IndustrialPoliciesfor

Innovation:ACost-Benefit

Framework

DanielGarcia-MaciaandAlexandreSollaci

WP/24/176

IMFWorkingPapersdescriberesearchin

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2024

AUG

?2024InternationalMonetaryFundWP/24/176

IMFWorkingPaper

FiscalAffairsDepartment

IndustrialPoliciesforInnovation:ACost-BenefitFrameworkPreparedbyDanielGarcia-MaciaandAlexandreSollaci1

AuthorizedfordistributionbyDavideFurceriJuly2024

IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicit

commentsandtoencouragedebate.TheviewsexpressedinIMFWorkingPapersarethoseofthe

author(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement.

ABSTRACT:Whenandhowshouldgovernmentsuseindustrialpolicytodirectinnovationtospecificsectors?Thispaperdevelopsaframeworktoanalyzethecostsandbenefitsofindustrialpoliciesforinnovation.Theframeworkisbasedonamodelofendogenousinnovationwithasectoralnetworkofknowledgespillovers(LiuandMa2023),

extendedtocaptureimplementationfrictionsandalternativepolicygoals.Simulationsshowthatimplementing

sector-specificfiscalsupportisonlypreferabletosector-neutralsupportunderrestrictiveconditions—when

externalitiesarewellmeasured(e.g.,greenhousegasemissions),domesticknowledgespilloversoftargetedsectorsarehigh(typicallyinlargereconomies),andadministrativecapacityisstrong(includingtoavoidmisallocationto

politicallyconnectedsectors).Ifanyoftheseconditionsarenotfullymet,welfareimpactsofindustrialpolicyquicklybecomenegative.Theoptimalallocationofsupportentailsgreatersubsidiestogreenersectors,butotherfactors

suchascross-sectorknowledgespilloversmatter.Forasampleoftechnologicallyadvancedeconomies,existingindustrialpoliciesseemtobedirectinginnovationtobroadlytherightsectors,buttoanexcessivedegreeinmosteconomies,includingChinaandtheUnitedStates.

RECOMMENDEDCITATION:Garcia-Macia,DanielandAlexandreSollaci.2024.“IndustrialPoliciesfor

Innovation:ACost-BenefitFramework”,InternationalMonetaryFundWorkingPaperNo.2024/176.

JELClassificationNumbers:

O38,O41,L52

Keywords:

Industrialpolicy;innovation;knowledgespillovers;climatepolicy;AI.

Author’sE-MailAddress:

dgarciamacia@;abalduinosollaci@

1WearegratefulforthecommentsanddiscussionfromUfukAkcigit,KevinBryan,EraDabla-Norris,RuuddeMooij,VitorGaspar,PeteKlenow,ErnestLiu,LiLiu,RekaLukasz,NatalijaNovta,SongMa,RafaelMachadoParente,DmitryPlotnikov,YizhiXu,andparticipantsattheIMFFiscalMonitorworkshop.NathanLane,ErnestLiu,RekaLukasz,SongMa,EmilyOehlsen,VeronicaC.

Perez,andMicheleRutakindlyshareddata.VictoriaHaverandZhonghaoWeiprovidedexcellentresearchassistance.AselectionoftheresultsinthispaperwasfeaturedintheApril2024IMFFiscalMonitorChapter2.

