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Transforming China into an innovation-driven economy has been one of the top priorities of the Chinese Government. This paper examines the policy choices involved in the extended national innovation performance framework for creating an open innovation system. Innovation capabilities, incentives and institutional frameworks are examined. The paper argues that China should continue to increase its investment in R&D and in education, and that there should also be an attempt to strengthen the incentive system at the macro, meso and micro levels. This strengthening may include reforms to: release the power of competition and guide resources towards innovative sectors; adopt appropriate human resource management, such as appraisal and remuneration systems; create effective policies for research funding management; and evaluate the efficiency of research to encourage the creativity of researchers, managers and employees. The paper also discusses the space for industrial policy in the 21st century.The past decade has seen an exponential increase in research and development (R&D) investment in China. Developing an innovation-driven economy in the coming decades is a major objective for China. Although there are many research papers and government reports concerning national innovation capabilities in China, most of them address this problem using the national innovation system (NIS) approach (e.g. Chen and Liu, 2008; OECD, 2008; MOST, 2010;Wu, 2010;Mu and Fan, 2011). The NIS framework is powerful in mapping out the major players in the innovation system and allows policy-makers to identify the objects for policy intervention, but it does not explain how to increase the capabilities of players and strengthen the linkages between them. The question of how to enhance the innovation capabilities and performance of the country requires in-depth and systematic analysis.The present paper examines policy choices for the development of innovation capabilities in China using the national innovation performance (NIP) framework developed by the OECD (1987) andLall (1992), and modified and extended by Fu (2014). The importance of policy in enhancing national innovation performance vis-à-vis simply leaving it to the market is validated by several factors. First, given the nature of knowledge as a public good and the prevalence of externalities that may benefit other users of knowledge, government intervention is required to protect R&D investors and to encourage innovation activities. Second, innovation is risky and costly. Therefore, there is a need for government financial support to enable active innovation activities, especially in basic research where uncertainty is high, because it is difficult to control the direction of the development of a technology and the cost of failure of an experiment is high. Third, the presence of market failure caused by problems such as information asymmetries, externalities of knowledge and public goods also calls for policy intervention in information and knowledge provision. Finally, China is be...