordinary least squares regressions showed significant direct and indirect impacts of training in production sectors but only indirect effects in market services. These results were robust to using instrumental variables (IV) techniques that used measures of the industry structure of labour markets as instruments, although with smaller coefficient values. The indirect impact of training associated with using ICT was found to be significantly higher in market services than in production sectors so that at medium to high levels of ICT, the overall impact of training on productivity was much higher in services.
Training was also the subject of a paper titled Age-training gaps in the European Union by Fiona Carmichael and Marco Ercolani. This paper examined the relationship between age and training in the EU15 countries, using the European Union Labour Force Survey data (EU LFS). This is important in the context of policies aimed at raising the European Union’s average age of permanent labour market exit which is currently about 61 years. An ageing European population, coupled with the recent financial crisis has increased the urgency with which governments are implementing reforms such as raising statutory pensionable ages and retrenching early retirement benefits. Such initiatives to raise the age of labour market exit are best combined with policies that increase the employability of older workers and one such measure is providing appropriate levels of training. The paper reports cross-country comparisons of the training undertaken by older people (aged 50-64) and younger people (aged 20-49), including an analysis of the training undertaken by non-workers as well as that of workers. It indicates that although overall training rates vary by country, a common feature across countries is that older people are less likely to participate in training even after contolling for confounding factors. The results also suggest that older people are less likely to participate in ‘high quality’ training, those that are work-related, take place during working hours and are of long duration. Age-training gaps are wider among non-workers. One interpretation is that older people are simply less likely to train because of their close proximity to retirement. Increases in statutory retirement ages in various EU countries may therefore mitigate this effect. However, the statistical significance of the age-training differences is also consistent with other explanations including higher costs of training, ageist attitudes, differences in learning ability, lack of perceived need and institutional factors.
A paper titled The Contribution of Intangible Assets to Sectoral Productivity Growth - Comparing Growth Accounting and Econometric Estimation by Thomas Niebel, Mary O’Mahony and Marianne Saam reports econometric results on the impact of intangible capital on labour productivity growth for the period 1995 to 2007. This covers 10 EU countries and 11 industries. Intangible capital in this paper is broadened to include most of the categories included in the previous research, namely four categories of own account intangible investment (organisational capital, firm-specific human capital, development of new financial products and R&D) and the four categories of purchased intangible investment (organisational capital, architectural and engineering designs, market research and advertising). This paper is a first attempt to compare results from growth accounting and econometric estimation concerning the contribution of a broad range of intangible assets to growth based on industry-level data. The econometric specification regresses value added per hour worked on ICT capital, non-ICT capital and Intangible capital. In the regression that pools across industries and countries, intangible capital has a large positive effect on labour productivity growth with coefficients varying between 0.10 and 0.17 depending on the estimation method, e.g. fixed effects or GMM. Using the fixed effects estimates, intangibles account for about 27% of the growth in labour productivity. This compares to 16% using a growth accounting methodology with factor shares as weights on input growth. Thus, the econometric results are suggestive that there are significant spillovers from using intangible capital. Similar results hold for ICT capital but not for non-ICT capital. When the sample is split between production and service sectors, it appears that intangible capital contributes more to labour productivity growth in service sectors than in production sectors, although these differences are relatively small. Finally the value of the output elasticity of intangibles in this paper is lower than the values of 0.25 − 0.55 found in the previous literature based on aggregate country level data. Therefore externalities from intangible capital are considerably dampened when allowance is made for heterogeneity across industries.
The paper Organizational Trust, Organizational Fear and TFP Growth – A Sectoral Analysis for the EU, by Felix Roth examines the implications of the concepts of trust and fear as intangible organisational practices that can impact on productivity. This builds on a literature that suggests trust fosters the competitiveness of an organisation through ensuring employees will be more committed to their organizations, making it easier to achieve flexible work organisation and to manage collective action within the firm. This is manifested through lower levels of monitoring. However, too much trust can lead to complacency and a lack of commitment. This curvilinear relationship between organisational trust points towards the potential importance of an opposite but distinct concept, organisational fear. In this paper the concept of fear is operationalised by considering job insecurity. Fear of losing one’s job might motivate employees to work harder in order to build a safeguard against their individual job loss but can also lower economic performance as insecure employees are less involved with the firm. This paper employs a regression analysis to investigate the impact of organisational trust and fear on the growth of total factor productivity, using data on sectoral productivity from 1996 to 2006. The trust measures uses the question from the European Working Conditions Survey on whether an employee can get assistance from his or her colleagues and boss while fear is measured by employees expectations on if they will lose their jobs. The paper suggests that there is no significant relationship between organisational trust and productivity growth at the sectoral level. In contrast there is evidence of a curvilinear relationship between fear of losing one’s job. In the three transition countries, the Czech Republic, Slovenia and Hungary, fear levels seem to be above optimal. In a sample of EU15 countries the paper also finds a curvilinear relationship driven by the sectoral variance in the sample. The sectors with levels of fear that are too high are hotels and restaurants, construction and business activities, those with seemingly optimal levels of fear are wholesale and retail trade, manufacturing and mining, and transport and communication while financial intermediation, public administration, and education and health appear to have too low levels of fear. As expected, employees with indefinite contracts are significantly less afraid of losing their jobs than those with fixed contracts. These results suggest that labour markets may be too regulated in some countries/sectors and too liberal in others. Especially in business services, fear has already reached levels that are counterproductive to Europe’s productivity performance. This sector is deeply engaged in knowledge production – a key asset for the future competiveness of European economies.
Linkages between Manufacturing and Services
The second main strand of the research in workpackage 2 was to investigate linkages between manufacturing and services, both looking at services as inputs to manufacturing but also the increasing services content of manufacturing output. The services content of manufacturing output has been increasing steadily in the EU in the past decade. Manufacturing firms increasingly offer services in combination with their products and/or services that are embedded in new physical products. On the input side, there has also been both an increase in the share of intermediate service inputs from abroad and a strong increase in the share of service occupations in the manufacturing sector, suggesting a shift in the production process towards service functions. Thus the distinction between manufacturing firms and service firms has become more blurred over time.
A first paper on this topic The Increasing Service Intensity of European Manufacturing by Martin Falk and Fei Peng considers both the direct impact of services content of manufacturing output on services occupations and the degree of complementarity of in-house services personnel and purchased services inputs. The idea is that an increase in the output of services will directly increase the demand for specific service occupations involved in preparing and delivering services. The increase in service revenues also has an indirect effect on in-house service occupations when internal and external services complement each other - external services are often used as an instrument to access specialised knowledge and skills and intermediate business services support services produced in-house. Using data on the manufacturing sector for 18 EU countries for the period 1995-2007, and fixed effects panel regressions, this research finds that labour demand is shifting away from production occupations to skilled service occupations. The results suggest that, on average, about 13% of the increase in the employment share of service occupations in the manufacturing sector can be attributed to the increase in the output share of services. When service occupations are disaggregated by different categories, the research finds that the output share of services is significantly and positively related to the share of managers, professionals, and technicians but service occupations involving clerks, administrative support, and other office-related personnel do not benefit. Also the paper finds that external services and highly skilled service occupations are complements, which supports the resource-based theory of external linkages with suppliers.
A second paper Export performance and increased services content in EU manufacturing, by Yvonne Wolfmayer, examines links between manufacturing-service linkages and export performance. The analysis finds a positive and highly significant impact of services on export market shares of manufactured goods. Thus, while price/cost competition and innovative activity are crucial in the explanation of international trade, market success is further driven by service inputs such as good product marketing, efficient distribution and transportations systems which are seen as proxies for increased product quality. Distinguishing between domestically-sourced service inputs and imports results in a robust and highly significant impact of international service linkages, while the analysis finds no impact of domestic service linkages. Thus, growing international service linkages – most likely service linkages to the export market – are more important than national linkages in promoting export competitiveness. Multinational firms and intra-firm trade might play an important role in this process. It might also reflect better access to internationally traded service inputs, which may be of higher quality than those from domestic sources.
The paper Determinants of Greenfield Foreign Direct Investment in Business Services by Martin Falk investigates the determinants of bilateral Greenfield FDI projects/flows in business services from OECD/BRIC countries to 40 industrialized and emerging countries for the period 2003-2010. Three types of Greenfield FDI projects in business or producer services are distinguished: (i) business services and (ii) logistics, distribution & transportation and sales marketing & support activities and (i) software and ICT services. The paper estimates an FDI ‘gravity’ equation using panel count data models that account for host, home and common time effects. The results show that distance, common border and a common language and a former colony relationship all play a significant role for bilateral FDI flows in business services. Corporate taxes and hourly wages also play a significant role. However, the impact of corporate taxes, wage costs or unit labour costs is higher in absolute terms for the EU-25 countries than for the total sample including 40 industrialized and emerging countries. For Greenfield FDI in software the paper finds that the strength of investor protection and costs of starting a business are important FDI determinants. The EU countries are still lagging behind in this respect, particularly to the US and other emerging countries.
The paper What affects the main engine of growth in the European economy? Industrial interconnectedness and differences in performance of business services across the EU25, by Maciej Sobolewski and Grzegorz Poniatowski examines the main factors which stand behind the diversity in performance of business services measured by their contribution to growth in the EU Member States. This paper argues that the extent of interconnectedness of business services with upstream industries is important to explain service-based economic growth. The paper first describes patterns of industrial interconnectedness of business services suggesting considerable diversity across the EU Member States. This diversity can be explained by differences in labour productivity and in forward linkages. The results indicate that investment in human and intangible capital are crucial for the service-dominated economy as they not only enhance economic growth inside knowledge intensive services but also facilitate transmission of growth impulses to downstream industries by increasing diffusion and integration of services as suppliers of high value added inputs to other sectors.
