Getting It Right

• Author: Ruud De Mooij

Getting It Right Finance & Development, March 2017, Vol. 54, No. 1

Ruud De Mooij

Well-designed fiscal incentives can help spur innovation and ultimately growth

There is considerable debate over how countries can increase their potential economic growth in the coming years. Many will rely on productivity growth, driven by innovation.

Just as inventions such as electricity and the internal combustion engine in the late 19th century laid the foundation for high growth in the mid-20th century, so too could three-dimensional printing, driverless cars, and artificial intelligence pave the way for growth during the coming decades. Some observers, such as Erik Brynjolfsson and Andrew McAfee of the Massachusetts Institute of Technology, believe a major growth surge is in the offing. Others, such as Northwestern University’s Robert Gordon, are less optimistic.

Whatever your view of the future, one thing is clear: policy matters. Governments generally pursue a wide variety of policies to make a welcoming environment for innovation—through the protection of intellectual property rights, competition policies, labor market regulation, and effective bankruptcy laws. Tax and spending policies do much to stimulate innovation and growth—provided they are well designed.

Inspiration, perspiration, incentivesResearch and development help drive innovation. Governments play an important role in funding higher education and basic research at universities and public laboratories, which helps advance innovation at private companies. But fiscal policies can also play a direct role in fostering innovation by businesses.

Private firms typically do not invest enough in research and development, in part because they lack adequate incentives. These investments tend to benefit the broader economy in addition to what the firm itself can appropriate. Others may imitate the technology in new products, which often inspires follow-up innovations. As a result, research by one firm usually ends up being beneficial to others. Private companies are not interested in giving anything away, so they will not spend enough on research and development.

This underinvestment can be addressed by fiscal incentives such as tax credits and direct subsidies, which lower the cost of innovation and encourage firms to invest more. Empirical studies suggest that fiscal incentives must reduce a firm’s research and development costs by approximately 50 percent to factor in the spillover benefits that...