IMFWORKINGPAPERSIndustrialPoliciesforInnovation:ACost-BenefitFramework

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WORKINGPAPERS

IndustrialPoliciesforInnovation:ACost-BenefitFramework

PreparedbyDanielGarcia-MaciaandAlexandreSollaci

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Contents

I.INTRODUCTION 4

II.MODEL7

A.Set-up 7

B.OptimalR&DAllocationandDecentralizedEquilibrium 8

C.IndustrialPolicy 9

D.ImplementationFrictions 10

E.AlternativeGoals 12

III.DATAANDCALIBRATION 12

IV.RESULTS 17

A.ImplementationFrictions 17

B.EconomyOpenness 19

C.AlternativeGoals 21

D.AllocatingSupportAcrossSectors 23

E.AssessingExistingPolicies 24

V.CONCLUSIONS 26

REFERENCES 28

ANNEX 31

A.DecentralizedEquilibriumandImplementationoftheOptimalPolicy 31

B.WelfareCostsofIgnoringGreenGoals 33

FIGURES

Figure1.IncreasingUseofIndustrialPoliciesforInnovation 4

Figure2.SectoralCitationNetwork,SelectSectors,UnitedStates 14

Figure3.DomesticKnowledgeSpillovers,SelectEconomies 15

Figure4.EvolutionoftheAverageShareofDomesticCitations 15

Figure5.SimulatedWelfareImpactofIndustrialPolicy,UnitedStates 18

Figure6.SimulatedWelfareImpactofIndustrialPolicy,SelectEconomies 21

Figure7.WelfareGainsofIndustrialPolicywithGreenGoals 22

Figure8.OptimalR&DSupportbySector’sShareofGreenPatentsandAIexposure 24

FigureB.1.WelfareGainsfromAlternativePolicies 34

TABLES

Table1.CalibratedParameters 13

Table2.OptimalityofExistingIndustrialPoliciesforInnovation,SelectEconomies 26

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I.Introduction

Therecentstrategicpushforindustrialpoliciesinlargeeconomies(Figure1,panel1)hasbroughtto

theforethequestionofwhetherandunderwhatconditionsgovernmentsshoulddirectfiscal

supporttowardinnovationinspecificsectorsortechnologies.Recentindustrialpolicyinitiativesinadvancedeconomies,suchastheCHIPSActandInflationReductionActintheUnitedStates,theGreenDealIndustrialPlanintheEuropeanUnion,theNewDirectiononEconomyandIndustrial

PolicyinJapan,andtheK-ChipsActinKorea,aswellaslongstandingpoliciesinemergingmarket

economieslikeChina,shareastrongemphasisoninnovationinspecificsectors,amongother

objectives.Mostpackagesincludefiscalincentivesforinnovationingreenandadvancedtechnologysectors(suchasAIandsemiconductors)(Figure1,panel2),withaheavyrelianceoncostlysubsidies.

Figure1.IncreasingUseofIndustrialPoliciesforInnovation

1.ShareofIndustrialPolicies

(Percentoftotaltradepolicies)

2.IndustrialPoliciesbySector,2023

(Percent)

Sources:Juhászetal.(2022),usingtheGlobalTradeAlertdatabase.

Sources:Evenettetal.(2024);andIMFStaffestimates.

Note:ClassificationbasedonEvenettetal.(2024).Green

sectorsarehighlightedingreen,andhigh-techsectorsin

blue.Sectorswithblueandgraystripesincludetechnologiesthatarebothadvancedandnon-advanced.

Technologicallyadvancedeconomiesmaywanttodirectthecourseofinnovationforvarious

reasons,includingaddressingmarketfailures—externalitiesrelatedtoclimateandpublichealth,

knowledgespilloverstoothersectors,supplychainresilience,ornationalsecurity.However,historicalexperiencesuggeststhatgettingindustrialpolicyrightisatallorder(IMF2024a).Whereaspolicies

mayhelpsomefirmsbecomemoreproductive,theycanalsoleadtoaninefficientallocationof

resources.Indeed,anabundanceoffailedprogramsineconomieswithstronginstitutionsshowsthatitisdifficulttoavoidpolicymistakes.Evenwhenprojectssucceedintransformingindustries,they

canincurhighfiscalcostsand,insomecases,generatenegativecross-borderspillovers.

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Thispaperdevelopsaframeworktoassessconditionsunderwhichsector-specificfiscalsupportforinnovation(“industrialpolicy”)ispreferabletosector-neutralsupport(“horizontalpolicy”).The

frameworkbuildsuponamodelofendogenousinnovationwithasectoralnetworkofknowledgespilloversfromLiuandMa(2023).Inthismodel,thekeybenefitofsector-specificsupportisthatit

allowstodirectinnovationtowardssectorsgeneratinghigherknowledgespilloverstoother

domesticsectors(measuredbycross-sectorpatentcitations).This,inturn,raiseseconomy-wideinnovation,productivitygrowth,andwelfare.

