How do investments in innovation translate into future productivity growth? Empirically answering this question is challenging. R&D spending is an observed input into the innovation process, but mapping it to productivity growth requires assumptions about the depreciation of R&D capital, gestation lags, and how well such expenditures capture true innovative effort (Hall, 2007). Patents, an alternative measure, capture successful innovations but vary widely in novelty (Kelly et al., 2021) and economic value (Kogan et al., 2017). Firms may forgo patenting to preserve secrecy, while others patent strategically to protect existing products even when their underlying innovations are marginal.
A second challenge is at least as important: accurately measuring real output growth. Innovation often raises quality by introducing new products or improving existing ones, but conventional output deflators may not fully capture these improvements — biasing measured TFP growth downward in innovative industries. As emphasized by Griliches (1979, 1994) and Hall, Mairesse and Mohnen (2010), estimates of the returns to innovation hinge on how well deflators capture quality change.
In this short article, we show in an empirically relevant setting how correcting TFP mismeasurement meaningfully strengthens the estimated relationship between industries’ past innovation efforts and their subsequent productivity growth. The TFP corrections come from our recent work arguing that PPI-based deflators miss important quality improvements for high-tech manufactured goods (Atalay et al., 2025). There, we show that replacing producer-facing price indices with consumer-facing indices, the latter of which incorporate richer hedonic adjustments, increases implied manufacturing TFP growth by approximately 0.7 percentage point per year, with little impact on TFP growth outside of manufacturing. Using this corrected measure, we find the slope of the relationship between productivity growth and past investments in innovation is roughly twice as large as that obtained using uncorrected TFP. These results are consistent across different measures of innovation, time horizons, and industry definitions.
View the Full Working Paper