Today's Letter IEDI presents the main points of a study published by the International Monetary Fund (IMF), in its Fiscal Monitor of April 2024, where it examines the role of fiscal policies in the promotion and dissemination of technological innovations, with an emphasis on harnessing the potential of green and digital technologies. 

The study, entitled “Expanding Frontiers: Fiscal policies for innovation and technology diffusion,” finds that, despite rapid advances in digital technologies, the pace of growth in global productivity and innovation has weakened in the last two decades. 

The main driver of productivity growth and improved living standards, the generation of innovation —defined as the invention and introduction of new and/or improved products and processes— has become more costly, unbalanced across sectors and increasingly driven by applied research. 

IMF researchers recognize that public policies play an essential role in accelerating the pace of innovation in advanced and emerging economies, since the private sector's research and development (R&D) efforts are insufficient, given the failure to capture all the social benefits (or “externalities”) of innovation. 

State support may be even more beneficial, the authors argue, in sectors or technologies where innovation produces additional public goods, such as reductions in greenhouse gas emissions and improvements in public health, which are recent trends around the world.

Despite this, they warn: industrial and innovation policies in specific sectors and technologies are not a panacea for higher productivity growth and can lead to high tax costs and low impact if they are poorly designed. 

For IMF researchers, an industrial policy for innovation generates productivity and welfare gains under certain conditions: 

 •  if social benefits are measurable, as is the case with carbon emission reductions; 

 •  if there are knowledge spillover effects coming from the specific sectors subsidized; 

 •  if governments have good administrative and enforcement capacities; and 

 •  if the measures do not discriminate against foreign companies. 

For advanced economies and industrialized emerging markets, estimates by IMF researchers indicate that increasing fiscal support for R&D by 0.5% of GDP (about 50% of the current level in OECD economies), through the combined use of public research funding, corporate subsidies and tax exemptions, could generate a GDP increase of up to 2%. 

The combination of innovation policies would also reduce the ratio of public debt to GDP by about 0.5% over an eight-year horizon, as the initial increase in debt resulting from higher fiscal expenditure on innovation is gradually offset by GDP growth and, consequently, higher tax revenues.

As for the instruments, the study also estimates that public R&D has the highest “return on investment,” with more than an additional dollar in total R&D per dollar of fiscal spending. This is due to the fact that public investment tends to focus on basic research, which has high knowledge spillover effects, benefiting more sectors and for longer.

On the other hand, tax incentives and subsidies for private R&D lead, on average, to almost an additional dollar in total R&D expenditure per dollar of tax cost, with slightly greater effects for companies with financial constraints. 

An advantage of tax incentives, according to the Fund, is that all private R&D activities receive equal treatment. The downside, however, is that private sector R&D decisions may not adequately address the complex knowledge diffusions associated with innovation.

In the authors' assessment, the effectiveness of other fiscal instruments in promoting innovation and productivity growth is less clear. Moonshot projects that focus on a single mission may catalyze resources for specific goals, but their effectiveness for broad objectives is inconclusive. Therefore, the definition of the objective or mission, as it has been widely used, is of great relevance.

On the other hand, patent or intellectual property regimes, which offer preferential tax treatment to income from protected intellectual property assets, such as patents, trademarks or copyrights, tend to reward established companies with fewer financial restrictions.

According to the authors, the careful granting and targeting of tax incentives for all companies and throughout the innovation life cycle are crucial to minimize tax costs and avoid capture by large established companies. To promote innovation, it is essential to develop a coherent and simple tax system and to institute a framework for periodic evaluation of actions.

The study emphasizes that structural, competition, commercial and financial policies are also necessary to provide a level playing field, avoid the concentration of market power and ensure adequate access to financing throughout the innovation cycle, especially for long-term green energy projects.

In the case of emerging and developing economies far from the technological frontier, the authors emphasize that strategic public investments in human capital and infrastructure, especially in digital infrastructures and skills, facilitate the adoption of more advanced technologies developed abroad. 

The Fund's estimates show that for these economies a 1% increase in education spending can boost medium-term GDP by up to 1.9%, on average, through increased diffusion of new technologies. 

Still for those economies farther from the technological frontier, the study recommends that governments focus on a combination of well-calibrated policies to facilitate the adoption of existing technologies. If well implemented, investments in digital infrastructure, education and training programs can accelerate technological diffusion, including for laggard firms. 

However, the Fund warns, removing barriers to the diffusion of green technologies requires investment in essential complementary infrastructure, together with adequate carbon pricing that aligns private sector incentives and helps finance these initiatives.

Reaching the full innovative potential of the world and accelerating the diffusion of technology requires maintaining and deepening international collaboration, points out the authors of the study. Economies farther from the technological frontier may lose more with protectionist policies, given their dependence on foreign technology. 

International innovation policy coordination is critical to catalyzing the transnational dissemination of knowledge, harnessing the potential of ongoing green and digital transformations, and expanding the technological frontier for all.

The full text is available in Portuguese.