Growth and Labor Reallocation : Vertical versus Horizontal Innovation

Labor reallocation is often regarded as an essential component of productivity growth, based on the thought that innovation is made by firms expanding to new business areas with better technology (horizontal innovation). I study the relationship between long-run growth and labor reallocation by introducing innovation made by incumbent firms previously operating in the product market (vertical innovation). I use novel data from a German establishment-level panel survey to distinguish innovation types from different survey questions about innovation activities and construct an endogenous growth model with different types of innovation to decompose the relative contribution of innovation types on long-run growth. I calibrate the model with the survey data merged with the administrative employer-employee matched data and use the calibrated model to quantify the aggregate effect of the Hartz reform (which increased labor supply and reduced labor market rigidity in Germany during the mid-2000s). I find out that vertical innovation that does not cause direct creative destruction accounts for more than 90% of productivity growth on the balanced growth path. Moreover, vertical innovation generates 85% of dynamic gains from faster productivity growth after the reform. Since vertical innovation has a smaller effect of reallocating labor inputs toward innovating establishments, despite the sharp increase in output growth, labor reallocation rates, especially job destruction rates, do not increase but decrease over the transition path