The innovation channel of fiscal consolidation

When preparing their medium-term fiscal adjustment plans to implement the new set of EU fiscal rules, EU Member States are facing a trade-off between the need to consolidate and the need to improve competitiveness and deploy innovation-enhancing fiscal policies. Over the past decades, public R&D spending evolved largely in line with economic activity among euro area member states, but displayed a high degree of volatility and was pro-cyclically cut during fiscal consolidation periods, both in absolute terms and in relation to total primary spending. Private spending, however, outpaced economic activity, though with large heterogeneities across euro area member states (see Figure 1a, b). Deeper integration in the euro area should have made capital more readily available to firms, but European business investments in R&D did not reach the levels of the United States (US), and China became a major competitor in the global arena.

Understanding the impact of fiscal consolidation on research and development is a crucial topic for the ESM because the choices affect market access, long-term growth, and fiscal sustainability – all linked to our role in crisis prevention and financial stability oversight. Hence, we examine how fiscal consolidation plans have caused more fragmentation in the euro area due to uneven cuts in public R&D spending and the varying capacities of private investments to offset reductions in public spending. We also suggest policy options to address this issue.

The innovation doom-loop: low R&D intensity and fiscal consolidation

During fiscal consolidation, countries with moderate R&D intensities have cut public R&D expenditure proportionally more than those leading in innovation. Fiscal consolidation led governments to prioritise immediate fiscal needs over long-term investment in innovation, particularly in countries with moderate innovation capacities.^[2] These countries, which were already lagging in R&D spending and innovation, thus entered a doom-loop, where a deeper innovation gap and further reduction of their competitive edge perpetuated low and decreasing R&D expenditure and innovation (see Figure 2a, b).

The private sector response exacerbated fiscal consolidation effects for less innovative countries. For highly innovative countries, the private sector appeared to be able to step in and reallocate resources efficiently, thus overall compensating for the lower level of public R&D investment. Less innovative countries displayed an opposite response, with private R&D investment decreasing following a consolidation episode, thereby contributing to a reduction in total domestic R&D expenditure.

The design of fiscal consolidation matters

The overall effect of fiscal consolidation on domestic R&D investment depends on the fiscal policy mix adopted. Expenditure-based consolidation does not seem to reduce domestic research, but rather tends to spur businesses to fill the gap left by the public sector in countries with high innovation potential. There the private sector response helps maintain overall R&D levels, thus supporting ongoing innovation activities. Contrastingly, tax-based consolidation, which raises taxes to balance budgets, directly reduces the resources available for businesses to invest in R&D. The higher tax burden dampens private investment, leading to a decline in overall R&D activities for all countries, those with moderate and high innovation potential (see Figure 3a, b).

Our analysis stresses the importance of the innovation channel of fiscal consolidation, which refers to the impact of fiscal policies on innovation activities. It also aligns with the literature arguing in favour of expenditure-based consolidation. Tax-based consolidation plans have been found to be associated with reduced growth in investment and decreased business confidence. ^[3] By focusing specifically on R&D spending, our results add another perspective to that literature, highlighting potential medium- to long-term consequences associated with the type of consolidation plan implemented. Expenditure-based consolidation tends to incentivise private innovation investment, thereby compensating for the cut in public innovation investment. Conversely, tax-based consolidation tends to weigh on both public and private innovation investment.

To conclude: R&D investment has been highly sensitive to fiscal consolidation, and failing to acknowledge how fiscal consolidation affects this crucial part of investment can fuel an innovation doom-loop. As this is particularly acute in less innovative countries, the innovation doom-loop can lead to divergence and fragmentation across the euro area. The medium-term focus of the new EU economic governance framework is conducive to breaking this vicious cycle. Consolidation strategies should prioritise expenditure-based adjustments, targeting spending types that are normally more rigid. This approach would preserve government investment and R&D spending and foster private sector investment to complement public R&D funding.

In the last months, the Eurogroup exchanged views on the nature of policies designed to boost competitiveness, both in the short and long term. At the same time, the European Commission has recently featured research and innovation as a high priority as part of the 2024–2029 political guidelines. Acknowledging and factoring in the interlinkages between R&D investment and fiscal policy design will be important in preserving long-term growth and fiscal sustainability, two core focus areas for the ESM.

Acknowledgements

The authors would like to thank Marialena Athanasopoulou, Giovanni Callegari, Rolf Strauch, Konstantinos Theodoridis and participants of an internal ESM seminar for valuable discussions and contributions to this blog post, and Raquel Calero for the editorial review.