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

R&D incentives

Fiscal policy can promote research and development 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 given 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 at 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 market 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 market and developing country 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. Innovative entrepreneurship can however be encouraged by fiscal policies that are targeted towards new enterprises rather than just towards all small enterprises. The entry of new firms can also be facilitated by tax simplification.