A Tax Plan for Endogenous Innovation

M.M. Croce, A.G. Karantounias, S. Raymond, and L. Schmid

Working Paper 2017-13
November 2017

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In times when elevated government debt raises concerns about dimmer global growth prospects, we ask: How can the government provide incentives for innovation in a fiscally sustainable way? We address this question by examining the Ramsey problem of finding optimal tax and subsidy schemes in a model in which growth is endogenously sustained by risky innovation. We characterize the shadow value of growth and entry in the innovation sector. We find that a profit tax is required to replicate the first-best in order to balance the externalities associated with innovative activity. At the second-best, the profit tax is designed to optimally respond to growth shocks above and beyond what is prescribed by the standard tax-smoothing incentives in economies with exogenous growth. The interplay of risk and innovation opens a new margin for optimal taxation.

JEL classification: E32, E62, H21, H63, O3

Key words: innovation, R&D investment, endogenous growth, government debt, labor tax, subsidy, profit tax

The authors are grateful to Marco Bassetto for his discussion. They are also thankful to Yongseok Shin for comments and to conference participants at the 2017 AEA Meetings in Chicago, the 2017 Econometric Society Meetings in St. Louis, the 2017 SED Annual Meetings in Edinburgh, the 16th Conference on Research on Economic Theory and Econometrics in Milos, and the 2017 European Economic Association Meetings in Lisbon. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.
Please address questions regarding content to M. M. Croce, Kenan-Flagler Business School, University of North Carolina at Chapel Hill, mmc287@gmail.com; A.G. Karantounias, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309-4470, 404-498-8825, anastasios.karantounias@atl.frb.org; S. Raymond, Economics Department, University of North Carolina at Chapel Hill, smr9@live.unc.edu; or L. Schmid, The Fuqua School of Business, Duke University, lukas.schmid@duke.edu.
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