Industrial Policies for Innovation: A Cost-Benefit Framework

IMF Working Papers, August 16, 2024

Source details

Research question: When and how should governments use industrial policy to direct innovation to specific sectors?
Core contribution: Develops a framework to analyze the costs and benefits of industrial policies for innovation.
Basis: Framework built on a model of endogenous innovation with a sectoral network of knowledge spillovers (Liu and Ma 2023), extended to capture implementation frictions and alternative policy goals.
Authors and date: By Daniel Garcia-Macia, Alexandre Sollaci — August 16, 2024.

Model features:
- Endogenous innovation.
- Sectoral network of knowledge spillovers (Liu and Ma 2023).
- Extensions to capture implementation frictions and alternative policy goals.
Policy instruments compared:
- Sector-specific fiscal support.
- Sector-neutral support.

Conditions under which sector-specific support is preferable:
- Externalities are well measured (example given: greenhouse gas emissions).
- Domestic knowledge spillovers of targeted sectors are high (typically in larger economies).
- Administrative capacity is strong (including the ability to avoid misallocation to politically connected sectors).
Sensitivity to unmet conditions:
- If any of these conditions are not fully met, welfare impacts of industrial policy quickly become negative.
Optimal allocation insights:
- Entails greater subsidies to greener sectors.
- Cross-sector knowledge spillovers matter for optimal allocation.

Finding: Existing industrial policies seem to be directing innovation to broadly the right sectors.
Caveat: Direction is to an excessive degree in most economies, including China and the United States.

Prefer sector-specific fiscal support only under restrictive conditions:
- Accurate measurement of externalities (e.g., greenhouse gas emissions).
- High domestic knowledge spillovers in targeted sectors.
- Strong administrative capacity to implement and avoid political misallocation.
Where conditions are not met:
- Sector-neutral support is generally preferable given risk of negative welfare impacts.
Design principle:
- Allocate greater support to greener sectors while accounting for cross-sector knowledge spillovers.