In a related paper by Iain Paterson and Richard Sellner, Professional Business Services and their Role in the EU Economy: Measuring ‘Knock-on’ Effects, the authors investigate the wider economic role of professional services within the EU. Besides their importance measured by shares in value added, gross output or employment, professional services contribute significantly to the economic performance in other sectors via forward linkages. Traditionally these linkages are defined by the Inverse-Leontief Matrix of an Input-Output system. However, this paper introduces a measure more closely related to the concept of forward linkages than captured by most previous empirical studies. The proposed linkages describe the embodied content of professional services per unit of gross output in the other industries. These linkages are then used to outline the importance of business services visually by network graphs, showing the most important forward links in an economy. Input-Output data from 2005 show that the sector ‘other business services’ holds a central position in the inter-industry network in most countries of the EU-27. The paper then introduces some new summary measures of economic knock-on effects out of these linkages. This finds that business services are the sector with the highest knocked-on value added and embodied valued within the European Union. Sectors depending most on forwarded inputs are office machinery, chemicals, computing services and R&D. The highest embodied value is found in trade, construction and finance. Attributable value added share of other business activities is 14% compared to its value added share of 8% in the economy of the sample. The economic importance of business services nearly doubles when one considers their inter-linkages with, and effects on all other sectors, highlighting the economic importance of business services.
The competitive and regulatory environment
Following on from measuring linkages between professional services and economic activity, a companion paper on regulation of these services is Regulation of Professional Services in EU Member States: Classification, Measurement and Evaluation, by Iain Paterson, Bianca Brandl and Richard Sellner. This paper has a two-fold purpose. Firstly it presents methods and results from studies (mainly involving the authors) that have fed into ongoing efforts at European Union level to classify regulatory systems in Member States, to find ways to measure the extent of regulation, and to evaluate whether state-legislated or self-regulation is anti-competitive as distinct from quality-enhancing regulation for consumers’ benefit. On the other hand, the paper presents results from a partial update of regulatory knowledge (regulation indices) and further develops a new measure of regulatory effect of professional services throughout the Member States’ economies based on the newly developed empirical measures of inter-linkage from the previous paper.
In the first part of the paper regulation of professional services was surveyed for a chosen subset of EU Member States, including Austria, Estonia, Finland, Germany, Italy, Spain and the United Kingdom. The results for the Accountancy profession in 2012 show for all countries a decrease of the regulation indices compared to 2002. The main determinants of this deregulation are the duration of compulsory practice and the liberalisation on prices and fees as well as on advertising. For Architects a decrease of regulation indices can also be identified. In Austria for example this is largely because there are now two entry routes into the profession, not just by university graduates possible but also through polytechnic degrees. For the market conduct regulations in Austria a liberalisation took place for advertising and for prices and fees. Binding and recommended fees have been abolished for the benefit for clients. Currently under review are the regulations on inter-professional co-operation and the access to the professions chamber. The deregulation of market conduct can be identified in all countries. For the Engineering profession often the same deregulation impulses as for Architects apply. The decrease can be chiefly explained by the liberalisation of market conduct behaviour. In Austria, for instance, the same reforms for Engineers as for Architects have been implemented during the past few years, facilitated by the sharing of some administrative structure. In contrast there is little evidence of any changes in regulation for lawyers and notaries. At present access to the notary profession is currently under review by the EU Commissions (Revision of the Professional Qualifications Directive). It is worth noting that the speed and alacrity by which common standards at the European level are enacted nationally varies considerably. Some implementations have to wait until a decision of the European Court is obtained. In terms of the community pharmacy profession, the conduct regulation index has been revised in some countries. For example in Finland inter-professional cooperation is allowed since 2002 which represents a slight upward revision of the overall index (combined market entry and conduct indices). In contrast in Estonia there was a trend to concentration of pharmacies opening in towns, and a corresponding shortage in the countryside, highlighting a case where regulation be introduced in the public interest.
The second set of questions being asked in the paper concern differences in economic effects of regulation in professional services. The answers are not always readily available. but considerable empirical evidence has been obtained on the “outcome” side in several studies that show (negative) links between particular types of regulation and economic performance e.g. in conveyancing services. In this paper a new measure of regulatory effect of professional services throughout the Member States’ economies was developed that refines previous approaches through taking into account direct and indirect effects, the relative contribution of sectors to the economy and the economic effects of regulation through downstream (as well as upstream) impacts. The results of the updated indicator show some modest decrease in anti-competitive regulation in professional services, mainly with respect to market conduct behaviour: more openness to new forms of businesses, price setting, fees and advertising.
An extension of this work is the paper titled Regulation of services industries and ICT diffusion: Accounting for upstream and downstream linkages, by Iain Paterson, Ana Rincón-Aznar, Richard Sellner, Bianca Brandl, and Catherine Robinson. Excess regulation is often considered to be a barrier to growth because it stifles competition and prevents the market from efficient functioning in terms of the allocation of resources. Recently, empirical research has focused on the forward or “knock-on” impact that regulation of key input-providing services industries has across the economy. The main results in this paper suggest that regulation hinders ICT capital accumulation but only when accounting for the harmful effects of both forward and backwards linkages between heavily-regulated sectors and the remaining sectors. This is found mainly in the services sectors where most of the productivity differences between high-regulation and low-regulation countries seem to lie. The paper finds that in addition to regulatory effects being transmitted forward (“knocked-on) they may induce negative effects on production through backward linkages. The paper then shows that regulation significantly harms the ability to translate ICT into productivity gains. EU countries that have been characterised by lower ICT investment and regulation have prevented re-organisation of production and incorporation of skills necessary for an effective implementation of ICT technologies.
The current global financial crisis has revealed the complexity of the interactions between regulations, competition and stability in the financial services industry and led to a crucial debate over how to improve the financial regulatory and supervisory framework. In particular, bailing out financial institutions during the crisis, together with the proposed regulatory changes, raised concerns over the resulting market structure and the implications for competition in the finance sector. The paper Market power in CEE banking sectors and the impact of the global financial crisis by Georgios Efthyvoulou and Canan Yildirim seeks to undertake an up-to-date assessment of market power in Central and Eastern European (CEE) banking markets and identify the factors that explain its size and variation over time. In particular, this study aims to analyze how the global crisis has affected market power and what has been the impact of foreign ownership. The focus on CEE countries stems from the observation that the banking sectors in these countries have undergone a major restructuring process as the transition from centralized systems to market economies progressed. In addition CEE banking systems share one common trait: high level of foreign bank penetration due to high economic and financial integration with the European advanced countries. While this has been instrumental in the pre-crisis economic growth of these countries, during the crisis their banking systems became highly susceptible to deepening European debt and banking crisis. Hence, the results contribute to a better understanding of how the market power of banks with different ownership classes evolved over time and whether the impact of ownership on market power has changed in response to the crisis.
The empirical analysis is undertaken for 17 CEE banking sectors over the period 2002 to 2010 and involves two stages. In the first stage, the authors develop non-structural bank-level Lerner indices and examine the evolution of market power during the sampled period, whereas in the second stage, they use a dynamic econometric framework to identify its determinants. The bank level variables include proxies for operational inefficiency, revenue diversification, funding preferences, asset quality, capitalization, and bank size. The GDP growth rate and the inflation rate are included as controls for macroeconomic fluctuations and business cycle effects, while institutional measures include the degree of concentration and the EBRD index of banking sector as a proxy for the financial sector development. The overall picture emerging from the country averages and the changing trends over time is rather mixed, with some countries reflecting more competitive behaviour than others, and/or exhibiting relatively more competitive practices in certain years. In analysing what determines market power, the authors find that the coefficient on the lagged Lerner index is positive and statistically significant, indicating persistence of market power over time. Concerning bank-level variables, operational inefficiency reduces market power; banks with higher share of non-interest income in total revenue tend to have higher margins; capitalization has a positive and highly statistically significant impact on market power. On the other hand, the proxies for funding preferences and the quality of the asset portfolio appear to exert little or no influence on the margins. Among the macroeconomic variables, the results show that during economic expansions banks have relatively higher margins. In examining the role of ownership and home-county characteristics on margins, the results suggest that foreign banks have higher margins, primarily driven by foreign banks originating from the US and the EU. Splitting the sample period to explore the impact of the recent financial crisis on the banks’ market power determinants, the results suggest that the impact of capitalization and the extent of non-performing loans on market power does not depend on the ownership status in the years preceding the crisis but this alters significantly during the crisis years with opposite impacts for domestic and foreign banks. This result can be attributed to the fact that foreign-owned banks carry significantly less non-performing loans than domestically-owned banks, and hence, in times of financial turmoil, foreign ownership can eliminate the negative impact of non-performing loans by signaling lower risk or better quality. Also the important role of capitalization on margins in the case of domestically-owned banks suggests that higher risk perceptions in financial markets disproportionately affect domestic banks with lower capital levels. Domestically-owned banks may face higher costs of external funding and increased barriers to international financial transactions during episodes of financial turmoil, and may also be subject to market discipline.
WP3: Firm strategies in the knowledge-based economy
Innovation in Services
There has been considerable interest in what determines whether a firm innovates. Whilst firm-level characteristics are undoubtedly important, less evidence is available on the impact that local infrastructure has on their firm-level propensity to innovate. In their study Which Firms Innovate in British Manufacturing and Service Sectors? Rebecca Riley and Catherine Robinson use a combination of firm and regional measures to explore the extent to which the external environment affects the probability that a firm will innovate, differentiating between high and low skilled manufacturing and service sectors. For the empirical analysis, successive waves of the UK Community Innovation Surveys (CIS) are linked and then matched to their financial data from the Annual Respondents Database. Previous analyses have suffered from timing issues in relation to the performance and innovation variables, since they are at best simultaneous, but quite often post innovation measures of performance. The linked longitudinal data allow to identify variation within the cross section (i.e. between enterprises) and also over time (within an enterprise). The key findings are that agglomeration effects have more influence on the propensity to innovate in higher skilled sectors of both manufacturing and services. Thus, co-location plays a more important role in high-skilled sectors. Also agglomeration is more important in manufacturing than in services. In manufacturing, SME status has a negative effect and foreign ownership has a positive effect on the propensity to innovate.
