Government debt hurts innovation

Beginning with the Great Financial Crisis of 2007-2008, in many countries we have seen a massive escalation government debt. And in all likelihood, the sizeable investment programs launched to fight the effects of the Covid-19 pandemic will lead to another upsurge in government debt. Although it may stimulate short-term demand, many consider this debt buildup as a threat to the prospects of long-term growth. Over time, in fact, the debt consolidation process could lead to higher tax pressure and inflation rates. What’s more, the need to restore a balanced budget could bring with it greater uncertainty and growing political tensions and instability.

Among economists, there is a fairly broad consensus on the negative impact of government debt in the long term. In contrast, as of yet few studies have delved into the question how exactly debt affects the real economy. One factor that could prove critical is the cost of capital. As we can imagine, the higher the level of government debt, the greater the uncertainty investors feel and the less appetite they have for risk. This makes it more difficult for companies to raise capital, which in turn means they would need to guarantee investors a higher risk premium. But not all companies would be affected in the same way: the bigger innovators would be the hardest hit. In the long run, we would see less of a tendency toward innovation in the private sector, with negative fallout on overall growth.

To verify the impact of the debt level on both the cost of capital and economic growth, we conducted a study on around 6,000 listed firms in the US from 1975 to 2013. Our analysis focused primarily on the risk premium paid to investors by innovative and traditional companies respectively. The resulting data show not only that innovation-intensive firms are obliged to guarantee their investors bigger returns (with an average annual cost of capital 7.5% higher than traditional firms): the risk premium paid by innovative companies rises as public debt grows.

Lying at the root of this dynamic is the uncertainty associated with higher levels of government spending. In fact, rising debt fuels concerns about tax pressure in subsequent years and possible upticks in interest rates, making future cash flows less predictable. Innovation-centric companies and projects are especially impacted, as they base their value on temporary monopolistic rents which are volatile and intangible, such profits from patents. In a context of uncertainty, both investors and managers tend to shift their focus to more traditional initiatives involving tangible assets, which they perceive as less risky.

Our empirical analysis also allows us to quantify the cost of higher government debt both for innovative companies and for the economy as a whole. In fact, our findings reveal that the fiscal variable alone can explain as much as a third of the supplementary risk premium that innovators are forced to pay over traditional companies (2.5% in absolute terms). In the face of an increase in government debt from 60% to 100%, an innovation- or research-based project has to guarantee an expected return on average 1.6% higher on a five-year timeline to be considered justifiable by a manager.

Even though the difference might seem negligible, in reality at an aggregate level the effect of raising the bar on innovation investments is anything but: the loss in aggregate growth deriving from missed opportunities for innovation is estimated at 4% of the GDP, again on a five-year timeline. So higher government debt not only generates negative fallout on levels of innovation and the national economy overall; the repercussions are substantial in quantitative terms as well.

Although public spending might seem like a valid approach for buffering against exogenic shocks in the short term, governments should reflect carefully before embarking on this path. The long-term repercussions on the national economic system are extensive, particularly with regard to levels of innovation.

A determinant factor is the uncertainty that higher debt engenders surrounding future fiscal policy: concerns that tax pressure might intensify tomorrow lead investors to ask for a higher risk premium today. This is especially applicable for initiatives and projects that are perceived as particularly risky, i.e. when they involve more intense innovation and research and development.

To prevent this type of dynamic, governments should take advantage of periods of economic growth to pursue debt reduction programs. Equally critical is to promote fiscal policy that convinces investors, and looks solid and secure even in the long term. Through these “prudential austerity” initiatives, farsighted governments will be able to face unexpected future crises with more room to maneuver and less impact on innovation processes, compared to nations overburdened by out-of-control debt.