The attribute xml:space is about input: that is to say, it
controls if the spaces will be present in the DOM (i.e. in
the internal version of the document inside the browser); it
says nothing about what will appear on your screen. Output
whitespace is controlled by the CSS property 'whitespace'.
Set it to 'pre' and the spaces in the DOM will be preserved
on output; set it to 'normal' and the whitespace will be
collapsed (CSS3 will have more properties to enable greater
control).

This is the reason that all elements are set to
xml:space="preserve" in XHTML2, otherwise the CSS
'whitespace' property would have no effect, and you would
have no control over visible whitespace. The default
stylesheet will set 'whitespace' to 'normal' for all
elements except <pre>, but you will be free to change them.