How Protectionism Poisons Innovation

In March, US President Donald Trump tweeted that “when a country (USA) is losing many billions of dollars on trade with virtually every country it does business with, trade wars are good, and easy to win.” US policy has reflected that sentiment: thus far this year, the United States has slapped tariffs on goods imported from the European Union, Canada, Mexico, Turkey, and China.

But protectionism has dire consequences for long-term economic growth, warn University of Chicago’s Ufuk Akcigit, Sina T. Ates of the Federal Reserve Board, and University of Nottingham’s Giammario Impullitti, who find that protectionist policies discourage innovation by domestic companies, and thereby hamper growth.

“When you close your borders, you’re removing the international competitive pressure on your firms, so they don’t need to upgrade their technologies anymore,” says Akcigit. “As a result, they don’t need to invest that much in R&D, and that’s why you have less innovation in the longer run and less economic growth in the long run.”

Akcigit and his colleagues looked back to the 1980s, when protectionist pressures were mounting as an earlier rising power, Japan, among others, was making inroads into industries US firms once dominated, such as automobiles and electronics.

US companies that enjoyed almost monopolistic power over certain markets, in some cases because World War II decimated foreign competitors, had become complacent. Between 1975 and 1985, the ratio of non-US patents to total patents doubled, while the US’s share of patent applications slid from 70 percent to 55 percent.

“Unlike in the debate today, concerns over US competitiveness in those years led to the introduction of a set of demand- and supply-side policies explicitly targeting incentives for innovation,” the researchers write.

“Economic growth is determined by new technologies, and new technologies are introduced by firms that have incentive to produce new technologies.”

—Ufuk Akcigit

So, instead of outright protectionist measures, President Ronald Reagan and Congress included in the 1981 tax law a targeted and ambitious investment tax credit. (Some of its provisions were rolled back the following year, but important incentives remained.)

The researchers mined a rich data set that showed how US companies responded over more than 30 years. Indeed, the Reagan-era tax credit set off a boom in investment and technological innovation that paid dividends to the US economy for decades to come.

“Upon these policy changes, aggregate R&D intensity of US public firms showed a dramatic increase,” the researchers determined. “Increasing R&D subsidies during periods of accelerating foreign competition proves to be an effective response to foreign competition, while raising trade barriers generates only small welfare gains in the short run at the expense of substantial losses in the long run.” Akcigit points out that furthermore, when trade partners retaliate against trade barriers, even the small and temporary welfare gains those barriers generate disappear and are replaced by substantial welfare losses.

“You can just close the borders and certainly protect your domestic industries from foreign competition. Or you can say, ‘Hey, I’m going to let my firms compete internationally, but given that they are being challenged at the moment, I’m going to support them,’” Akcigit says. “‘I’m going to provide R&D support. And that way I make them more competitive at the international scale.’

“Economic growth is determined by new technologies, and new technologies are introduced by firms that have incentive to produce new technologies,” he adds.

We must look to these incentives, the researchers argue, not to artificial trade barriers, in order to help domestic companies overcome challenges from foreign competitors. In so doing, we can not only encourage innovation that will drive growth, but also preserve the wealth created by trade.

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