Themaincontributionofourpaperistoaddtwoextensionstothemodelthatarerelevantfor

evaluatingindustrialpolicy.First,weconsiderdifferentformsofpolicyimplementationfrictions—eitherrandompolicymistakesorpoliticalcapturebycertainsectors—thatleadtomisallocationofinnovationinputsacrosssectors.Second,weallowforthegovernmenttopursuealternativepolicygoalssuchassupportinggreeninnovation.Wethenquantifyhowthesefactorsaffectthewelfareimplicationsofindustrialpolicy,andusetheextendedframeworktodescribeoptimalindustrial

policyandassessexistingpoliciesindifferenteconomies.

Thesimulationsshowthatalarge,advancedeconomy(forexample,theUnitedStates),optimally

targetingsupporttosectorswithlargerknowledgespilloverscanincreasewelfarebyalmost3

percentcomparedtoanequivalentamountofsector-neutralsupport.Thewelfaregainscanrisetoupto6percentwhenthegovernmentconsidersgreeninnovationgoalsandredirectssupportto

sectorswithahighershareofgreenpatents.Implementationfrictions,however,quicklyturnthe

potentialbenefitsofindustrialpoliciesintolosses,makingsector-neutralsupportpreferable.Benefitsarealsolimitedforsectorsandeconomiesthatrelymoreonforeignknowledgespillovers,asthesearelesslikelytobeaffectedbydomesticinnovationpolicy.

Overall,theresultssuggestthatindustrialpolicyforinnovationcanonlybebeneficialunderfairlyrestrictiveconditions.First,externalitiesmustbecorrectlyidentifiedandpreciselymeasured(forexample,carbonemissions).Second,domesticknowledgespilloversfrominnovationintargeted

sectorsmustbestrong.Andthird,governmentcapacitymustbehighenoughtopreventmisallocation(forexample,topoliticallyconnectedsectors).

Theframeworkalsoshedslightonhowtooptimallyallocateinnovationinputsacrosssectorswhentheaboveconditionsareinplace.Whilegreenersectorsshouldreceivemoresupport,thereisnoone-to-onerule,asthedegreetowhichinnovationineachsectorspillsovertoothersectorsalsoplaysabigrole.Conversely,sectorsprojectedtobemoreexposedtoAIdonotnecessarilywarrantstrongerinnovationsupport.Regardingexistingpolicies,wefindthatleadingeconomiestendto

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directinnovationsupporttobroadlytherightsectors(fromthelensofourframework),withapositivecorrelationof0.3-0.7betweentheactual(observed)andmodel-impliedoptimal

distributions.However,theintensityofindustrialpolicies,asreflectedintheconcentrationof

innovatorsincertainsectors,isexcessiveinmosteconomies,andparticularlysoinChinaandtheUnitedStates.Inthoseeconomies,scalingbacktheintensityofindustrialpolicieswouldreducemisallocationandincreaseproductivitygrowth.

Thispapercontributestothreeseparatebranchesoftheeconomicliterature.First,itisrelatedtotheresearchonhowinnovationpolicyshouldinteractwithknowledgespillovers(Aghionetal.,2005;

Bloom,Schankerman,andVanReenen,2013,Bloom,VanReenen,andWilliams,2019;HopenhaynandSquintani,2021;Sollaci,2022;LiuandMa,2023).Specifically,mostofthisliteraturefocusesonfindinganoptimalinnovationpolicyandmeasuringitspotentialbenefits.Incontrast,westudythewelfareeffectsofpossibleimplementationfrictions,showingthatevenrelativelysmalldeviationsfromtheoptimalpolicycansignificantlydiminishthegainsfromgovernmentintervention.

Second,thepaperrelatestostudiesonresourcemisallocation(RestucciaandRogerson,2008;HsiehandKlenow,2009;DavidandVenkateswaran,2019;BaqaeeandFarhi,2020;Bils,Klenow,andRuane,2021),particularlytheworkthatlinksitwitheconomicgrowth(Peters,2013;Garcia-Macia,2017;

Hsiehetal.,2019).Inthiscase,wefindthatresourcemisallocationcanarisefrompolicy

implementationfrictions,rangingfrompolicymakermistakes,lackofclarityonthegovernment’sor

society’sultimategoals(whichcansometimesbecontradictory),orthroughpoliticalcapture(Acemogluetal.,2016;Choietal.,2021;Akcigit,Baslandze,andLotti,2023).