Iulia Siedschlag, Neill Killeen, Donal Smith and Catriona O’Brien address the relationship between firms’ internationalisation and their innovation performance in their paper Internationalisation and the Innovation Activities of Services Firms. With growing tradability of services and increasing exposure to competition, there is more pressure for services firms to innovate and increase productivity. For a sample of Irish firms covering the period 2004 to 2006, the authors analyse whether services firms with international linkages are more likely to invest in innovation and whether they have more innovation output than firms serving only the domestic market. The econometric results suggest that compared to firms serving only the domestic market, domestic exporters are more likely to engage in R&D and innovation and are more successful in realising innovation output. IT use is found to be positively related to innovation output. Also cooperation with stakeholders external to the firm is positively linked to innovation activities.
Innovation activities might be constrained by scarce financial resources. In particular, during the economic crisis there is a broad discussion about whether firms are financially constrained and therefore cannot exploit their innovation potentials. So far, there has been a lack of cross-country micro-level studies exploring the effects of financial constraints on innovation performance in Western Europe and only very little research about the variability of such effects between the broad sectors of production and services. The paper Financial Constraints and Innovation Performance: Are All Firms Similar´ by Georgios Efthyvoulou and Priit Vahter analyses how the effects of financial constraints on innovation performance vary by sector and firms. The analysis is based on the CIS 4 and/or the CIS2006 for the eleven EU countries. The paper examines whether the effects depend on firm characteristics (export orientation, membership of a larger enterprise group) and vary between the broad sectors of production and services. In order to avoid the spurious positive correlation due to firms not wishing to innovate (and thus without financial obstacles to innovation), the authors restrict the sample to include only the potentially innovative firms. They consider the effects on the propensity to have high innovation performance (high share in sales of innovative products or services) rather than the propensity to engage in innovation activities. In addition, they tackle the endogeneity problem by estimating the probability of having high innovation performance and the likelihood to face financial constraints simultaneously using recursive-mixed process estimators and employing various sector-level instrumental variables for the endogenous financial constraints indicator. Their results suggest that innovative firms facing financial constraints have a significantly lower probability (by approximately 15-20%) to be in the group of most successful innovators. The responsiveness to such constraints is stronger in innovative manufacturing than in innovative services firms. In addition, within sectors, non-exporting firms are more sensitive to financial constraints than exporting firms.
Information technology has diffused through all economic sectors. In particular services sectors are relatively IT intensive since a high percentage of employees work with computers. Owing to rapid technological progress firms are faced with the obsolescence of their technical equipment and know-how. As a consequence, many firms source out IT services such as the maintenance of hardware, or software programming, to external service providers. In 2006, on average 43% of the firms in the EU-15 sourced out IT services to external service providers. This share varies between 20% in Greece and 78% in Denmark. The determinants of information technology outsourcing (ITO) as well as firms' incentives to source out non-core activities have been examined extensively and suggest that the main motivation is to reduce costs on non-core IT activities that are better provided by suppliers with superior expertise and technical capabilities. Less research focused on the impact of ITO on firm performance. In their study IT Outsourcing – A Source of Innovation? Microeconometric Evidence for Germany, Irene Bertschek and Daniel Erdsiek analyse whether ITO increases a firm's probability of realising product or process innovations due to setting free resources that can be redirected to core competencies such as innovation activity. For the empirical analysis, the authors use two waves of the ZEW ICT survey, 2007 and 2010, comprising 1453 firms from the manufacturing and the services sector in Germany. The data set allows the use of different measures of ITO taking into account that the degree of outsourcing might matter and that there might be nonlinear relationships between ITO and innovation activity. The key findings are that ITO is particularly important for process innovation in services since services firms are generally more IT intensive and more dependent on a well-functioning IT infrastructure. In contrast, a high share of ITO is positively related with manufacturing firms‘ product innovations.
An important result from economic research on the role of IT for productivity and innovation is that investment in IT should be accompanied by complementary investment in organisational capital. Organisational capital is an intangible asset and its measurement is quite challenging. The paper Innovation and Productivity in Services: The Role of Organisational Capital and IT by Rebecca Riley and Priit Vahter focuses on the issue of organisational capital. It attempts to answer the question what roles IT and organisational capital (OC) play in the innovation process. In particular, the authors are interested in the relationships between IT and OC and innovation investments, innovation outputs and productivity of services firms. They investigate whether there is evidence of complementarities between IT and OC in different stages of the innovation process and whether the importance of IT and OC vary in different types of services sectors. The econometric analysis is based on the UK innovation surveys covering the periods 2002-2004 and 2006-2008. This data is merged with firm-level data on own-account intangible assets developed in the FP7 INNODRIVE project. The key findings are that organisational and IT capital contribute to innovation performance of UK services firms mainly through a strong relationship with the intensity of innovation investments; this is especially so in the knowledge intensive services (KIS) sectors. Organisational capital is positively associated with firm’s productivity level in all sectors. This correlation is very high, even when controlling for workforce qualifications. IT capital matters for productivity much more in KIS than in non-KIS sectors. This is consistent with the notion of complementarities between other knowledge assets and IT and between other knowledge assets and organisational capital. The authors find no evidence of complementarities between organisational capital and IT in either innovation or final output.
In their paper Innovation and Productivity in Services: Evidence from Germany, Ireland and the United Kingdom, Bettina Peters, Rebecca Riley, Iulia Siedschlag, Priit Vahter and John McQuinn provide empirical evidence on the links between innovation investment, innovation output and productivity in service enterprises. To this purpose, they use firm-level data from the Community Innovation Surveys 2006-2008 in Germany, Ireland, and the United Kingdom and estimate an augmented structural model linking innovation inputs, innovation outputs and productivity. They find that the predominant innovation types in services are organisational and marketing innovations. In manufacturing, the highest innovation rates vary across the three analysed countries: in Germany, the highest innovation rates are for marketing innovations, in Ireland for process innovation and in the UK for product innovation. Successful innovation in service enterprises appears associated with size, innovation expenditure intensity (in Germany and the United Kingdom), foreign ownership (Ireland), exporting and engagement in co-operation for innovation activities. The authors also show that innovation in service enterprises is related to higher productivity with the link strongest for marketing innovations in all three countries.
The paper External vs internal determinants of firm technology strategy: Evidence from the Polish services sector by Krzysztof Szczygielski, Wojciech Grabowski and Richard Woodward considers technology strategy based on the responses of over 1000 Polish service sector firms reporting innovation-related activity to the Community Innovation Survey (CIS) for 2004-2006 and 2008-2010. The research begins by using factor analysis to identify patterns in the strategy variables for the firms that introduced product or process innovations, leading to proposals for a group of strategy variables. These include the firm’s posture as pioneer or follower, its R&D efforts, technology portfolio variables (capacity building, innovations in organization and marketing, process- and product- orientation of innovations), monitoring the science sector and monitoring the markets. The paper then examines the determinants of technology strategies. The authors find that Industry is a significant determinant of technology strategy. The firms in knowledge-intensive business services, telecommunications and ICT services are more likely to pioneer technologies, to invest in R&D and to monitor the science sector. Financial services is similar in its propensity for radical innovations, but is less likely to invest in R&D and highly unlikely to use information from the science sector. Low-tech service industries are clearly less likely to invest in R&D or become technology pioneers. Low-tech firms are also less likely to engage in easy to adopt capability-building activities (such as conducting innovation-related training or acquiring equipment, and software needed for innovation purposes). Thus, it appears that firms from high-tech industries are more likely to introduce all kinds of innovations. Finally, smaller and standalone (i.e. resource-poorer) firms are less likely to pioneer technologies and to invest in R&D while foreign-owned firms are more likely to introduce radical innovations.

Innovation and Employment
Stimulating innovation activity and productivity growth is a desirable task for firms and policy makers. However, this might have effects on employment. The paper The Influence of Technological and Non-Technological Innovation on Employment Growth in European Services by Bettina Peters, Rebecca Riley and Iulia Siedschlag analyses the role of technological (product or process) and non-technological (organisational) innovations for employment growth in stimulating employment and if these differ between manufacturing and services firms. For the econometric analysis, data from the Community Innovation Survey CIS2008 in 20 European countries is used, i.e.18 countries for which data are available at the Eurostat Safecenter plus data from the UK and Ireland. This data covers employment growth for the period 2006-2008. The results show that product innovation stimulates employment growth in all 20 countries and in all sectors. However demand effects of old products contribute more to employment growth than product innovations (exceptions are Germany, Portugal and high tech KIS sectors). Employment growth owing to product innovation appears to be smaller in services than in manufacturing and the role of organisational innovation differs across sectors. The results suggest only weak evidence of employment effects of process innovations and that there is no evidence of complementarities between process and organisational innovation.
The paper The Impact of New Service Products on Employment Growth: Evidence based on Linked Firm Level Data by Martin Falk used matched innovation survey and structural business statistics for Austria to investigate the link between the introduction of new service products and subsequent employment growth. The linked data set made it possible to investigate the impact of past innovations on subsequent employment growth. The analysis is based on 3400 firms in the manufacturing and service sectors. The results from regressions covering all firms suggest that both the introduction of new goods and process innovations have a significant and positive impact on subsequent employment growth on average while the introduction of new services has no discernible effect. Possible explanations are that new service products are often characterized by imitations rather than radical innovations. In contrast, however, quantile regressions show there is a significant positive employment effect of service product innovations for high-growth firms. Traditional forms of technological innovations, namely the introduction of new goods and process innovations leads to higher employment growth not only for high growth firms but also for shrinking firms.
