Innovation Union: Costs and Benefits of Innovation Policy Coordination

Abstract What is the scope for international cooperation in innovation policy in economies closely integrated via trade? We address this question by building a two-region innovation-driven growth model with endogenous technology diffusion via FDI. We use the model to analyse R&D subsidy cooperation in the EU, which has a common trade and monetary policy but where a coordinated innovation policy is still in its infancy. Stark differences in innovation capabilities between the West (old member states) and the East (new member states) shape optimal policies. Western countries have higher R&D efficiency and serve as primary sources of knowledge spillovers, through FDI-driven technology transfer. Cooperation is driven by two factors: correcting distortions from subsidy competition, the strategic motive, and leveraging intertemporal knowledge spillovers that sustain growth. A coordinated policy involves substantial subsidies for the West and taxes for the East, reflecting the West’s superior R&D efficiency and role as a key source of knowledge spillovers. Both regions experience welfare gains, primarily by internalising cross-border spillovers. We find strong complementarity between innovation and FDI subsidies, showing that jointly supporting knowledge creation and diffusion yields greater benefits than implementing each policy in isolation.