Conclusions: A Framework for Innovation Policy

Abstract

In the previous chapters, we have discussed the future challenges faced by the European welfare states, in particular Sweden. We have also presented the theoretical and empirical foundations for a restructuring of innovation policies in order to handle an uncertain and demanding future. The issue at stake is how well-equipped countries will cope with a novel competitive landscape, characterized by transformations to abate and adapt to climate change, escalating geopolitical tensions paired with an (as it seems) intensified use of state aid and subsidies, new digitized instruments, and the emergence of platform firms. Even though the world seems to have entered a stage of deglobalization, more and more countries have become integrated into the world economy over the last decades. Several of these countries are resolutely and systematically building up their knowledge bases, with a long-term perspective, increasing their innovation capacity and developing their business sectors. These changed circumstances make innovation imperative and warrant new and distinct policy strategies that strengthen the incentives to engage in risky, often experimental, endeavors to deal with these challenges.

In the previous chapters, we have discussed the future challenges faced by the European welfare states, in particular Sweden. We have also presented the theoretical and empirical foundations for a restructuring of innovation policies in order to handle an uncertain and demanding future. The issue at stake is how well-equipped countries will cope with a novel competitive landscape, characterized by transformations to abate and adapt to climate change, escalating geopolitical tensions paired with an (as it seems) intensified use of state aid and subsidies, new digitized instruments, and the emergence of platform firms. Even though the world seems to have entered a stage of deglobalization, more and more countries have become integrated into the world economy over the last decades. Several of these countries are resolutely and systematically building up their knowledge bases, with a long-term perspective, increasing their innovation capacity and developing their business sectors. These changed circumstances make innovation imperative and warrant new and distinct policy strategies that strengthen the incentives to engage in risky, often experimental, endeavors to deal with these challenges.

The growth models and the ensuing prescriptions that have dominated both Swedish and international economic thinking have not lived up to the high expectations that they originally engendered. This is evidenced by the slowdown in economic performance in virtually all mature economies. Throughout this book, we have argued that an important explanation emanates from a major flaw in knowledge-driven growth models. In these models, it is assumed that investment in education, research, and development will more or less automatically be transformed into new business models, products, processes, and firms. The fact that sufficiently strong economic incentives, aligned across all relevant actors, are also required for knowledge to be developed into innovations and welfare-enhancing benefits is neglected—or completely ignored—in these models. An important lesson is that without appropriate incentives, even the most advanced knowledge risks being left unutilized.

A strategy for greater innovation—a more creative country—must, to simplify somewhat, be based on two pillars: First, the capacity to build and upgrade an internationally competitive knowledge base; second, the institution of policies that ensure effective mechanisms for transforming knowledge into valuable goods and services through commercialization. If these two conditions are not in place, the probability of producing innovations diminishes. This impairs the capacity to establish new and growing firms, raise investment, boost value added, and increase employment.

Once again, we want to emphasize that innovation policy involves not only R&D and seed financing for new businesses. Nor does innovation concern advanced technology alone—it embraces all goods, services, and organizations, regardless of industry or technology level. Countries should aim to be successful both in terms of skills and well-functioning, dynamic markets for basic and personal services as well, not least in education, health, and social care.

Do our policy conclusions in this chapter differ from those of previous commentators? Obviously, there are overlapping components. But compared to the proposals of our colleagues, our approach is broader and focuses on incentive structures and driving forces for creating an environment that fosters innovation and the entrepreneurial effort necessary for any innovation to attain its full potential. These incentive structures must be well defined for both private and government actors. Today, there are shortcomings in this regard, especially among public actors.

The ways in which countries and regions prioritize across initiatives vary significantly, but several of our proposals work well in many other countries as well. Institutional competition has been increasing, which is likely to have real economic effects. The United States emphasizes entrepreneurship and “cut-throat capitalism,” while European countries often focus on more traditional business policies and “cuddly capitalism” (Acemoglu et al. 2017). Within the EU, there is some coordination of research policies and measures for a better functioning internal market. Several countries have also introduced substantial tax subsidies for research-intensive activities. Israel is one example of a successful cooperation between the government and the business sector to strengthen early-stage supply of risk capital and encourage entrepreneurship and innovation. It was preceded by several policy failures before the appropriate constellation was found (Avnimelech and Teubal 2006). China is investing massive resources in R&D and has managed to sharply increase its patenting activity. But as far as we know, no country has prioritized measures for knowledge transfer in the broad sense as systematically as we are proposing here, in particular measures to strengthen incentives for all relevant actors to transform knowledge into social benefits through innovative entrepreneurship and/or intrapreneurship. We believe adopting such a broad approach is particularly important for small open economies.

