Non-technical summary of ESM Working Paper 75:
The innovation channel of fiscal space

This study explores how government fiscal room to manoeuvre —known as “fiscal space”— affects spending on research and development (R&D), which is crucial for innovation and long-term economic growth. The authors look at a group of OECD countries and show that when governments have less fiscal room, they tend to cut back on R&D spending. This is particularly true in countries that are already less innovative, making it even harder for them to catch up with more advanced peers. 

The paper highlights that fiscal consolidation—measures taken to reduce government deficits, such as spending cuts or tax increases—often results in lower public investment in R&D. These cuts are more severe in countries with weaker innovation performance, while innovative countries are better able to maintain R&D spending, and their private sector can sometimes even increase investment when public support is reduced. 

Importantly, the type of fiscal consolidation matters. Tax-based adjustments (raising taxes) have a more negative impact on overall R&D spending than expenditure-based adjustments (cutting spending). Tax hikes tend to reduce business investment in R&D, which is a key driver of technological progress. This means that the way governments choose to restore fiscal space can have lasting effects on their country’s ability to innovate and grow. 

The authors warn of a “doom loop” for less innovative countries: tight fiscal space leads to R&D cuts, which in turn slow innovation and economic growth, making it even harder to rebuild fiscal space in the future. They argue that policymakers should design fiscal consolidation plans carefully, preserving R&D investment to avoid widening the innovation gap and undermining long-term competitiveness.