Europe’s growth outlook has weakened notably in the wake of the global financial crisis, and policy-makers are understandably preoccupied with achieving a near-term rebound. But sustained growth can only be achieved by also addressing the structural causes of low growth. One such element is Europe’s relatively low spending on research and development (R&D), which hampers innovation and productivity growth. This study sheds light on this shortfall by decomposing R&D spending along different dimensions. It shows that Europe’s underinvestment in R&D is unevenly distributed across countries, regions and sectors. Strong economic forces underpinning this differentiation imply that misdirected R&D policies could be highly wasteful. Another key finding is that, by its sheer size, the services sector accounts for a substantial portion of Europe’s lag vis-à-vis the United States in terms of both R&D spending and productivity growth. This points to a continuing need to foster competition and deregulation in this protected segment of the economy, if higher economic growth is to be achieved.