Innovation Dynamics and Fiscal Policy : Implications for Growth, Asset Prices, and Welfare

We study the equilibrium implications of different fiscal policies on macroeconomic quantities, asset prices, and welfare by utilizing two endogenous growth models. The expanding variety model features only homogeneous innovations by entrants. The Schumpeterian growth model features heterogeneous innovations: "incremental" innovations by incumbents and "radical" innovations by entrants. The government finances its expenditure stream by labor income and corporate taxes and supplies subsidies to household's consumption, to final goods firm's capital investment, and to investments in research and development (R&D) by entrants and, if applicable, incumbents. Regardless of the innovation structure, an increase in consumption subsidies induces lower economic growth resulting in sizable welfare costs. Differently, higher R&D subsidies induce higher economic growth alongside a welfare loss in the homogeneous innovation model. However, in the heterogeneous innovation model subsidies to incumbents are growth-enhancing and welfare-depressing, whereas subsidies to entrants lead to lower growth but higher welfare. Only higher capital investment subsidies lead to jointly higher growth and welfare in both innovation models. Fiscal policies should therefore prioritize the allocation of resources to capital investment