The IMF’s Fiscal Monitor April 2016 (“Acting Now, Acting Together”) looks at fiscal policies for innovation and growth. Fiscal policy can promote growth in productivity by encouraging innovation.

The global recovery is slowing and fiscal risks are rising. Public debt ratios are being revised upward and the largest revisions are in emerging market and middle income economies. Commodity exporters, including the oil exporters of the Middle East and North Africa, have been hit hard, and advanced economies have high levels of public debt, low inflation and sluggish growth.

In advanced economies, the focus should be on fiscal measures that boost both short- and medium-term growth (such as infrastructure investment) and policy actions that support the implementation of structural reforms. The IMF suggests that states in the euro zone should make full use of the existing room within the Stability and Growth Pact to increase public investment. In Japan and the US, policy space can be created by commitment to credible medium-term consolidation plans.

A sustained increase in economic growth of 1 percentage point could reduce debt ratios in advanced economies to their pre-crisis levels within a decade. These economies must accelerate structural reforms, including tax and expenditure policies that reinforce incentives to work and invest, and boost productivity growth.

In commodity-exporting countries, public spending has to be brought in line with reduced resources. The fiscal adjustment could be helped by further revenue diversification. In other emerging market and developing economies, an important challenge is to create budgetary room for necessary expenditure on public services, health, education, and infrastructure. This could be done by implementing pro-growth structural reforms, better mobilizing revenue and improving expenditure efficiency. Capacity building in the field of revenue mobilization is required to achieve the Sustainable Development Goals.

Comprehensive, reliable, and timely public reporting on public finances can also reduce vulnerabilities by fostering more informed and accountable fiscal policy. Developing economies should closely monitor the rapid increase in corporate debt. Tax policy can be combined with macroprudential measures to limit excessive leverage.  

Fiscal Policies for Innovation and Growth

Improvements in productivity are at the top of the global policy agenda. The decline in total factor productivity (TFP) explains a significant part of the overall decline in growth potential in advanced economies since the early 2000s, and more recently in emerging market economies. This can be improved by structural reform of labor and product markets, but fiscal policy is another important way to improve TFP.

Fiscal policy is a potent instrument for productivity growth through innovation. Innovation can be built on a base of strong human capital and a business environment that provides adequate incentives. Macroeconomic policies that provide higher growth are important because growth permits firms to more quickly recover their sunk costs, and it therefore encourages R&D investment.

The IMF focuses on three channels of innovation that could be improved: research and development (R&D), technology transfer, and the promotion of entrepreneurship. These three pillars of innovation affect different countries to varying degrees — for example, R&D policies are more important for advanced economies that are closer to the global technology frontier. Policies that encourage technology transfer and entrepreneurship are also important to emerging market and developing economies.

R&D Incentives

Private R&D undertaken by one firm may increase productivity in other firms through knowledge spillovers. These positive externalities imply that market forces will lead to an underinvestment in R&D compared with the level that is socially efficient. This can be addressed by fiscal instruments to promote private R&D. Fiscal policy can promote R&D in the private sector by providing incentives in the form of subsidies and tax relief. The effectiveness of these policies depends on how they are designed and implemented.

Tax incentives could be in the form of tax credits, enhanced allowances, accelerated depreciation, or special deductions for labor taxes or social security contributions. The tax incentives are usually available to all firms that invest in R&D, although they can also be targeted to particular groups of firms. They generally provide a level playing field, but private-sector R&D decisions may not adequately address the complex knowledge spillovers associated with R&D.

Subsidies for R&D are often specifically targeted at particular projects. If targeted well and based on accurate information, subsidies can be more effective than tax incentives. Subsidies can also bring about non-market benefits (such as a cleaner environment).

Best practices in provision of R&D incentives include the provision of payroll tax relief for researchers and refundable R&D tax credits for small enterprises. New enterprises often face loss-making situations in their opening years, and a refunded credit in the case of a negative tax liability is more useful to them. R&D incentives can also be cheaper if they target incremental R&D above a certain baseline.

Encouraging Technology Transfer

Most technology creation occurs in a small number of advanced economies, such as the G7 countries. The technologies are disseminated to the rest of the world through imitation and absorption. Technology transfer is important for productivity growth.

Technology transfers take place mainly through international trade and foreign direct investment. Firms import intermediate goods and capital equipment that include foreign technology. Multinationals transfer technology to their affiliates throughout the world by foreign direct investment. Inbound FDI may produce positive productivity spillovers through interactions between the multinational affiliate and local firms, worker turnover or improved management practices.

Emerging markets and developing countries often implement tax holidays or tax exemptions in special economic zones to attract FDI. These incentives erode the tax base. Also, it appears that tax incentives often have no effect on the investment decisions of multinationals. Instead, institutional quality in a target country is more important for multinational investment.

Governments of developing economies should invest in education, infrastructure and institutions to facilitate the absorption of technologies from advanced economies. The provision of tax incentives to attract foreign investment is generally ineffective and depletes the tax base.

Promoting Entrepreneurship

Productivity gains and innovation also result from new firms engaging in experimentation and risk-taking. New firms expand the technology frontier by engaging in more radical innovations, while established firms are more likely to concentrate on incremental innovation to improve their existing products and processes. Competition from new entrants also spurs innovation by incumbent firms, especially in the technology sector.

Although business entry rates are typically higher in emerging economies, many of these new entrants are “necessity driven,” from economic need when alternative work opportunities are absent, rather than “opportunity driven” entrepreneurship, which is more closely related to innovation. An important development goal in many emerging markets and developing economies is therefore to increase the share of entrepreneurship that is driven by opportunity.

Tax incentives aimed at all small enterprises may merely serve as a disincentive for these enterprises to grow, as tax rates may increase sharply after the firms reach a certain size and lose the tax incentives. Innovative entrepreneurship can, however, be encouraged by fiscal policies that are targeted toward new enterprises rather than just toward all small enterprises. The entry of new firms can also be facilitated by tax simplification.

Conclusions

The IMF study concludes that good fiscal stabilization policies promote R&D and can help firms maintain spending on R&D during recessions. Governments should do more to promote R&D, and private investment in R&D in advanced economies should be increased by 40% (on average) to achieve efficient levels. This could increase GDP by 5% in the long term in those economies.

Governments can invest more in public R&D that could also advance the research activities of private firms. Research subsidies and tax incentives for private R&D can improve productivity growth. Some existing policies are not efficient — for example, patent boxes may not stimulate R&D efficiently and may become part of aggressive tax avoidance strategies.

Technology transfer in developing economies requires better institutions, education and infrastructure. Tax incentives commonly used to attract FDI are largely ineffective. These economies should strengthen their capacity to absorb foreign technology by improving the human capital base and infrastructure.

Income taxes have only modest effects on business entry rates. Preferential tax treatment of small firms should be avoided as it may create a barrier to further growth of those firms. Tax relief targeted to new firms can, however, promote entrepreneurship and innovation.

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