developed countries (Estonia, Finland, Germany, Mexico, New Zealand and Sweden do not employ R&D tax incentives). Based on a general equilibrium model calibrated to US data, Acemoglu and colleagues (2013) caution against subsidization of all R&D activities based on the one market failure of underinvestment in R&D. In comparison to a relatively non-distorted business environment, they show that subsidies to incumbent enterprises (or equivalently higher exit costs) reduce growth, consumption and welfare: a subsidy to incumbent R&D equivalent to 5% of GDP reduces aggregate welfare by 1.5% in consumption equivalent terms because it deters entry of new high innovation-capacity firms. The policy has a negative selection effect, with an adverse impact on both incumbents and potential entrants, reallocating resources from more- to less-efficient enterprises since it directly helps only those firms that are near the lower end of the product quality/innovation distribution and at the exit margin, namely disproportionately low-productivity enterprises – further depressing innovation. Due to the importance of selection effects in their model, it turns out to be much better to support entry and incumbent R&D by freeing resources such as skilled labor from inefficient low innovation-capacity incumbents by taxing their operating costs or subsidizing their exit (or more realistically taxing all incumbents’ operating costs, leading the least cost-efficient ones to exit) than to subsidize entry or incumbent R&D directly. In addition, R&D subsidies may mainly increase the wages of inelastic inputs rather than innovation (Romer 2001 and Wilson 2009), and may be ineffective when other complementary investments such as basic science are not also in place and subsidized (Akcigit, Hanley and Serrano-Velarde 2012). In support of these views, recent OECD studies find no correlation between R&D tax incentives and TFP growth at the aggregate level (Westmore 2013) and a negative correlation in more R&D intensive sectors, with more generous R&D tax credits being associated with a higher share of stagnant firms and a lower share of shrinking firms, slowing down an otherwise more efficient reallocation process (Bravo-Biasca et al. 2012).

# **_IV.2 Supporting skills upgrading_**

Inappropriate reallocation and innovation decisions can have dire short and long-term impact on people. Enterprises worldwide together with education systems have not performed adequate investment and reallocation decisions given the persistence of the twin crises of a shortage of jobs and a shortage of skills: 75 million youth are unemployed worldwide, with young people three times more likely than their parents to be out of work, representing not only a huge pool of untapped talent but a long-term underinvestment in human capital and a source of potential social unrest and individual despair. In addition, half of youth are not sure that their post-secondary education has improved their chances of finding a job, and almost 40% of employers say a lack of skills is the main reason for entry-level vacancies (Mourshed et al. 2012).

As a second area of policy action, policymakers should support more knowledgeable and skilled risktaking by people within individual enterprises and as part of urban agglomerations. While a KBC focus invites a re-examination of the priorities of all types of government policies, perhaps the most important area concerns the importance of appropriate human capital policies, given that human capital underpins KBC. Appropriate policies that balance skills supply and demand become even more essential, as do the need for such policies to be even more demand-driven by the current and anticipated future needs of employers, with education/training curricula and apprenticeships that produce workers that enterprises want to hire supported by PPPs (Hulten 2013, OECD 2013). Key policy imperatives are to support 27