6.1 The Use of Frameworks for Key Policy Areas

Since the 1990s, it has become popular to talk about “frameworks” for different policy areas. This has been inspired by the successes of the monetary and fiscal policy frameworks that have played a central role internationally as well as in Swedish macroeconomic policy since the crisis of the 1990s:

• In monetary policy, the Riksbank (Sweden’s central bank) has a price stability target (interpreted as two percent inflation) together with a secondary target, namely, to support growth and employment insofar as this does not threaten the inflation target. Its primary tool is the repo rate, which is set after transparent, recorded debate on the Riksbank’s Executive Board. The Riksbank’s activities are evaluated by, among others, its Finance Committee and now also regularly by external assessors.

• There is a surplus target in fiscal policy which stipulates that the consolidated government sector should have a surplus of one-third of one percent of GDP over the business cycle.¹ The goal is motivated by a perceived need for building a buffer against rising costs because of future social changes (e.g., aging) and unexpected economic disturbances. It is combined with a debt anchor, implying that the consolidated governmental debt cannot exceed 35% of GDP. The fiscal framework also includes a ceiling on central government expenditure and a requirement that local government budgets be balanced annually. Additionally, the framework stipulates that the government budget contain an account of how the surplus target will be met. Fiscal policy is evaluated partly by the parliament and partly by a special expert body, the Fiscal Policy Council.²

When these goals and the frameworks for achieving them were set, they were far from uncontroversial, and they are still debated. Monetary policy had experienced an experimental period as the inflation target was not met, which triggered vivid debate and seems to have lowered confidence in the Riksbank. In fiscal policy, there was controversy surrounding the surplus target itself and its effects, but also about how it was to be defined (annually or over the business cycle, with or without a capital budget for public investment, and so forth).

While the monetary policy framework has been more heatedly debated, the success of the Swedish fiscal policy framework is extraordinary. Government debt is below the ceiling despite the recent crises, expenditure has been kept below the stipulated level, and budget deficits have been on target. This stands in stark contrast to most other EU countries, which have failed to exercise similar budget discipline despite the Maastricht conditions prescribing a debt ceiling of 60% of GDP and budget deficits not exceeding three percent of GDP.³

Both frameworks are based on quantitative targets using a special set of policy tools according to a set schedule, which are tractable and transparent. Still, this is considerably more complicated in other areas. New frameworks may therefore be more politically and analytically controversial than existing successful macroeconomic frameworks.

At the same time, it is important to affirm that long-term growth is not created by the establishment of a certain level of government spending or by an independent central bank with an inflation target. Continued prosperity presupposes above all that ideas—innovations broadly defined—can be implemented in the form of new firms, renewal of incumbent firms, new products, new ways of organizing production, and new markets. Macroeconomic stability must therefore be combined with microeconomic dynamics fueled by policies that incentivize the relevant agents to create and act on opportunities, aiming at increasing innovation capacity and the forces of creative destruction.

Consequently, there are reasons to implement a clearly defined framework governing innovation policy as well in order to achieve long-term credibility and transparency. However, such a policy must be able to handle a myriad of conceivable situations of different characters and magnitudes, and in which knowledge and information are spread across a large number of actors. This means that the policy must, as far as possible, be general and ensure that competitive neutrality prevails both among domestic actors and between domestic and foreign actors.

A general policy does not preclude targeting specific sectors or issues under certain circumstances, notably when there is a market failure. Problems can arise as a result of information gaps or asymmetries regarding, for example, the commercial potential of an invention, when economies of scale risk leading to monopolies, or when oligopolistic structures make it hard for innovative firms to enter the market. When there is reason to expect significant societal externalities even if firms or innovative endeavors fail, taking measures to rectify the situation, such as specific policies, is a justifiable course of action.

