Three economists at the Luxembourg-based European Stability Mechanism warned of a significant risk of innovation divergence within the eurozone due to current fiscal consolidation efforts. According to a blog post on Tuesday 10 September 2024, by Silvia Calò and Robert Kraemer, senior economists, and Francesco Tomasone, consultant, the ongoing fiscal consolidation in the euro area is likely to exacerbate technological fragmentation if governments fail to preserve research and development spending.
R&D during fiscal consolidation
Fiscal consolidation involves policies aimed at reducing government deficits and debt levels, typically through a mix of spending cuts and tax increases. These measures can significantly impact long-term economic growth and innovation. The ESM report argues that maintaining R&D investment during these consolidation periods is essential for fostering sustained growth and maintaining competitiveness. Given the challenges posed by climate change, digital transformation and ageing population, adequate R&D funding is crucial. The covid-19 pandemic and the energy crisis have intensified fiscal pressures, leading to higher debt-to-GDP ratios and increased debt service costs, which have constrained governments’ fiscal flexibility, noted the ESM economists.
They argue that countries with lower R&D spending have tended to cut their R&D budgets more severely during fiscal consolidations compared to their peers. This trend creates a cycle where reduced public investment in R&D leads to decreased innovation capacity. The report highlights that when governments adopt revenue-based consolidations that increase the tax burden, this often undermines private sector R&D investments. Without sufficient R&D funding, less innovative countries may enter an “R&D doom-loop,” where declining innovation capacity results in further reductions in R&D spending, thereby increasing divergence within the euro area.
R&D and fiscal policies
The report differentiates between expenditure-based and tax-based consolidations. Expenditure-based consolidation focuses on reducing government spending, while tax-based consolidation involves increasing taxes to balance budgets. According to the ESM economists, expenditure-based consolidation generally does not reduce domestic R&D investment. Instead, it may encourage businesses to offset reductions in public funding by increasing private R&D investments. Conversely, tax-based consolidation directly reduces the resources available for private R&D, negatively affecting overall R&D activities across all countries, regardless of their innovation levels.
Innovation doom-loop
The concept of an “innovation doom-loop” is introduced to describe how fiscal consolidations impact countries with moderate R&D intensities. During consolidation periods, these countries often cut public R&D spending more drastically than nations with higher innovation capacities. This creates a worsening innovation gap, further decreasing R&D spending and competitive advantage. While highly innovative countries might see private sector investment compensating for reduced public R&D, less innovative countries experience a decline in private R&D investment following consolidation, which exacerbates the total reduction in R&D expenditure.
Policy recommendations
The economist trio advocated in the post for prioritising expenditure-based consolidation strategies to mitigate the adverse effects on R&D investment. Expenditure-based measures are seen as less detrimental to innovation, as they help preserve government investment in R&D and encourage private sector contributions. They stress the importance of recognising the link between R&D investment and fiscal policy design to support long-term growth and fiscal sustainability.
According to the ESM, recent discussions among the eurogroup and the European Commission underscore the need for policies that enhance competitiveness both in the short and long term. The commission has highlighted research and innovation as a priority in its 2024–2029 political guidelines. Recognising these interconnections is crucial for ensuring that fiscal policies do not undermine R&D investment, thereby supporting a more robust and competitive economic environment in the euro area.
Calò, Kraemer and Tomasone conclude that by maintaining a focus on R&D during fiscal consolidations, the eurozone can better navigate the challenges of technological change and global competition, ensuring sustained growth and reducing the risk of economic fragmentation.