In the paper Innovation and firm growth in Polish service firms 2006-2009, Krzysztof Szczygielski, Wojciech Grabowski and Richard Woodward investigate the link between innovation performance and employment growth in Poland. The paper uses data on several thousand Polish service firms for two time periods 2006-08 and 2008-10 from the Community Innovation Survey and employs quantile regressions. The results are not consistent with Gibrat’s Law in that the paper finds that small firms consistently grow faster. Rather curiously, the positive contribution of service innovations to employment growth is significant for the slower-growing firms. It is therefore clear that for the fastest growing firms, employment growth was driven by other things than the introduction of new services. Marketing innovations contribute to employment growth in 2006-2008 both for slow and fast growers. As the second of the subperiods, 2008-2010 saw much more sluggish growth than the first one, the significant and negative coefficients for process innovations confirm the hypothesis that process innovations were more likely to result in employment reduction in economic downturns than in times of rapid growth. Finally, the paper suggests some support for the hypothesis that higher-skill industries would tend to see more rapid employment growth than those in lower-skill industries.
WP4: Internationalisation of services and growth
International Trade in Services
According to the World Development Indicators, 69% of global value added was generated in services sectors in 2008 compared to 53% in 1970. In line with the increasing importance of the services sectors especially in developed countries, trade in services has increased substantially since the mid-1990s. Not all services are traded by service-producing enterprises, indeed many services accompany the delivery of goods by manufacturing enterprises. The opposite is true as well, however, as many services sector enterprises also trade goods. A large literature on the manufacturing industries has established that larger, more productive, more capital and skill-intensive enterprises are more likely to engage in trade. Moreover, only a small number of large trading enterprises trade many products with many countries and it is these enterprises that account for the bulk of trade in value terms. Evidence on such patterns on trade and trading enterprises in the services sectors is still limited. This research task examined the extent to which enterprises in services engage in importing and exporting, obstacles to trade in services and the impact of international trade in services on enterprise productivity and employment in EU countries.
To better understand trade in services at the enterprise level, the research paper “A Portrait of Trading Enterprises in the Service Sectors – Comparable Evidence from Four EU Countries” by Stefanie Haller, Jože Damijan, Ville Kaitila, Črt Kostevc, Mika Maliranta, Emmanuel Milet, Daniel Mirza and Matija Rojec, provides comparable empirical evidence on: (i) the characteristics of the enterprises that trade; (ii) how important foreign markets are for these enterprises; and (iii) what they trade. In addition, the authors compare these patterns to those in the manufacturing sectors. This research paper establishes a set of stylised facts on trade and trading enterprises in the services sectors based on similar patterns in four rather heterogeneous EU countries, namely Finland, France, Ireland and Slovenia. It finds that, in all countries except Ireland, exports and imports of services enterprises grew faster than exports and imports of manufacturing enterprises. Trade by services sector enterprises also grew faster than the overall sales by these enterprises (again with the exception of Ireland). The share of traders in services is substantially lower than in manufacturing where 60-80 per cent of enterprises are engaged in trade. This analysis shows that on average across services sectors 15-25 per cent of enterprises export and 15-32 per cent of enterprises import. Only in Slovenia do these figures exceed 50 per cent. The only services sector with a share of trading enterprises close to those in manufacturing is wholesale and retail trade, especially on the import side. The share of traders in the services sectors is larger among multinational enterprises and is also high among larger enterprises. As in manufacturing most trading enterprises both export and import, but one-way traders – enterprises that export only or import only – are more important in the services sectors than in manufacturing, contributing around 30 per cent to aggregate trade in some services sectors and countries compared to about 2 per cent in manufacturing. Exports are marginally less concentrated in the largest traders in the services sectors than they are in manufacturing in all countries but France. On the import side, these differences vary by country. On average the services traded are of much higher value than the traded goods. Probit regressions further indicate that, as in manufacturing, an enterprise’s past trading status is always the strongest predictor of its current trading status. The paper shows that, similar to manufacturing enterprises, there is a negative relationship between the number of enterprises involved and the number of markets served as well as between the number of enterprises involved and the number of services traded. While a relatively small share of enterprises (23-38 per cent) export services to five or more countries, these enterprises account for 67-90 per cent of overall export value.
An interesting hypothesis of why trade might be lower in professional services than goods is provided in the paper Missing Cross Border Trade in Professional Services: the Nature of the Product Matters by Guillaume Gautier, Francesco Magris and Daniel Mirza where the authors argue that the one off nature of many services contracts can explain the lower propensity to trade. The paper focuses on professional services such as legal services, management consultancy, engineering and R&D services where, like goods, face to face contact between sellers and buyers is not required. These services have two distinguishing features: they are customised to the clients’ needs and repeat services are not the norm. The authors set up a theoretical model of the decision to enter a foreign market and show that this is increasing in the probability of contract renewals and decreasing in contract setup costs. Using a rich dataset merging various sources of information on French firms providing professional services, preliminary estimates by the authors show that differences in trade between manufacturing and services appear to be driven by differences in contract renewals.
So far, liberalizing cross-border trade and investment in services has not been very successful. The most important reason is that access barriers to services markets are ' behind the border measures', essentially domestic regulations and supervision. In this context, understanding these barriers implies uncovering the nature and economic rationales of domestic regulation that hinders or prevents foreign trade or FDI. The research paper titled “Market Access Barriers in Services: A Survey”, by Jacques Pelkmans and Federica Mustilli provides a detailed overview of the barriers to market access in services, their restrictiveness and economic meaning. They distinguish between market access barriers restrictions in a non-European Union (EU) environment (WTO/GATS) relative to the intra-EU environment, and highlight the significant differences in scope and coverage. This research finds that in the non-EU WTO/GATS environment, the practical effects of GATS disciplines and commitments for the reduction or removal of services market access barriers are rather limited. This is true for both cross-border trade in services (GATS modes 1, 2 and 4) and FDI (mode 3). In fact, the existing somewhat crude empirical measurements of services access barriers, on the basis of restrictiveness indices, show numerous and often high or even prohibitive access barriers, with many barriers even based on 'discrimination'. When access barriers are numerous and usually not disciplined by GATS (as yet), restrictiveness indices need to be extremely refined for conveying the central messages for policy makers. Using the case of airline service liberalisation, the authors illustrate the need for a greater refinement of restrictiveness indices for understanding barriers to services market access.
In the case of intra-EU services market access, the regulatory regime is far more ambitious and radical, by introducing treaty fundamentals such as non-discrimination, proportionality, free movement, right of establishment, EU competition policy and a common reasonably credible enforcement. The reduction and / or removal of services market access barriers in the EU under the 2006 Services Directive (covering some 60 % in terms of values of services turnover in the EU) has been relatively successful, due to 'ownership' by EU Member States when implementing the directive, to close cooperation between Member States and the European Commission and to a number of services trade facilitation measures. The remaining barriers call for assessment on the basis of a much more refined restrictiveness index and a careful evaluation of the 'public interest' (i.e. market failures) justification at national level. Detailed inspection of the barriers tackled by the Services Directive also show the vast variation in instruments, as well as the many features of regulatory heterogeneity which often seems to serve no justified purpose. Finally, services access restrictiveness indices are only moderately helpful, and much more refined tools ought to be developed.
Further empirical evidence on service enterprises engaged in trade from the same four EU countries is provided in the research paper “The Performance of Trading Enterprises in the Services Sectors – Comparable Evidence from Four EU countries” by Jože Damijan, Stefanie A. Haller, Ville Kaitila, Mika Maliranta, Emmanuel Milet, Daniel Mirza and Matija Rojec. More specifically, this paper compares the performance of non-traders, one-way traders (enterprises that export only or import only) and two-way traders (enterprises that export and import). Furthermore, it establishes whether or not among exporters and importers there are differences in performance between enterprises that trade services, goods or both. In addition, it compares the performance of enterprises that change trading status to those that retain the original trading status. It thus determines whether enterprises are more productive before changing trading status or whether the new trading status confers specific advantages.
This research finds that service enterprises are relatively less engaged in trade than manufacturing enterprises. Similar to manufacturing enterprises, service enterprises that engage in trade are larger, pay higher wages and have higher productivity than enterprises that do not trade. Service enterprises are more likely to be engaged in imports than exports, and the prevalent type of trade is trade in goods only. The complexity of trading activities is increasing in firm size and productivity. Two-way traders always outperform one-way traders. It also finds that trade in services is quite rare; services are more likely to be traded by enterprises already engaged in goods trade. In addition, changes in trading status by either adding another dimension of trade (imports, exports) or another type of product traded (goods, services) are infrequent and are associated with significant pre-switching premia. Learning effects from switching trading status are uncommon. These findings suggest that, similar to manufacturing enterprises, trade by services enterprises is associated with significant fixed costs of engaging in trade with the costs of importing being lower than costs of exporting. Consequently, importing is a prevalent trade mode. The costs of trading services are larger than the costs of trading goods. Only the largest and most productive enterprises can afford to engage in imports and exports of both goods and services.
Further in-depth evidence on export behaviour of enterprises in manufacturing and services is provided in the research paper titled “Differences in Export Behaviour of Services and Manufacturing Enterprises in Slovenia” by Jože Damijan and Tanja Grublješič. The results show that Slovenian exporting services enterprises are more productive than non-exporting enterprises when observed and unobserved heterogeneity are controlled for. More productive services enterprises self-select into export markets, the magnitude of future exporters’ pre-entry productivity premia compared to non-exporters’ is even larger than for manufacturing enterprises. In terms of learning-by-exporting effects they find no conclusive results.