With the approach we are advocating—a micro-based, evolutionary approach—it goes without saying that it will be much more difficult to identify a number of clear-cut quantitative targets or a few unambiguous tools and transparent methods to evaluate how well the innovation policy framework performs. The arsenal of tools will be larger and not as rigorously defined as for macroeconomic policies. The policy instruments suggested by our approach can also have political and redistributive consequences in more areas than a change in the repo rate, to cite one example.

6.2 An Innovation Policy Framework

Before we outline our policy recommendations, let us briefly recapitulate the theoretical and empirical arguments in favor of an innovation policy framework. In Chap. 2, we identified and discussed at some length the shortcomings of the current mainstream knowledge, or endogenous, growth models. Instead, we argued that research in the vein of Schumpeter’s thinking and that of the evolutionary growth school is more fruitful and provides better guidance for policy. It highlights the conditions and opportunities at the micro level, i.e. how individuals and firms facing genuine uncertainty exploit new and existing knowledge for innovation, but also the heterogeneity and variety of these environments. One key notion in this research is that knowledge and skills are decentralized across markets and spread over a large number of individuals and firms. This situation requires appropriate institutions that harmonize the incentives of the different types of actors with complementary competencies. The key differences between the so-called neo-Schumpeterian growth models and the view we advocate are summarized in Fig. 6.1.

Fig. 6.1

The key difference between the neo-Schumpeterian view and our view. Source: Adapted from Henrekson et al. (2023)

Empirical research in the field of innovation has shown, among other things, that:

• Relatively few firms demonstrate any extensive innovation activity, broadly defined. Most small businesses are not, and do not see themselves as, entrepreneurial, and the distribution of R&D expenditure is heavily skewed; in Sweden, firms with more than 250 employees account for approximately 75% of R&D and the ten largest firms account for roughly 50%.⁴ The proportion of Swedish firms with up to ten employees that have any R&D activities at all is far below one percent. Swedish industrial R&D is thus heavily concentrated to a few large firms.

• Access to cash flow and equity, a high equity-to-debt ratio, and access to a well-educated workforce are crucial for firms aiming to pursue sustainable innovation initiatives. As discussed in Chap. 1, patenting in Sweden exceeds both the EU and OECD averages, paralleled by increased access to early-stage financing over the last decades. This coincides with an increase in Swedish entrepreneurship (Thulin 2023).

• Innovative firms have three to five times as many employees with several years of post-secondary education, often belong to a multinational firm, and are generally classified as high-tech or medium-high-tech. They are usually internationalized. The connections seem to work in both directions: More innovative firms are more involved in international trade, while trade generates learning as well and contributes to a higher capacity for innovation (Fassio 2022). In other words, international knowledge sources, connectivity, and competition are important drivers of innovation and productivity.

• The cost of adopting new technology can be significant. Skills are also required to import and adapt technology developed by others. Replicating technology can generate costs that amount to as much as 65% of the original development expense. Likewise, the transfer costs of technology between firms or units in a firm can amount to 25% of the original outlay. If the recipient does not conduct significant R&D in-house, absorption capacity suffers, further increasing transfer costs (Mansfield et al. 1981).⁵

• R&D and innovation efforts make a clear impact on firms’ productivity and competitiveness (Griffith and Van Reenen 2021). Private return is high, and the productivity effects are significant. Companies with a sustainable innovation strategy have—compared with other similar firms—about ten percent higher productivity and two percent higher productivity growth (Martinsson 2010).

• The success of university-based innovation depends on which pedagogy and which system are implemented. For example, students play a much more significant role in establishing new firms than university-employed researchers—at least ten times more, according to several studies. In addition, several studies indicate that up to 80% of start-ups are located close to universities, and that there is positive feedback between these entrepreneurs and universities. They are therefore important for cluster formation and agglomeration.⁶ Nevertheless, most innovation efforts at universities are directed towards researchers rather than students.

Based on this view of how the economy works—decentralized knowledge, the combination of individuals and ideas with the surrounding institutional environment—we would like to summarize our analysis, all the associated analytical and political difficulties notwithstanding, in what can be called a framework for innovation policy. This framework focuses on the two main tasks presented above: to build and gather knowledge, and to disseminate and commercialize that knowledge.