Lastly,giventhefocusonsector-specificsubsidies,thispaperalsocontributestothegrowing

literatureonindustrialpolicy(Liu,2019;Evenettetal.,2024;Juhaszetal.,2022;Juhaszetal.,2023).

Thepaperprovidesanintegratedframeworktoassessthedynamicimplicationsofindustrialpolicyforinnovationacrosstheeconomy,complementingrecentmodel-basedanalysisfocusedonspecificindustries(Barwick,Kalouptsidi,andZahur,2023;Barwicketal.,2024).Thisexercisecautionsagainstthewidespreaduseofpoliciestoredirectresourcestowardstargetedsectors,unlessastrongsetofinstitutionalconditionsisinplace.

Therestofthepaperisorganizedasfollows.SectionIIdescribesthemodel.SectionIIIdiscussesthedataandcalibration.SectionIVpresentsthesimulationresults,includingthewelfareeffectsof

industrialpolicyundervariousimplementationfrictions,levelsofeconomicopenness,andalternativegoals,aswellastheoptimaldistributionofinnovationsupportacrosssectorsandtheassessmentofexistingpolicies.SectionVconcludes.

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II.Model

OurtheoreticalframeworkbuildsuponamodelofendogenousinnovationwithasectoralnetworkofspilloversfromLiuandMa(2023).Inthismodel,itisoptimalforgovernmentstosubsidizerelativelymoretheR&Dofsectorsthataremorecentralintheinnovationnetwork,astheygeneratehigher

innovationspilloverstoothersectors.Theframeworkalsoaccountsfortheshareofforeigninflowsofknowledgebysector,asforeigninnovationislesslikelytobeaffectedbydomesticinnovation

policy.Weextendthismodelto(1)capturedifferencesinimplementationcapacity,whereby

governmentswithweakerinstitutionsmakepolicymistakesordivertsubsidiestopolitically

connectedsectors,and(2)accountfornegativeexternalitiesfromclimatechange,whichcallforredirectinginnovationtogreenersectors.

A.Set-up

Thereisarepresentativeconsumerwithpreferencesgivenby

wherepistheintertemporaldiscountrate,C(.)aconstantreturnstoscalepreferenceaggregator,c

abundleofdomesticallyproducedgoods,andcabundleofforeigngoods.Importsofforeign

goodsarefinancedbyexportingdomesticproduction,andundertradebalancewehave

pc=yt-c,(2)

wherethepriceofthedomesticbundleisnormalizedto1(notethateconomiesimportandexport

bundlesofgoods,removingincentivesforasocialplannertouseR&Dallocationtomanipulatethetermsoftrade).

Domesticproductionisgivenby

βi=1(3)

Wherei=1,…,Kindexessectorsandyitisasectoralgood,producedbyaggregatingallvarietiesvofgoodswithinasector

with?it(v)representingthenumberofproductionworkershiredinvarietyvofsectori,andqit(v)isthequalityofthesamevariety.

Innovationineachsectorbenefitsfromthestockofknowledgeofallothersectors,measuredastheaveragequalityofallvarietiesofgoodswithinthesector:

IMFWORKINGPAPERSIndustrialPoliciesforInnovation:ACost-BenefitFramework

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lnqit=lnqit(5)

Cross-sectorknowledgespilloverscancomefrombothdomesticandforeignfirms.Thus,afirminsectorithathiressitscientistswillhaveanarrivalrateofinnovationgivenby

nit=sitηi(6)

whereηiisasector-specificproductivityparameterandxitrepresentcross-sectoralknowledgespillovers

Thestockofknowledgeineachsectorisgivenby1fordomesticinnovationand1for

foreigninnovation,withxijrepresentingtheshareofspilloverscomingfromdomesticknowledge.Finally,wijrepresentstheelasticityofspilloversfromsectorjtosectori.Notethatthecondition

Σ=1wij=1imposesconstantreturnstoscaleininnovation.However,somesectorsmaygenerate

moreresearchspilloversthanothers,i.e.,wij≠1.