International Investment in Services
An increasingly important activity in the European service sector is international investment. Over the past decade there has been a surge in cross-border mergers and acquisitions (M&A) in both manufacturing and services. While existing studies have looked at the effects of foreign ownership on firm performance in manufacturing, there is a lack of knowledge and understanding of the effects of foreign ownership on firm performance in services. This research task provided novel evidence on the profile of firms engaged in M&A, the prevalence of “cherry-picking” by foreign investors and the effect of foreign acquisition on firm productivity and employment in services. In addition, it examined the variation of these effects across countries and uncovered country-specific factors that enable productivity gains following foreign investment. While it is widely documented that the superior performance of foreign-owned enterprises is linked to their large endowments of intangible assets to compensate for a lack of local information and experience, the difficulty is to identify the causal link between foreign ownership and firm performance, given other firm-specific confounding factors. Foreign M&A imply a change of ownership and they thus provide a natural experiment which can help to identify the effects of foreign ownership on firm performance. While most existing analyses have focused on enterprises in manufacturing, the evidence for enterprises in services is scarce.
The research paper titled “International Investment and Firm Performance: Empirical Evidence from Small Open Economies” by Ville Kaitila, John Mc Quinn, Iulia Siedschlag and Xiaoheng Zhang, examines the causal link between foreign investment and firm performance in six European Union small open economies: Austria, Belgium, Denmark, Finland, the Netherlands and Sweden. Specifically, using micro data for manufacturing and services over the period 2001-2009, it analyses the effects of foreign M&A on labour productivity and employment growth. The research methodology consists of the estimation of the foreign acquisition propensity conditioned by the observed enterprise characteristics which is then used to match foreign acquired and domestic non-acquired enterprises. A difference-in-difference empirical approach is used to determine the causal effect of foreign M&A on enterprise performance, by calculating the difference between outcomes of foreign acquired and matched domestic non-acquired enterprises up to five years after acquisition. Calculating the difference over time allows controlling for unobserved time-invariant characteristics. The results indicate that foreign M&A had stronger effects on enterprise performance in services in comparison to manufacturing. However, overall, no general pattern emerges with respect to the effects of foreign investment on firm performance across the countries in terms of productivity and employment. For example in services, productivity increased in only three of the countries while employment grew in four and declined in two. In most of the countries foreign M&A led to lower productivity growth in manufacturing.
While the popular media and the general public tend to associate outward investment by multinationals necessarily with economic losses (in employment, wages, etc.), much economic research has found that this is not the case. Indeed, studies find that multinational enterprises (MNEs) have an advantage over others in terms of efficiency and productivity, which can be further exploited abroad. Even if they relocate activity abroad, they tend to concentrate on high-value, high-skill headquarter activities at home, and overall there is little evidence that they substitute host country for home country employment. The recent wave of cross-border M&A added a new dimension to this debate. The question that is discussed now is: What will happen to the domestic multinationals, and in particular their R&D and other headquarter activities, once they are acquired by a foreign owner?
To answer these concerns, the research paper “Foreign Acquisitions, Domestic Multinationals, and R&D” by Roger Bandick, Holger Görg, and Patrik Karpaty evaluates the causal effect of foreign acquisition on R&D intensity in targeted domestic enterprises. It distinguishes domestic multinationals and non-multinationals, which allows investigating the fear that the change in ownership of domestic to foreign multinationals leads to a reduction in R&D activity in the country. Overall, the results give no support to the fears that foreign acquisition of domestic enterprises lead to a relocation of R&D activity in Swedish MNEs. Rather, this paper finds robust evidence that foreign acquisitions lead to increasing R&D intensity in acquired domestic MNEs and non-MNEs. These research results suggest that fears that the acquisition of large Swedish multinationals by foreign owners may lead to a relocation of R&D activities abroad appear unfounded.
Foreign acquisitions are an increasingly important mode of FDI in the new EU member states (NMS). The research paper “Growing Lemons and Cherries? Pre- and Post-acquisition Performance of Foreign-acquired Enterprises in New EU Member States”, by Jože Damijan, Črt Kostevc and Matija Rojec uses enterprise level data and a common estimation framework for seven New Member States to analyse pre-and post-acquisition performance of acquired enterprises. Using a standardized approach it finds that selection criteria of target enterprises differ significantly across countries. In some countries evidence tends to support the idea of 'cherry picking' with better enterprises being chosen as targets for acquisition, while in the others `lemons' with growth potential seem to be selected. Regardless of what type of firms were targeted, the performance of acquired enterprises improved after the acquisition, and the boost in productivity has not been achieved by reducing employment but mostly by increased efficiency in the use of labour and especially capital. This paper also finds that foreign ownership generates biggest benefits to small and less productive enterprises. Finally, it appears that manufacturing enterprises benefit more from an acquisition than services enterprises in this group of countries as they start off with a more substantial productivity lag and experience more evident post-acquisition improvements.
In recent years most investment incentive policies were geared toward attracting greenfield investment, which was deemed safer than investment driven by takeovers or mergers of existing enterprises by many policy makers and economists alike. The conventional thinking about the two types of direct foreign investment was that greenfield investment represents a direct beneficial impact of job creation on an economy, whereas M&A often result from market competition and elimination of successful competitors. As such they rarely imply creation of new jobs, improvement of performance and new capital investments into the acquired firm. This paper shows that the impact of foreign M&A can be positive overall for both the targeted firm as well as the local economy. It shows that foreign acquisitions can have a beneficial effect on acquired-enterprises’ efficiency as they are shown to improve their post-acquisition productivity substantially. It is important to note that the effects are most pronounced for small and initially less productive enterprises which may hold more potential ex-ante for investors and turn out to experience most robust benefits. In addition, this research shows that these effects, contrary to popular belief, do not stem from downsizing and/or capital weakening. The effects of a domestic takeover are by comparison not as strong as those of a cross-border acquisition, signalling that the effects are not due purely to the act of the acquisition, but are, to a large extent driven by the origin of capital.
The research paper “Foreign Investment and Firm Financial Performance” by Georgios Eftyvoulou and Liza Jabbour examines the causal effect of foreign and domestic acquisitions on firm financial performance in Italy and Spain over the period 2002-2010. Financial conditions tend to influence the enterprises’ capacity to grow and export and their likelihood to survive. In addition, the absence of financial constraints is positively related to enterprises’ propensity to engage in innovation activities and to have high levels of innovation success. The results show that highly productive enterprises are more attractive to foreign acquirers than to domestic acquirers. This may be driven by the fact that domestic investors have better knowledge of the local market, customers, and business networks, and hence, rely less heavily on basic observable information, such as productivity, to select their potential targets. The research suggests that larger and younger enterprises are more likely to be acquired but foreign acquirers of Italian enterprises tend to favour higher capital-labour ratios, whereas those of Spanish enterprises tend to favour lower capital-labour ratios. This research finds that foreign acquisition leads to a significant and steady reduction in financial risk. While the treated and control groups start with very similar levels of gearing (ratio of short and long term debt to shareholders funds) in the pre-acquisition period, the former exhibit lower ratios and therefore levels of financial risk in subsequent years. In contrast, the analysis indicates that the impact of acquisition on financial risk is weaker and statistically less robust when the enterprises are acquired by domestic investors. Foreign acquisitions lead to a significant improvement of acquired enterprises’ financial performance, which becomes visible in the acquisition year and lasts for several years after acquisition.
In the paper Surviving the Crisis: Foreign Multinationals vs Domestic Firms in Ireland, by Olivier Godart, Holger Gorg, and Aoife Hanley, the authors investigate the propensity of firms to leave markets following a negative shock. The paper considers the case of Ireland which has been very adversely affected by the crisis but where export growth, both in manufacturing and services, has remained strong. They examine in detail firm closures, controlling for other firm and industry characteristics. The results suggest that foreign firms are no more likely to exit the market than domestic firms following the crisis, although exit probabilities increase for both. This result holds for both manufacturing and services. Foreign firms do not introduce instability to the market.
As discussed above, empirical estimates of the effects of foreign investment on productivity in both manufacturing and service enterprises vary across countries. To understand what factors drive this variation of results, the research paper “Foreign Investment and Firm Productivity in Services: A Meta-Analysis” by John McQuinn and Iulia Siedschlag employs a meta-analysis methodology to examine econometrically the variation in estimates across countries. The evidence suggests that those service enterprises likely to experience increases in productivity following foreign acquisition are located in more economically advanced, less open economies, with high human capital, more efficient financial markets, more product market competition and stricter employment protection legislation. In addition, R&D intensity measures and specialisation in technology-intensive exports are also linked to increased productivity following acquisition. For service enterprises, absorptive capacity is greater in more developed economies with higher human capital. Business investment in R&D increases absorptive capacity and hence the productivity gains experienced by foreign acquired service enterprises. Similarly to the service sector, it appears that in manufacturing enterprises, greater technology-intensive industry specialisation enables productivity gains following foreign acquisition, with larger economies gaining the most from these policies.
International Outsourcing of Services
This research task investigated empirically the profile of firms engaged in international outsourcing and the effect of outsourcing on productivity, employment, and innovation. Over the past two decades, technological advances have led to the reduction of transport and communication costs which in turn have enabled a greater fragmentation and internationalisation of production. In recent years, there has been a growing offshoring of services. While the public and policy attention have focused primarily on labour market effects of offshoring, robust empirical evidence on the factors driving offshoring including enterprise and location characteristics is still scarce. The research paper titled “Determinants of Offshoring - Evidence from Ireland” by Gavin Murphy and Iulia Siedschlag analysed factors that are expected to influence an enterprise’s decision to offshore business activities using data for enterprises in Ireland over the period 2001-2006. The results suggest that in services, larger, more productive enterprises, foreign-owned enterprises, domestic exporters and those which used information and communication technologies intensively were more likely to offshore business functions. Furthermore, characteristics of the import source region had an important influence on enterprise offshoring behaviour, with offshoring to regions outside of the more advanced EU economies (EU15) being less likely. It appears that patterns of offshoring differed between service and manufacturing enterprises. Core business activities were more likely to be offshored compared with service support business functions.