The purpose of the main recommendations we make is to anchor innovation policy in a few fundamental principles in order to foster a long-term perspective and transparency. The policy recommendations can in turn be divided into two categories: those that are declarations of intent, and those that should be codified in legislation. Although the Swedish economy is our point of departure and reference case, we argue that our recommendations are, on the whole, applicable to most other countries.

6.2.1 Build and Assemble Knowledge

The first pillar of our proposed framework—a globally competitive knowledge base—is based on the following recommendations:

• 1. Sweden should, based on international knowledge assessment, set quantitative targets for Swedish students’ performance in the TIMSS and PISA assessments. As shown in the OECD study The High Costs of Low Educational Performance (OECD 2010) and in research showing that results in these assessments are strongly associated with economic growth (Henrekson and Wennström 2023; Heller Sahlgren and Jordahl 2023), there are major gains to be made in social welfare if primary and secondary school education is improved.

• 2. Based on best practices experience elsewhere, universities and colleges should use the pedagogical methods that have been shown to have the greatest effect on innovation and entrepreneurship. This means, among other things, involving students more directly in innovation and entrepreneurship initiatives, which also has a positive effect on regional development and cluster formation.

• 3. Resources for research and innovation should be distributed according to quality criteria to a greater extent, while university autonomy should be strengthened. This would clarify the often obscure and even counterproductive incentive structures currently in place at institutions of higher learning.⁷ Universities should themselves be able to choose which IPR regime they prefer to adopt (professor’s privilege, where ideas are owned by faculty, or a Bayh–Dole type system where the IPR belongs to the universities). This is likely to stimulate deeper collaboration and more diverse relationships with the business sector. A university’s basic funding should be partially tied to its accomplishments with respect to innovations and the commercialization of ideas.

• 4. Research and innovation proposals in parliament should be supplemented with a more long-term “statement of intention” regarding government research initiatives, with a possible horizon of ten to 12 years. One version of this was introduced in Sweden approximately ten years ago and has created greater predictability and confidence in research and innovation policy among both business and academia, which is important for the planning and location of both companies and individuals. Based on the Swedish experience, we recommend that other countries follow suit.

With the exception of the second recommendation, these proposals could be decided by parliament and codified in law. A mandatory report on future research investment plans (comparable to reports on infrastructure investment plans) must of course be subordinated to the fiscal policy objectives, but it is nevertheless central to the long-term perspective.

6.2.2 Dissemination, Innovation, and Commercialization of Knowledge

Our second pillar concerns the transformation of knowledge into innovation. Here we choose to highlight the following recommendations:

• 5. There are strong tendencies to advocate for over-regulation of the economy. To the greatest extent possible, only effective and socially justified regulations should be introduced. Therefore, a Better Regulation Council should be established for the submission of regulatory proposals and incisive analyses of the direct and indirect consequences of new regulations. These Councils should also have the authority to block regulations that entail large socio-economic costs. In specific cases, the Council’s decision could be revoked by a qualified parliamentary majority. This should be complemented by a “sunset” clause: regulations that are not used or become obsolete should be repealed. Authorities should be required to periodically review their regulatory frameworks and propose simplifications and streamlining.

• 6. Labor market mobility, particularly among highly skilled workers, has been shown to have a positive impact on innovation (Kaiser et al. 2015; Braunerhjelm et al. 2020) thanks to better matching and improved knowledge networks. Policies should therefore facilitate mobility of employees across organizations and from salaried employment into entrepreneurial occupations. This entails streamlining different social security systems such that social insurance entitlements and workplace-related benefits become fully portable when changing employers or labor-market status.

• 7. Competition is an important driver of innovations. Prerequisites for well-functioning competition are informed customers and the weeding out of substandard goods and services. In regular markets, this happens in the course of day-to-day transactions—firms that deliver inferior quality go bankrupt in the long run. In markets for tax-financed social services, this control mechanism is not operative. Deregulation, customer choice models, and competitive neutrality therefore require other forms of monitoring, follow-up, and control. Today, the Swedish Competition Authority is the supervisory agency for laws on public procurement, freedom of choice and competition, and the possibilities for monitoring the public sector have been expanded. The Competition Authority, or another appropriate agency, should also be made responsible for monitoring and control of quality and customer information, combined with credible and financially sensible sanctions of public services. Moreover, the global platform firms that have emerged recently may pose a threat to long-run market entry and innovation; this must be counteracted by appropriate measures.