Theremainderofthemodelfollowsastraightforwardqualityladder:innovationsincreasethequalityofagoodvarietyqit(v)byafactorofλ>0,makingtheinnovatingfirmthetechnologyleaderina

productandthusabletopriceallcompetitorsout.Thisresultsinadeterministiclawofmotionforeachsector’sknowledgestock

=λln(8)

B.OptimalR&DAllocationandDecentralizedEquilibrium

Threemainequilibriumresultsfromthemodelarerelevantforthecurrentpaper(seeproofsandmoredetailsinLiuandMa,2023):theoptimalR&Dallocation,theequilibriumallocationina

decentralizedeconomy,andthewelfareimpactofchangingtheR&Dallocation.Toobtaintheoptimalallocation,wesolveacentralplannerproblem,givenby

subjecttotheeconomy’sproductionfunctionofinnovation,thegoods(sectoralandfinal)productionfunction,thetradebalance,andthelawofmotionofdomesticknowledge

it/qit=λln(10)

obtainedfromaggregatingtheinnovationuponallvarietiesvwithinasector.

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Thesolutiontothisproblemisgivenbyanallocationofproductionworkers{?it∝βiandanallocationofscientists

9=β9(11)

wheres=[sit]isthevectorofscientistshares,β=[βi]isthevectoroffinalgoodproduction

elasticities,Ω=[wij]isthematrixofspilloverelasticities,andX=[xij]arethesharesofdomestic

spillovers.Theoperator°indicatesaHadamard(orelement-wise)product,andξisascalingfactortoguaranteethat(s?)91=1(thetotalnumberofscientistsissetto1foreaseofexposition).

Incontrast,inadecentralizedeconomyequilibrium(i.e.,intheabsenceofanypolicyintervention)theallocationofscientiststoeachsectorisproportionaltothesector’sshareintotaloutput:1

s=β.(12)Notethisresultisintuitive:thisiswhatthesocialplanner’sallocationwouldlooklikeiftherewerenocross-sectorinnovationspillovers(i.e.,thetermΩ°X∝Isothatsectorsonlygetspilloversfromtheirowninnovation),oriftheplannerinfinitelydiscountedthefuture(p→∞),thusneglectingany

benefitsfromcurrentR&Dtofutureinnovation.

Finally,theconsumption-equivalentwelfareimpact(i.e.,theamountthatconsumptionwouldhavetochangetogeneratethesameimpactonwelfare)ofmovingbetweenanytwotime-invariantR&D

allocations,sayfroms0tos1,is

where,again,s?isthevectorcontainingthewelfaremaximizingallocation2andξthescalingfactorfromabove.Notethatthiscalculationcomparestotalwelfareundertwodifferentbalancedgrowthpaths(inducedbythedifferentdistributionsofR&Dresources).

C.IndustrialPolicy

TheoptimalallocationofR&Ddefinedabovecomesfromasocialplanner’sproblem,wheretheonlyconstraintstotheproblemaregivenbythephysicallimitationsofproductionfunctions.Assuch,thisallocationisnotafunctionofanyparticularpolicythatmightbeusedtoimplementit—aslongas

thegovernment’sgoalsarethesameastheplannerabove.

1SeeAnnexAforanexampleofadecentralizedequilibrium.

2Notethats?=argmax(s?)9×(lnx-lns0)s.t.x91=1.x

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Bearingthatinmind,westillshowthattheoptimalallocationcanbeimplementedbyagovernmentusingconventionalpolicies:inthiscaseanR&Dsubsidy.Weassumethatgovernmentscanchoosetherateofsubsidiesortaxestoinnovationinputs(scientistwages)ineachsector,withthe

governmentbudgetbalancedbylump-sumtransfersortaxes(seeAnnexAfordetails).“Industrialpolicy”referstoinnovationpolicieswithsubsidyortaxratesthatvarybysector,while“horizontalpolicy”referstopoliciesthatsetthesamesubsidyortaxratesforallsectors.