In the public perception, international outsourcing or offshoring is often associated with layoffs, wage reductions, and a rise in wage inequality. Moreover, while offshoring has for a long time been limited to manufacturing activities, the last decade has also witnessed an increase in offshoring of services, thus further fuelling the debate about the social consequences of offshoring. Past studies have not distinguished accurately between offshoring, domestic outsourcing, and supplier changes. The research paper “Offshoring, Domestic Outsourcing and Productivity: Evidence for a Number of European Countries” by Tillmann Schwörer provides stylized facts on offshoring in European countries between 1995 and 2008 taking into account this distinction. This research shows that service activities have been systematically offshored and domestically outsourced, whereas manufacturing activities have been either offshored or moved from domestic to foreign suppliers. The strong overall decline in the share of internal production observed in this period evokes the question whether this has led to productivity gains within enterprises. Combining industry data on offshoring and domestic outsourcing with a firm panel, this study finds that service offshoring and offshoring of non-core manufacturing activities have contributed to an increase in productivity. In contrast, no statistically significant link is found for offshoring of core manufacturing activities and domestic outsourcing. The estimated productivity gains are found to be driven in particular by the gains of multinational enterprises - offshoring does not raise productivity if the enterprises are poorly integrated into global markets. The costs of managing the relation and the contract with the offshore supplier can be too high for enterprises that have little knowledge about foreign markets or are too small. The results suggest that enterprises should keep the activities that they are most specialised in within the firm, preserving their firm-specific know-how. In terms of services, there is, however, scope for offshoring-induced productivity improvements, because many service activities performed in manufacturing enterprises are not core activities. Overall, the share of in-house production in the total value chain has decreased by more in European countries than in the US. The decrease of in-house production in Europe is due to a systematic increase in offshoring and domestic outsourcing of services with no trend towards domestic outsourcing of materials. Rather, there is evidence that domestic suppliers of material inputs have been systematically replaced by foreign suppliers. In the case of service inputs, domestic supply is about eight times as important as foreign supply. This is taken as evidence of the specific nature of certain types of services which are (still) not tradable or only tradable at high costs over long distances and points to existing barriers for the cross-border trade of services.
Recent advances in information and communication technologies (ICT) are recognised to be an important driver behind the rise in offshoring intermediate inputs from the mid-1990 onwards. ICT have the potential to reduce communication, information and transaction costs, which in an international context, can be interpreted as trade costs. In particular, the Internet has made previously mostly non-tradable services tradable, even across international borders. Moreover, ICT facilitates the splitting up of production processes. The research paper “Offshoring and ICT - Evidence for German Manufacturing and Service Enterprises” by Fabienne Rasel analyses the relationship between offshoring and ICT at the enterprise level and provides characteristics of offshoring enterprises differentiating between manufacturing and services. Using enterprise-level data from the manufacturing and service sectors in Germany and a broad range of ICT measures, overall, the results reveal a positive relationship between offshoring and ICT. Controlling for other enterprise characteristics, software to coordinate and to manage the supply chain increases the offshoring probability, in particular for manufacturing enterprises. For service enterprises, also general enterprise software and e-commerce purchases from suppliers make offshoring more likely. Furthermore, this research reveals a significantly positive relationship between offshoring and labour productivity as well as realised product innovations. The research suggests that it is important to understand why purely domestically enterprises seem to perform on average worse, and what intangible assets enable offshoring enterprises to perform better.
While, most empirical studies have focused on outsourcing by enterprises in industrialized countries, outsourcing by enterprises from emerging economies is far from negligible and growing. The research paper titled “Outsourcing, Offshoring and Innovation: Evidence from Firm-level Data for Emerging Economies by Ursula Fritsch and Holger Görg investigates the link between outsourcing and innovation empirically using enterprise-level data for over 20 emerging market economies. The results indicate that international and domestic outsourcing are associated with a greater probability to introduce new products and upgrade existing products. The analysis also shows that the results crucially depend on the level of protection of intellectual property in the economy with enterprises benefiting more from outsourcing in terms of increased new product development when their intellectual property is sufficiently protected. This result suggests that a lack of protection of intellectual property prevents enterprises from restructuring the company towards innovation activities. Taken together, these results suggest that both domestic and international outsourcing lead to a reorganization of the production process towards innovative activity.
Concerning the effects of international outsourcing, it was expected that international outsourcing provides access to foreign technology through imported inputs. However, no evidence is found to support this hypothesis. Does this mean that foreign technology is not important in emerging economies? This is unlikely to be the case. The similar effects of international and domestic outsourcing may rather suggest that access to foreign technology is not just through offshoring activities abroad. It may, for example, also happen through sourcing inputs from foreign multinationals located in the countries, or from enterprises being part of large diversified business groups. Furthermore, the positive coefficient on the general import dummy indicates that imported foreign technology may be important. In a similar vein it is possible that trade barriers could render international outsourcing unprofitable or at least not more profitable than domestic outsourcing. This could be a possible explanation for the fact that domestic and international outsourcing does not have a different effect on innovation activities. This could be particularly applicable to the country sample employed in the analysis, which includes countries, for instance Kazakhstan and Uzbekistan, which are not members of the WTO and may, hence, face high trade barriers. Lowering these trade barriers could provide scope for beneficial international outsourcing.
Finally, as part of workpackage 4, a case study approach, reported in The New Modes and Geography of Pharmaceutical R&D: Implications for Policy by Paulina Ramirez was employed to examine outsourcing of R&D in the pharmaceuticals industry. This adopts a global value chain framework, a conceptualisation of the firm that broadens it to include relationships outside the borders of the firm which influence the performance and strategy of the organisation. This approach focuses attention on the organisation and location of specific activities of the value chain allowing for a more accurate analysis of the governance of the R&D process. The paper employs a qualitative methodology based on semi-structured interviews with senior R&D managers from a sample of nine European and US pharmaceutical firms. The study also interviewed the senior management of eight leading European and US as well as five Indian contract research organisations (CROs).
The pharmaceutical industry has a very high ratio of R&D investment to net sales and historically was an area of European strength. The performance of the industry has to be understood in the context of a prolonged crisis of productivity in R&D where, despite significant increases in R&D expenditure, the number of new chemical entities (NCEs) has stagnated. Restructuring of the industry has been proceeding for some time but since the early 2000s new processes of restructuring have emerged including the closure of R&D centres. All the interviews with R&D managers from pharmaceutical companies indicate that there is a general acceptance that after many years of high investment and low R&D productivity the present R&D model is no longer viable. One of the ways the industry has responded to this crisis is with the increasing externalisation of research activities. Two distinct externalisation strategies can be found: (i) An increase in the number of strategic alliances with academic institutions and, other specialist technology firms; and (ii) a significant increase in the outsourcing of research and discovery work to various types of contract research organisation (CROs).
The 1980s and 1990s witnessed some strategic outsourcing of parts of the value chain such as clinical trials, a process facilitated by advances in information technology. Nevertheless, in these periods in-house R&D effort of firms was also growing. The sizeable increase in the externalisation effort in the 2000s is seen as a qualitative shift in the way the industry organises its R&D activities with firms also outsourcing different parts of their research and discovery functions. The problem with the science base has led to the intensification of collaborations and partnerships with academic institutions and biotechnology firms working close to the scientific frontier. Working effectively with these groups of scientists require pharmaceutical firms in terms of their on-going strategies for new product development .to be part of networks of research excellence, working at the frontier of the relevant areas of science and technology. Large in-house R&D facilities located far away from these centres of scientific excellence are seen as no longer relevant or sustainable, leading to a number of closures of such facilities. In addition interviews also revealed the importance of having a R&D presence in countries perceived to be the future drivers of market growth, an indication of which was the opening of R&D facilities in China as well as increasing collaborations with Chinese and Asian academics.
In terms of outsourcing, the interviews indicate that this may now take place anywhere along the research and discovery value chain. However experience has shown that the pharmaceutical firms must retain design and problem solving capabilities in-house in order to be able to monitor and effectively manage the outsourcing relationship. The emergence during the late 1990s and early 2000s of a number of CROs with the technological capabilities to undertake research contracts is a key factor behind the growth of research and discovery outsourcing. From our interviews with UK-based as well as Indian CROs it is clear that the competition in the CRO market is fierce and firms have to regularly add new technologies and capabilities to their offerings in order to survive. Recruitment of the required highly skilled personnel is crucial but there are implications of the rationalisation of existing R&D facilities for the training of future chemists and the loss of loss of knowledge by the pharmaceutical companies. Such losses might not be compensated through the growth of CROs as they are under intense competitive pressure and in this environment it is difficult to set aside resources in terms of manpower and time to consolidate the knowledge learned by their research staff. The closure of R&D facilities by the established firms in Europe could therefore represent a serious undermining of the knowledge base of specific firms, the industry and for the competitiveness of countries where the closures are taking place.
Overall, the research carried out for the Servicegap project indicates the importance of understanding the operation of services markets. It suggests a key role for knowledge intensive business services in generating growth with implications for education policy, given the high skill intensity of these services, and for policy on regulation, given still very high international access barriers to trade and investment.

Potential Impact:
The results from the analytical papers can be used to inform policy and many highlight important policy relevant issues. The research carried out for workpackage 2 highlighted a number of areas of relevance to policy. It suggests that investing in intangible assets, especially training, is important for both productivity growth and employment. Intangible investments go hand in hand with information technology and both are particularly important in service sectors. The results on training also have implications for policy interventions that aim to increase the employability of older workers by encouraging them to undertake more training. The evidence suggests that there is considerable scope for raising the training rates of older people and particularly older people who are out of work. Older people need to be offered more opportunities for training and this may require changes in attitudes towards age. Policies such as raising or abolishing mandated retirement ages may encourage older workers to take up training but will do little to help unemployed older people if they have limited scope for re-entering employment. Also the nature of the training matters suggesting that policies should be carefully designed to specifically promote the work-relevance of the training.
