Despite current economic turmoil, UK manufacturing is in good shape with smaller companies playing a key role, says Lord Bhattacharyya

As a professor of manufacturing, I am more optimistic about this sector today than I have been for years. Manufacturing output is 22 per cent higher than it was at the start of 1980, while manufacturing productivity has grown by 50 per cent since 1997.

Look at the profits some of our companies are making. Take the aerospace sector. We have virtually 35 per cent of the world's aero engine market. Then there is the car industry — we are producing more cars today than we have done over the past 25 years. Even companies that were supposed to have lost their credentials, such as Jaguar and Land Rover, have produced billion-dollar profits. I would not say that we have never had it so good, but we are having it okay.

Firms with fewer than 250 employees are responsible for about 40 per cent of our manufacturing value-added. These companies are a vital part of our economic landscape, and have been exposed to increasingly tough global competition. As open markets have extended, they have affected manufacturing sectors in different ways. Some that have a high value-added technological content, like aeronautics and the automotive industry, have outsourced but retain manufacturing in the UK. Electronic components and clothing have faced huge pressures from overseas competitors. That is not a bad thing, as the consumer has benefited from the competition. We hear a great deal about the movement of investment to China and India, but, beyond the sectors I have mentioned, most of the investment in those countries is for their domestic markets, not to re-import to the UK.

Companies have also changed the way they work. Today many companies make more profit from design or servicing than from physical manufacture. In fact, it is not hard to tell which companies are purely service and which are manufacturing. Many of our best new businesses operate in this area.

Many have asked what the government should do to help manufacturing. The first response is to say bluntly: 'Get out of the way.' Manufacturers are good at being blunt. The burdens of regulation and taxation fall most heavily on the businesses with the tightest margins. We have seen the pressure of regulation increase. We all agree that regulation for its own sake must be eliminated, yet regulation is important. It is the way society reflects needs that are not met by the market. Good regulation improves our quality of life. Imagine what would have happened if tougher regulations in California had not sparked a wave of innovation in the drive to lower emissions. In the UK the minimum wage and health and safety regulation matter to us as a society. So while it is easy to call for deregulation, it is much harder to do.

The burden of taxation is one that all businesses complain about, and rightly. The good news is that corporation tax has fallen from 30 per cent to 28 per cent, yet small manufacturers are concerned about the increase in the corporation tax they pay to 22 per cent next year. Yet that change should be considered alongside the new measures that help small businesses — the new £50,000 tax-free capital investment allowance, the increase in the R&D tax credit to 175 per cent, the increase in the small firms loan guarantee from £60m to £360m, and the extension of the enterprise investment scheme to offer tax relief up to £500,000. The government has also made the right decision in providing an entrepreneurs' relief on capital gains tax.

These measures are in addition to services, such as the Small Business Service, which have seen major increases in funding. Economic competitiveness means more than just headline tax rates. We should focus on growth, being an economy with a good infrastructure and research base, high skills levels, a supportive fiscal framework and a focus on investing in the future.

One area where we have had enormous success is inward investment. This is because the perception of the UK abroad is that our fiscal and regulatory framework is second to none. The UK is now the second greatest beneficiary of inward investment in the world, with $1,135bn of foreign direct investment stock in 2006. That is more than twice the amount invested in Germany and almost a third more than in France. Inward investment has brought secure jobs in the long term.

These companies need a supply chain, and this will be predominantly made up of small and medium-sized manufacturers. These have improved enormously by learning from inward investors. Indeed, they have improved so much that they are now being targeted by inward investment companies themselves. These companies benefit from the challenge of improving business systems and increasing flexibility. Those skills will lead to rewards with other customers. The task of government is to help small businesses innovate, and here we have done an enormous amount. I welcome initiatives such as technology demonstrators which will help major inward investors and smaller companies innovate together; the work of the Technology Strategy Board in driving forward research funding; and regional development agencies' support for small business innovation and sector clusters.

Edited extracts of a speech by Lord Bhattacharyya, head of the Warwick Manufacturing Group, during a recent House of Lords debate on manufacturing