Government spending composition, technical change and wage inequality



SBTC, or directed technical change (Acemoglu 1998 and 2002b, Kiley 1998).3 We also share with
endogenous technology models the following two other features: first, the idea that innovation is
profit-driven and that market-size is one key determinant of profitability; second, the exploration of
the ‘sources’ of the type of technical progress at the roots of the observed increase in the skill premium.

The present paper contributes to this literature by exploring a new source of technical change:
the technological composition of government spending. The other sources of endogenous bias of
technical change analyzed in the literature are the market-size effect produced by trade liberalization
(Dinopoulos and Segerstrom, 1999, and Acemoglu, 2003) and the market-size effect produced by an
increase in the relative supply of skills (Acemoglu, 1998, and, 2002b). Although our model shares
many features with Dinopoulos and Segerstrom (1999) version of the quality-ladder model there are
three original departures: first, on the theory side, the presence of heterogeneous industries allows
government spending to affect innovation and the skill premium. This is not obtainable by simply
introducing government spending into Dinopoulos and Segerstrom’s symmetric industries framework.
Second, as stated above, while their application focuses on trade liberalization as the source of technical
change and wage inequality, we examine the role of government spending. Third, our paper puts a
stronger emphasis on quantitative analysis (calibration and simulation). To our knowledge, this is the
first attempt to assess qualitatively and quantitatively the relevance of the fiscal policy channel in the
debate on technical change and wage inequality in the U.S. These two features represent the main
contribution of this paper to the literature.4

The paper is organized as follows. Section 2 presents the stylized facts on government policy
and wage inequality. Section 3 sets up the model. Sections 4 and 5 derive the main results and
explain the intuition for the macroeconomic consequences of asymmetric steady states. In section
6 we calibrate the model to match salient long-run facts of the U.S. economy and focusing on the
steady-state perform a quantitative evaluation of our theoretical mechanism. Section 7 shows the
transitional dynamics implied by our model. Section 8 concludes.

2 Stylized facts

In this section we provide some motivating evidence on the dynamics of public spending composition
and wage inequality in recent decades. First, we show how the shift in the composition of government
expenditure can be viewed in a context of an overall structural change in innovation policy. Second, we
discuss some descriptive evidence on the dynamics of public spending composition and on the increase
in the skill premium in the 1970s and 1980s.

Technology policy during the Cold War consisted primarily of funding for basic research, on the
one hand, and funding for applied research and development related to federal defense projects on the
other. As suggested by Branscomb and Florida (1998), the assumption that these activities would also
sustain economic competitiveness was derived from a supply-side picture of the commercial innovation
mechanism. On one hand, there was a consensus on the so called ‘pipeline model’, which conceives

3 Galor and Moav (2000) in section IV introduce endogenous technical change through human capital accumulation.

4 For a deeper discussion of these three different sources of the endogenous bias of technical change and their implica-
tions for wage inequality see Hornstein, Krusell, and Violante (2005).



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