The research on trust and fear leads to the following conclusions. From a policy point of view most sectoral fear levels in the three transition countries are well above the optimal point fear with respect to TFP-growth. In all three countries employment relations seem to be too deregulated and liberalized with respect to the existent high levels of job insecurity in most sectors. From a fear perspective, these countries might be regulated towards more job security. These regulations could be implemented co-joint by governmental actors and in negotiations between labour unions and employer organizations. In contrast there are some sectors in the EU-15 in which employment relations need to be further deregulated and liberalized. Among those sectors are public administration, health and education and the financial intermediation sector to ameliorate the EU’s productivity performance. In some other sectors such as the construction industry and hotels and restaurants, fear has already reached levels which act counterproductive to Europe’s productivity performance. Here, foremost, the high levels of fear in the business services sector seem to be particularly worrying as this sector is strongly engaged in knowledge production, a key asset for the future competiveness of the European economies.
The research on linkages between manufacturing and services suggests that the dividing line between manufacturing firms and service firms has become less clear over time. An analysis of manufacturing performance in isolation is insufficient as trends in service sector performance may have important indirect effects. The relation between service inputs and the service output of manufacturing firms is highly relevant from a policy standpoint. For instance, the Monti report stresses the importance of service revenues for European manufacturers, stating: ‘European industry must move further into the provision of services.’ The results show that the increase of the output share of services in manufacturing leads to a shift from production occupations to skilled service occupations, particularly professionals and other high skilled workers. There is a need for the higher educational system to support the rising demand for service professionals and reforms of the vocational education systems to allow for a shift from production occupations to specific service occupations (e.g. skilled technicians). In addition, given the increasing service intensity of manufacturing one can conclude that service trade barriers not only affect services but also manufacturing firms. Therefore, service liberalization will have positive direct effects on the performance of the manufacturing sector. Further advancement of the internationalisation of service enterprises in general through awareness-building among small and medium sized service enterprises would also be beneficial. This could include measures to support the diffusion of "best practices" and reviews of export promotion systems with regard to their capability to advance international expansion of service enterprises. Policy could promote closer integration of production and service activities to include promotion of networks and cooperation among small service enterprises as well as between services and manufacturing, the joint development of service and manufacturing activities in specific fields and assistance in the cross-border search for service partners in the export markets. The finding that Greenfield FDI in software services depends significantly on costs of starting a business and on the strength of investor protection is highly relevant from the policy point of view. The EU countries are still lagging behind in this respect, particularly to the United States and other emerging countries.
In terms of the general regulatory environment, the research results point to the lack of complementary investments to ICT capital, including skills, organisational change and other intangibles, as crucial element to translate innovative expenditures into productivity outcomes. These findings may be of greater relevance for services sectors, characterised by a high intensity of ICT use and a high potential to drive growth globally, which may be hampered by strict regulations in the product markets as well as in the labour and financial markets. The findings support a broader role for the lack of competition of certain key sectors and its significant indirect impacts elsewhere across the economy as they feed through the supply chain. The research supports the idea that regulation of services is harmful beyond the regulated sectors themselves and its effects are amplified. Recently, the attention is focused on regulation of professional and business services, which remain largely sheltered from international competition in many countries and are highlighted as key in the process to achieve the European single market in services. Many of the research papers point to an important role for business services in generating growth. These services take up a central role in the European economies. The importance is illustrated by “economic knock-on effects”, which consider the inter-industry linkages within an economy and various economic performance measures such as gross output or value added. Thus regulation of business services and professional services takes on another layer of importance: for, if the effects of regulation prove to be anti-competitive, leading to economic gains being foregone, then such effects are likely to have ramifications in the wider economy, due to this large “knock-on” effect shown by the calculated interlinkages between sectors.
Efforts on behalf of the European Commission to question whether rules regarding market entry and market conduct that result from (self-) regulation of professional services, and which vary considerably across EU Member States, are necessary and minimal, may thus be regarded as being appropriate, given the economic role of these sectors in its widest sense, and should be continued. This requires continued dialogue between the EC and professional bodies in Member States based on inventories of regulations. Where regulations can be justified by quality considerations that benefit consumers, the least regulation sufficient to achieve the goals should be recommended. At the beginning of 2011 the EC set up a steering group with external experts to discuss the need for and the feasibility of a European Professional Card (EPC). According to the European Council the EPC would be an electronic certificate issued by the professional's country of departure that would facilitate the automatic recognition in the host country (the country where the professional seeks establishment). Applications for professional cards would be made through the relevant national authorities using the Internal Market Information (IMI) System. The advantages of the European Professional Card are seen for those professions interested mainly in temporary mobility. Its use would depend on whether professions request its introduction. But it is hoped that it would be an attractive innovation leading subsequently to more and more adoption by professional groups. Introducing an EPC also aims at improving the recognition procedure, thereby shifting some costs and administrative burdens from the host Member State to the home Member State. However, the use of IMI should reduce these costs and the new procedure. A prerequisite of adopting a European Professional Card would be agreement between Member States leading to automatic recognition based on professional experience. This policy should be pursued vigorously by the European Commission, the European Parliament and the Council alongside the adoption of the proposal for a modernised Professional Qualifications Directive as already urged by the European Council.
Turning to financial services regulation, the research suggests that despite the complexity of the relationship between market power and risk taking in banking, there seems to be a trade-off between the two, and hence, the optimal regulation should take into account the intensity of competition in the banking sector. Different sources of competitive power between banks with different ownership and home-country characteristics, as well as varying competitive conditions over time (for example, during times of financial turmoil) point to the necessity of adjustments in the way regulatory and competition policies are to be combined.
The analyses undertaken for workpackage 3 of SERVICEGAP, show that innovation activities are positively linked to IT and organisation capital, IT outsourcing, internationalisation, cooperation with stakeholders, the availability of financial resources and to agglomeration. Productivity is particularly driven by innovation, IT and organisational capital. Employment in services appears to be stimulated by product innovation but is only weakly related to process and organisational innovation. The policy implications that might be derived from this analysis mainly relate to the EU flagship initiatives ‘Innovation Union´ and ‘Digital Agenda for Europe´. In order to strengthen the innovation potential of the European economy the role of instruments to support R&D or innovation activities such as tax incentives or direct innovation subsidies should be further developed. Particularly product innovation is important for employment growth across almost all EU countries analysed. The research suggests that the main differences in the contribution of product innovation is a result of differences in the average innovation engagement and innovation success across countries and sectors rather than differences in transforming a given level of innovation success to employment growth. Therefore, policy measures should target to stimulating innovation in services opening up similar employment potentials across countries or sectors. Facilitated access to funding of innovation activities should differentiate according to constraints of firms since for example non-exporting firms might profit more than exporting firms. Innovation potentials can be supported by stimulating investment in IT and internet infrastructure as drivers of innovation and productivity, in particular in knowledge-intensive services sectors. Finally, supporting internationalisation, in particular for SMEs, is conducive to innovation activity and productivity improvements.
With respect to policy implications from the research carried out for workpackage 4, the paper on access barriers suggests that regulatory heterogeneity across countries is rather costly to European services business and that harmonising service regulations across EU countries would be beneficial for achieving a single EU services market. The research on trade in services suggests that, given the extent of similarities with the manufacturing enterprises, policies designed to enhance trade in manufacturing are likely to be applicable also in the services sectors. A notable difference with respect to manufacturing enterprises which trade mostly goods is that service enterprises trade services, but a significant proportion of their trade is in goods also. Hence, an increase in trade liberalisation, either specific to goods (e.g. a reduction in transport costs) or services (e.g. a reduction in telecommunication costs), should impact the services sector in much the same way as suggested by the most recent models in trade theory. Trade liberalisation reallocates resources towards more efficient enterprises and drives less efficient ones out of the market. Thus, we would expect aggregate gains from trade in the services sectors as a result of further trade liberalisation. However, economic policies should be concerned about easing the adjustment to trade liberalization in the service sectors which many policymakers still think of as being isolated from trade.
Overall, these research results support further deepening integration in the internal market of the European Union as well as deepening economic relations with the rest of the world. Market liberalisation in services sectors in the member countries should be a policy priority. However, liberalisation and standardisation of regulation should not increase enterprises’ administrative costs. Also for example the ongoing free trade area negotiations between the EU and the United States, are a window of opportunity for increasing competition in the services sectors. This can be expected to enhance productivity not only in services sectors but through spillovers also in the other sectors of the countries involved.
Trade policy is traditionally aimed at boosting exports or at facilitating export market entry for new exporters. The prevalence of importers (many of which go on to become exporters) uncovered in the research carried out for this project, and in earlier work for manufacturing, suggests that assisting enterprises in finding suppliers abroad – if required – may be equally if not more important. However, this analysis also suggests that there is a considerable amount of short-lived entry and exit from import and export markets. Thus it is not clear that a perceived lack of exporters or importers in an economy can be viewed as a market failure, which would justify government intervention. There seem to be higher barriers to trading services than to trading goods, and based on anecdotal evidence trade in services frequently accompanies trade in goods. Also here, there is no clear evidence that traders of goods or services need government assistance in order to enter international markets or to expand their operations abroad. Harmonising international regulation and reducing entry barriers would appear as the most promising measures to stimulate trade in services by service enterprises. However the research on the nature of the product traded has the interesting policy conclusion that removing barriers to trade may not have as large an impact on services and removing barriers to goods trade.
Turning to international investment, the research suggests that (i) the effects of foreign ownership per se on firm performance are likely to differ in services and manufacturing; (ii) are country-specific; and (iii) the case for incentives to attract foreign investment could be stronger in the case of services in comparison to manufacturing. The research on Swedish multinationals suggests that foreign acquisitions can have beneficial effects for domestic R&D activity - foreign acquisitions may be an important way to generate new knowledge and contribute to boosting the level of technology in the domestic economy. The research on new member states supports the conclusion that foreign acquisitions benefit the targeted enterprises. This is an important finding given the prevailing popular view on the effects of mergers and acquisitions on the economy. Whereas the effects of a domestic acquisition may be hiding changes in vertical market-concentration as there may be a case of vertical integration of supplier and buyer enterprises, this is less likely to be important in the case of foreign takeovers. Any policy would therefore have to take account of these effects of acquisitions and at the very least afford mergers and acquisitions the same consideration as that being given to greenfield investments. Especially meaningful is the fact that small and less productive enterprises reap the biggest benefits, which further strengthens the case for supporting cross-border acquisitions for struggling enterprises. The results for Italy and Spain suggest that foreign acquisitions should be welcomed particularly when targeted domestic enterprises are in difficulty and are financially constrained. Domestic acquisitions, while maintaining the ownership within the country of origin, do not offer the same potential for improving the performance and the financial strength of acquired enterprises.
