## Chapter 2: Expanding Frontiers: Fiscal Policies for Innovation and Technology Diffusion

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### Innovation, productivity, and diffusion — key findings
- Innovation is defined as the invention and introduction of new or improved products and processes and is a key driver of productivity growth and better living standards.
- Despite rapid advances in digital technologies and artificial intelligence (AI), productivity growth has fallen over the past two decades and global growth prospects for the medium term are weak.
- The pace of innovation is unbalanced across sectors and increasingly driven by applied research that does not generate wide-ranging knowledge spillovers.
- Diffusion of innovation across countries and firms has slowed, particularly the adoption of low-carbon and digital technologies.
- Improving growth prospects is essential amid high government debt, population aging, climate change, and large convergence gaps across countries.

### Directing innovation to specific sectors: when targeting helps and when it harms
- Industrial policy steering innovation to specific sectors (for example, “green” technologies and AI) is resurging in many major economies and often entails hefty fiscal costs.
- Historical experience shows industrial policy is prone to policy mistakes and can generate high fiscal costs and negative cross-border spillovers.
- A model-based framework indicates targeted industrial policy for innovation generates productivity and welfare gains only under restrictive conditions:
  - Targeted sectors must generate measurable social benefits (for example, lower carbon emissions or higher knowledge spillovers to other sectors).
  - Implementation capacity must be strong.
  - Subsidies must be driven by social returns rather than misdirected (for example, toward politically connected sectors).
- Policies discriminating against foreign firms can be self-defeating because a large share of knowledge is imported even in major advanced economies and such policies can trigger costly retaliation.
- The case for subsidizing innovation in AI is unclear because AI has already matured to the commercial adoption phase. Priority should be given to technologies that expand human capabilities and to facilitating AI adoption in sectors with greater social benefits.

### A pro-innovation fiscal policy mix — design and fiscal effects
- Recommended cost-effective mix of complementary policies (with attention to design features):
  - Public funding for fundamental research.
  - R&D grants for innovative start-ups.
  - R&D tax incentives to encourage applied innovation across firms.
  - Close public–private cooperation to create positive synergies at lower public cost.
- Design cautions:
  - Careful design and targeting of fiscal incentives across firms and along the innovation lifecycle is crucial to minimize fiscal costs and avoid capture by large established firms.
  - Develop a coherent and simple tax system with broad bases and low rates while instituting systematic evaluation.
  - Complementary structural, competition, trade, and financial policies are needed to ensure a level playing field and provide innovative firms with adequate access to financing.
- Estimated fiscal and growth dividends:
  - A well-designed innovation policy mix can yield substantial growth and fiscal dividends, raising long-term GDP by $3 to $4 for each dollar of fiscal cost.
  - Increasing R&D support by 0.5 percentage point of GDP annually, or about 50 percent of the current level in Organisation for Economic Co-operation and Development economies, could raise GDP by up to 2 percent and reduce the debt-to-GDP ratio for an average advanced economy over an eight-year horizon.
  - Economies with ample fiscal space could accommodate this approach; funding for innovation may be problematic for countries with immediate fiscal constraints.

### Facilitating diffusion and adoption of technology — priorities for non-frontier economies
- Countries below the technology frontier (primarily emerging market and developing economies) can reap larger productivity dividends by prioritizing policies that promote diffusion of technologies developed elsewhere.
- Strategic public investments that facilitate adoption:
  - Human capital and infrastructure, especially digital infrastructure and skills.
  - A 1 percent increase in education spending can boost medium-term GDP by as much as 1.9 percent in emerging market and developing economies, on average, by increasing technology diffusion.
  - Improving quality of trade and transport infrastructure in an average low-income country to bridge one-third of the gap with emerging market economies could lift GDP by 0.6 percent over the medium term.
- Public investment and financing are particularly beneficial to overcome barriers to green diffusion, since many technologies needed to cut carbon emissions already exist.
- Investments in digital skills and infrastructure accelerate diffusion from frontier firms to laggard firms.
- Targeted fiscal incentives for technology upgrades (for example, revenue-neutral investment tax credits for firms acquiring frontier technology) can further speed green and digital technology diffusion and raise aggregate productivity.

### Revenue, tax policy, and international cooperation to support diffusion and innovation
- To pay for priority spending and reap its dividends, countries need to:
  - Improve the efficiency of expenditure.
  - Upgrade tax systems.
- Policy tools and potential revenue gains:
  - A broad-based value-added tax with a simplified collection mechanism for services trade facilitates diffusion and can help raise revenue.
  - Scaling back ineffective corporate tax incentives and effectively addressing international tax avoidance by multinationals would help, increasing annual tax revenue by up to 1 percent of GDP in some developing economies.
- International collaboration:
  - Maintaining and deepening international collaboration is required to reach the world’s full innovative potential and accelerate diffusion of technology.
  - Economies farther from the technological frontier could lose the most from inward-looking policies due to reliance on foreign technology.
  - Coordinating innovation policies is critical to catalyze cross-border knowledge spillovers and harness green and digital transformations.

*Source: Executive Summary, Chapter 2: Expanding Frontiers: Fiscal Policies for Innovation and Technology Diffusion*

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_Source: https://www.imf.org/-/media/files/publications/fiscal-monitor/2024/april/english/ch2execsum.pdf_