Anallocationofscientiststosectorscanbeimplementedviacombinationsofsector-specificsubsidies{σi}:

(14)

whereanegativeσirepresentsatax.

Theaboveimpliesthatasector-neutralsubsidydoesnotchangetheshareofscientistsinanysector;andbecausethetotalnumberofscientistsisfixed,asector-neutralsubsidydoesnothaveanyeffectontheaggregateamountofinnovationintheeconomy(anyresultingincreaseinthedemandfor

scientistsisoffsetbyacorrespondingincreaseinscientists’wages).Thus,onlythedistributionof

subsidies/taxesacrosssectorsmatters,nottheirlevel,and“horizontalpolicy”leadstothedecentralizedeconomyequilibriumdescribedabove.3,4

Inwhatfollows,weusethedecentralizedeconomyasabenchmarktoanalyzetheimplicationsof

varioustypesofindustrialpolicies.Intheabsenceofimplementationfrictions,thegovernmentusesindustrialpolicytomaximizevtandreplicatesthesocialplannerallocation.

D.ImplementationFrictions

Inreality,implementationfrictionsmaydistortgovernment’spolicies.Next,weextendthemodeltoconsidertwotypesofsuchfrictions.First,weallowforthepossibilityofpoliticalcapture,inthesensethatthegovernmentcanfavoralargerallocationofresourcestopoliticallyconnectedsectors.

3Thisalsomeansthatthecombinationofsubsidiesandtaxescanbesetsothatlump-sumtransfers/taxesarezerowithoutlossofgenerality.

4Inpractice,however,horizontalpoliciescanaffectaggregateinnovation.Thiscanhappenbothbyincreasingthesupplyofscientistsrelativetootheroccupations,orbecausedifferentsectorsmightbeexposedtostructural

fundamentalslikeeducationandinfrastructureondifferentdegrees.Thus,horizontalpoliciesthataffectthesefundamentalsmightstillhaveaneffectonthedistributionofinnovationacrosssectors.

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Second,governmentsmightsimplymakerandommistakesinimplementation.Inthiscase,thesectoralallocationisstilldistorted,butnotnecessarilytowardspreferredsectors.

PoliticalCapture.Let{φi,i=1indextheextentof“politicalclout”agivensectorhasanddenotebyθtheweightthatthegovernmentassignstopoliticalfavoritism.Thegovernment’s

objectivefunctionbecomes:5

Underthisobjectivefunction,thegovernmentstillcaresabouttheutilityoftherepresentative

consumer(whichweightseachsectorbyβi)butfavorshigheroutputinmorepoliticallyconnectedsectors.Theparameterθgovernstheextenttowhichthosesectorsarefavoredrelativetothesocialplanner’sweight(notethatwhenθ=0theobjectivefunctionrevertstothecasewithnopolitical

capture).Sincetheonlychangeintheproblemaretheweightsontheoutputofeachsector,theR&Dallocationthatmaximizesthisfunctionis

whereagainξpcisascalingfactor.Pluggingintotheresultsabove,theconsumption-equivalentwelfareimpactofapolicythatimplementsthisallocation(relativetonoindustrialpolicy)is

Mistakes.Implementationerrorsneednotbe“malicious”orserveulteriormotivestomisallocateresources.Consider,forexample,acollectionofrandomdistortions{ψiobjectivefunction

Aswithpoliticalcapture,thesedistortionschangetheoptimalweightsattributedtoeachsectorinthegovernment’sobjectivefunction,andθcontrolsthesizeofsuchmistakes.Bysymmetry,the

sameequilibriumconditionsaswithpoliticalcaptureapply,withψreplacingφ.

5FollowingLiuandMa(2023),defineC-(yt,p)=aC(c,c)s.t.yt—c=pc.SinceC(.)featuresconstant

ct,ct

returnstoscale,wecanre-writethemaximizedconsumptionaggregatorasC-(yt,p)=ytC*(p)forsomefunctionC*(.).Giventhelogarithmicpreferencesandthefactthatpistakenasgiven,maximizingtherepresentative

consumer’sobjectivefunctionvtisthesameasmaximizinge-P(s-t)lnysds.Pluggingintheproductionfunctionforyta