In more developed countries, increasing product market competition and increasing both the effectiveness of government and the strictness of employment protection legislation are likely to enable greater productivity increases following foreign acquisitions. However, the productivity gains are likely to be lower in more open economies. Moreover, specialisation in technology-intensive industries will further increase the productivity growth of foreign acquired firms. In addition, increasing the efficiency of the financial system will also increase productivity following foreign acquisitions of service enterprises. Furthermore, a trade-off exists with respect to employment protection legislation in that stricter employment protection legislation is likely to enable productivity gains in service enterprises following foreign acquisition but would have the opposite effect in manufacturing enterprises. This suggests that a targeted sectoral policy approach, with less strict employment protection legislation for manufacturing, would lead to increased productivity growth through foreign acquisitions.
The strong reductions in the share of in-house production observed during the last decade across Europe are likely to have caused layoffs and adjustments of the employment structure in many enterprises across Europe. Given these adjustments, which are immediately visible to the employees losing their jobs and to the wider public, it is not surprising that offshoring is widely perceived as socially harmful. And indeed, it is true that the short-run adjustment costs for the European societies imposed by offshoring, e.g. in terms of unemployment benefits and training programs for laid off workers are not negligible. However, the findings on the productivity impact of offshoring suggest that there are also positive effects for European enterprises, in the sense that offshoring allows enterprises in globally competitive markets to survive or even to grow. Growing enterprises and industries, in turn, can provide additional jobs which compensate for the jobs lost to offshore suppliers. In other words, there may be a positive feedback effect from offshoring into the labour market due to increases in productivity. These positive effects need time to materialise and they are not easily perceived and associated with its cause by the public, which may make the practice of offshoring politically difficult to defend. However, in order to retain and foster competitiveness and growth of European enterprises and industries, it is vital to allow these market adjustments to happen.
The research highlighted the importance of integrating firms into global markets. There may be some role for government assistance to inform enterprises about these opportunities and risks of offshoring, and to foster information exchange between enterprises and industries on how relations with offshore suppliers have to be organised in order to reap productivity benefits. Clearly, there is an important role for policies dealing with the short-run adjustments imposed by offshoring. Given that offshoring changes the employment structure and the demand for skills (more high-skilled employees; more employees specialised in non-routine and face-to-face tasks, which are more difficult to offshore), it requires a system of education, formation, and life-long-learning which prepares citizens for the required types of jobs and, more importantly, prepares them to be open-minded for all the further changes which are yet to come. In terms of openness to service trade, there is also some scope for policy intervention. The evidence on the relative importance of offshoring and domestic outsourcing of services suggests that cross-border trade of services is still restricted by institutional barriers.
In relation to the effects of outsourcing on innovation, the research suggests that policy makers might support enterprises in their effort to split up the value chain. This could take various forms depending mainly on the sourcing location. In general, enterprises need advice on administrative and judicial matters and are often uncertain about international and even domestic standards. German enterprises which outsource internationally call linguistic and cultural barriers their biggest obstacle in the outsourcing process. Enterprises located in emerging economies might very likely face the same obstacles. Thus, it is advisable to provide enterprises with guidelines how to deal with the obstacles of outsourcing. An important condition needed for reaping the gains of outsourcing is the protection of intellectual property. In the absence of such regulations, enterprises do not turn the potential benefits from outsourcing into practice. This is an important finding for policy makers.
A number of policy implications flow from the case study of the pharmaceuticals industry.. All the interviews carried out for this research highlight the importance of public investment in basic science. There is a general recognition in this industry that for innovation to move forward requires significant advances in basic science as well as ‘translational research’, that is research that make the findings from basic science useful for practical applications. From the point of view of Europe it is important to allocate funding to both basic, ‘blue-sky’, science and to the work required to develop practical applications from scientific knowledge. Since an increasing number of research organisations are partnering in the research process it is also important to maintain the ‘scientific commons’ in areas where lack of scientific knowledge is a block to technological progress. This is an effective way to ensure that a variety of firms and organizations benefit from access to science.
National and regional strategies for skills development also need to be emphasised. The closure of industrial research sites poses significant difficulties for the training of future industrial scientists. Given that research activities can be undertaken and managed internationally it is increasingly important that Europe identifies the skills that need to be developed to maintain jobs in Europe. The interviews indicated that for work to remain in Europe the skills that are required involve problem-solving, independent and creative thinking as well as ideas-generation. These are the skills that differentiate ‘routine’ science and technology that can now be done in many places from more advanced research work. The study also highlights that policies that influence demand are also crucial. The shift of R&D to Asia (and above all China) is linked to perceptions of future ‘dynamic markets’. In the context of ‘austerity’ in much of Europe it is important to consider what is the role of public sector purchasing decisions as a tool to reward R&D.
Finally the project also highlights areas for future research. First the Eurofund foundation should consider incorporating a valid measure of organizational trust within the next design of the European Working Condition Survey (most likely to be conducted in 2015). The concept of organizational trust is theoretically too important to be not validly measured within publicly available surveys. The question of the importance of foreign trade inter-linkages (via trade and FDI) of professional services is still an open one and an area for fruitful future research. More generally, international service linkages are likely to be most closely connected to the activities of multinational firms, hence, the role of FDI is crucial. While the main limiting factor at present is the availability of FDI data at the disaggregated sector level, future work should look more closely at the role of multinational enterprises to further check the robustness of the results concerning the international service linkage term. Furthermore, bilateral trade data could also help to establish a clearer link between cross-border purchases of services and the export performance in a specific market. In future work it might also be interesting to analyse the role of “in-house” services, i.e. services performed within the firms. The inclusion of “in-house” services would help to analyse such questions as to whether it is better to outsource services and purchase it from outside the firm or to keep those functions within the firm. To do this, however, one needs employment data that is disaggregated by functional activities which are not readily available yet.


Dissemination activities undertaken in SERVICEGAP included the following
Project Website: A project website was created at the beginning of the project. The aim of the website was to provide information on both the researchers and the research produced by the SERVICEGAP project. The website address is
Review papers: These were mostly produced in the early stages of the project and were designed to review available data and highlight particular measurement issues. These are posted in the ‘Review Papers’ section of the website. The paper topics included: linkages between services and manufacturing in EU countries; intangible capital and productivity growth in service industries; the role of information technologies for service sector performance; regulation and economic performance; and internationalisation of services, productivity and economic growth.
Discussion papers: The website contains over 45 analytical discussion papers. Many of these papers subsequently were published in academic journals. These are posted in the ‘Discussion Papers’ section of the website.
Policy briefs: These covered the impact of service sector innovation on growth and productivity, the economic impact and regulation of business services, services innovation and employment and the new modes and geography of pharmaceuticals R&D. These are posted in the ‘Policy Briefs’ section of the website.
Project meetings: The research team presented the results of the projects at four SERVICEGAP conferences held in Birmingham (June 2010), Dublin (June 2011), Mannheim (November 2012) and Brussels (January 2013 - the latter joint with the INDICSER project). The results of the first stage of the project were disseminated at a workshop at CEPS in Brussels in March 2011 and at a workshop organised by DG Enterprise and Industry in Brussels in October 2011.
External dissemination: The project team also presented their research at a number of academic and policy conferences, workshops and seminars. These included conferences organised by the European Commission (DG Markt), December, 2012; European Commission-Joint Research Centre, February 2013; University of Copenhagen, November 2010; University of Glasgow, April 2012; Royal Economic Society, University of Surrey, April 2010; The Scottish Economics Association, Perth, April 2010; Oesterreichischen Nationalbank, Vienna, February 2013; OECD conference on Intangible assets, Paris, March 2012, Euroconference 2012, Global Economic and Financial Systems, Portoroz, Slovenia, July 2012; European International Business Academy, Bucharest, Dec 2011, Brighton, December 2012; European Trade Study Group, September 2011 and 2012; EARIE Conference (European Association of Research in Industrial Organisation), Rome, September 2012; XVI conference on Dynamics, Economic Growth, and International Trade (DEGIT-XVI), St. Petersburg, Russia, September 2011; Social Science Service Research (3sR) Conference, Munich, Germany, January 2012; IInd ICT Conference Munich on Management and Economics of ICT, Institute for Strategy, Technology and Organization (ISTO), Munich, Germany, March 2012; International Association for Research on Income and Wealth 32nd General Conference, Boston, USA, August 2012.
Workshop presentations included at Deutsche Bundesbank, Frankfurt, November 2010; The Paris School of Economics, January 2011, European Parliament- Internal Market Committee, public hearing on Services, February 2013; Aarhus-Kiel Workshop, Kiel Institute, December 2010; ISGEP Workshop, University of Gottingen, March 2011; Leuphana University of Lüneburg, September 2011; World Bank, Washington - jointly organised by Kiel Institute and World Bank, March 2012; Lazarski University, November 2011; University of Oslo, September 2012; INDICSER conference, Budapest, September 2012; Orléans, France (LEO), February 2013; KNOWINNO/Innoserve expert meetings on R&D and innovation in services, OECD, Paris, September 2011, March 2012; ICTNET Workshop No3 - ICT-enabled Innovation, Productivity and Growth, ZEW Mannheim, Germany, October 2011; 2nd ProdIT Workshop: Productivity in the Service Sector - Challenges of Measurement, ZEW Mannheim, Germany, November 2012.

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