What is the role of innovation policy in an open economy and how does it interact with foreign competition? We address this question employing a new innovation-driven growth model with two large open economies at different stages of development, which admits endogenous technology gaps and varying degress of competition between countries. We examine the implications of the US Research and Experimentation Tax Credit, introduced in 1981, and alternative protectionist policies. Key findings are as follows: First, the tax credit generates gains over medium and long horizons. Second, protectionist measures generate large dynamic losses by distorting the firms' innovation incentives. Third, the optimal R&D subsidy decreases in trade openess. Fourth, the optimal unilateral import tariff is only positive for policy horizons shorter than a decade and becomes zero thereafter.

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25 November 2025

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Journal of Political Economy: Macroeconomics 2025

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DOI: 10.1086/740428

https://www.journals.uchicago.edu/doi/10.1086/740428

This Journal article is published under the centre's Trade programme.