Innovation and Trade Policy in a Globalized World

What is the role of innovation policy in an open economy, and how does it interact with foreign competition? Our analysis adopts a new innovation-driven growth model with two large open economies at different stages of development, admitting endogenous technology gaps and varying degrees of competition. We examine the US Research and Experimentation Tax Credit and alternative protectionist policies. We find that the tax credit generates substantial welfare gains over medium and long horizons; protectionist measures generate large dynamic losses by distorting firms’ innovation incentives; the optimal R&D subsidy decreases in trade openness; and the optimal unilateral import tariff is positive only for horizons shorter than a decade and zero thereafter.