• 8. To a greater extent, the government should provide digital infrastructure, information, and statistics which can be used by private actors to build companies and create innovations. The government should not attempt to establish its own services. Simultaneously, the government has a responsibility to protect individual integrity.

• 9. Tax systems must be structured from the perspective of entrepreneurship and innovation. Three measures should be prioritized: Stock options should be taxed as capital gains according to the model described in the previous chapter; highly progressive income taxes should be avoided; and equality should apply between debt- and equity-financed activities. The tax system must avoid lock-in effects for potential venture capital, and direct government support should be restricted to the earliest investment phases. Owner-level taxes need to be adjusted to the level of competitor countries. Increased mobility of firms, entrepreneurs, and talent serves as motivation for an independent agency to regularly provide a transparent benchmark analysis to position the country in relation to other relevant economies.

• 10. Knowledge dissemination, innovation, and productivity are promoted by regional expansion, geographic density, and cluster effects. Dense and knowledge-intensive environments also have greater fiscal viability. The innovation policy framework should therefore aim towards strengthening existing or emerging clusters through labor market, housing, and infrastructure policies. In the Swedish case, this means larger regional units than today’s county councils, with greater decision-making powers.

Of these six recommendations, the first three and parts of the tax proposals are more suitable for consolidation into law, while the others are declarations of intent. Finally, imposed policies should be subject to regular, independent, evaluations of their effects, followed by modifications in the design of policy measures if deemed necessary.

Thus, our framework is based on ten innovation policy principles, four of which can be classified as support for knowledge reinforcement and knowledge building and the rest for the transformation of knowledge into innovations, new and growing firms. Implementation and credibility require that several of these (at least seven out of ten in our assessment) be concretized in legislation. Innovation policy should also be prioritized by top political leadership. As there is reason to believe that current attitudes towards entrepreneurship and innovation are influenced by the existing regulatory framework, a clearer policy in this area is likely to contribute to positive indirect effects that are reflected in a more positive view of entrepreneurship.

Regarding more direct investment of public funds to strengthen research (except for university research as discussed above) or innovation—where the guiding principle should be that the social return is estimated to significantly exceed the private economic return due to large positive externalities—there is no reason to further define what this may be. Public investment will vary from time to time and across projects. They may concern areas where countries, according to well-defined criteria, can develop international excellence with significant future potential or more large-scale projects where pilot facilities may be necessary (for example, in the fields of climate, environment, and energy), where public initiatives can contribute to increasing Sweden’s attractiveness (for example, making data available), or where clear system weaknesses have been identified. Such interventions should always be time-limited and continually evaluated.

6.3 An Innovative and Inclusive Society

Finally, we would also like to emphasize that the above-mentioned proposals for reorienting and institutionalizing innovation policy only cover the areas we consider to be the most significant. At the same time, we emphasize the importance of entrepreneurial and innovative efforts in all sectors: the bureaucrat who quietly reorganizes her department and provides better service; the forester who develops new methods for felling and pulping wood; the mining engineer who develops a better method of refining ore; the principal who reorganizes his school so that students become more knowledgeable—they and other hard-working colleagues are as important, and can be at least as creative as, any art director, event organizer, or industrial designer.

Our prioritized areas can of course be questioned, but our starting point is that knowledge and knowledge transformation are crucial for modernization, economic growth, and prosperity. In addition, there are a number of other measures that are also important but which either fall within the scope of the above recommendations or do not really carry the same weight. The list could be made longer, but we refer instead to Chaps. 4 and 5 for our more detailed proposals.

We realize, of course, that not all of these proposals may be implemented at once. Conflicting targets vis-à-vis other policy areas are in some cases significant. But as a gross list and a comprehensive program for more innovative and entrepreneurial economies, we consider it important to present them in their entirety. Overall, these concrete proposals address the challenge of influencing society’s basic attitudes and values—to create a more innovative and entrepreneurial economy. There is thus no shortage of information here for the innovative and entrepreneurial politician. And continued sustainable growth, high welfare levels, and societal prosperity are rooted in continued innovative efforts.