Imagine What Fiscal Policy Could Do For Innovation

IMF Blog, March 31, 2016

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Innovation (three-dimensional printing, driverless cars, artificial intelligence, IT, e-commerce, sharing economy) drives productivity growth, which determines prosperity and quality of life.
Innovation is shaped by effort and incentives, making it highly dependent on government policies.
IMF analysis finds that modest government support can markedly boost innovation and growth: policies that reduce the cost of private R&D by 40 percent raise private-sector effort by the same percentage and increase GDP by 5 percent over the long run.

Joseph Schumpeter and John Maynard Keynes debated long-term technological progress; Keynes predicted standard of living in progressive countries one hundred years hence would be "between four and eight times as high as it is today."
The U.S. economy since the early 1950s performed above the upper end of Keynes’s bands, suggesting innovation outcomes are unpredictable in detail but shaped by human incentives and can be anticipated in broad outline.

R&D is a key driver of innovation; governments fund higher education and basic research and can shape private R&D through fiscal policy.
Two key market failures justify fiscal intervention:
- Financing constraints: firms underinvest in risky R&D, especially during recessions; fiscal policies that help stabilize output significantly raise private R&D investments and support productivity growth.
- Spillovers: firm R&D generates wider-economy knowledge spillovers that individual firms do not internalize.
Quantitative findings:
- Fiscal incentives that reduce firms’ cost of investing in R&D by 50 percent on average in advanced economies would increase R&D by approximately 40 percent compared with current levels and lift GDP in advanced economies by 5 percent in the long term.
- International spillovers: R&D undertaken in the G7 yields productivity gains in other economies of about 25 percent of the G7’s own return.
- Accounting for international spillovers, global R&D should rise by 50 percent and global GDP could increase by about 8 percent in the long term.
- Fiscal support to R&D, justified by domestic spillovers, and costing 0.4 percent of GDP can deliver 5 percent higher GDP in the long run.
- Including international considerations, the cost would increase to 0.5 percent of GDP, and benefits would rise to 8 percent.

Fiscal incentives vary widely across countries:
- Australia and Korea grant R&D tax credits that effectively reduce the costs of extra R&D investment by nearly 50 percent.
- Other countries provide labor-cost relief for researchers or targeted R&D subsidies, often at rates less than 50 percent.
Effectiveness depends on implementation.
Cautions:
- Patent box regimes (reduced corporate tax on patent income) have in some countries had no discernible impact on R&D; where they did, fiscal costs were significant.
- Revenues lost to patent boxes could be better used for direct R&D incentives.
- Patent boxes can be part of aggressive tax competition, negatively impacting other countries’ tax bases.

Radical innovations often originate in small entrepreneurial ventures; innovation depends on efficient entrepreneurial entry, growth, and exit.
Obstacles include permits and licenses, labor-market regulations, financial constraints, and tax barriers.
Tax distortions matter:
- High corporate income taxes can have adverse effects on entrepreneurship.
- Special tax incentives for small companies are often not cost-effective and can create a "small-business trap" (bunching of firms just below the threshold for preferential treatment), constraining productivity growth.
Recommended fiscal approaches for entrepreneurship:
- Target fiscal support to new, young, innovative start-ups (examples cited: Chile and France have developed effective initiatives).
- Provide generous provisions to offset taxable losses to minimize tax distortions.
- Simplify tax rules to reduce compliance burdens for firms.

R&D responds to economic incentives and public policies; well-designed public support can go a long way.
Smart fiscal policies that complement private-sector activity can boost innovation and long-term growth substantially.
Key summary figures:
- 40 percent reduction in cost of private R&D → private R&D effort +40 percent; GDP +5 percent (long run).
- 50 percent reduction in firms’ R&D cost (recommended average in advanced economies) → R&D +approximately 40 percent; GDP +5 percent (long run).
- Global scenario including international spillovers: global R&D +50 percent; global GDP +about 8 percent.
- Fiscal cost for domestic-spillover-justified R&D support: 0.4 percent of GDP → 5 percent higher GDP (long run).
- Fiscal cost including international considerations: 0.5 percent of GDP → 8 percent higher GDP (long run).

IMF Blog post by Vitor Gaspar and Ruud de Mooij, March 31, 2016.

Chapter 2: Fiscal Policies for Innovation and Growth, Fiscal Monitor, April 2016
- Chapter 2: Fiscal Policies for Innovation and Growth, Fiscal Monitor, April 2016 (Markdown version)
- Chapter 2: Fiscal Policies for Innovation and Growth, Fiscal Monitor, April 2016 (PDF)