Notching R&D Investment with Corporate Income Tax Cuts in China

Abstract

We study a Chinese policy that awards substantial tax cuts to firms with R&D investment over a threshold or “notch.” Quasi-experimental variation and administrative tax data show a significant increase in reported R&D that is partly driven by firms relabeling expenses as R&D. Structural estimates show relabeling accounts for 24.2 percent of reported R&D and that doubling R&D would increase productivity by 9 percent. Policy simulations show that firm selection and relabeling determine the cost-effectiveness of stimulating R&D, that notch-based policies are more effective than tax credits when relabeling is prevalent, and that modest spillovers justify the program from a welfare perspective. (JEL D22, D24, H25, O14, O32, P31, P35)

Effects of Industrial Policy on Firms’ Innovation Outputs: Evidence From China

“…Prior studies focus on the valuation impact of industrial policy (Barbieri, Di Tommaso et al, 2021; Calder, 1995; Chang et al, 1998; Chen, Li et al, 2017; Eaton & Grossman, 1986; Etzkowitz & Leydesdorff, 2000; Rodrik, 2004). Five-Year Plans are increasingly used to measure industrial policy for China and is proven to play positive roles in firm financing (Deloof et al, 2022; Chen, Li et al, 2017), foreign direct investment (Li et al, 2022), productivity (Chen, Feng et al, 2022; Chen, Liu, Suárez Serrato, et al, 2021), and corporate tax avoidance (Geng et al, 2021). The significant positive effects of industrial policy on firm innovation activities indicating industrial policy can help alleviate the negative externalities in carrying out innovation activities for firms (Schumpeter, 1934) and somewhat overcome market failure.…”

“…The sample period ends in 2020, the ending year of the 13th Five-Year Plan. To construct our sample, following Chen, Liu, Suárez Serrato, et al (2021), the samples are processed as follows: (1) financial institution observations are removed; (2) ST firms are removed; (3) firms with negative rights and interests of enterprise owners are removed; and (4) firms with missing values in key variables (e.g., total assets, age). To eliminate the impact of outliers, 1% data is trimmed in year-industry pair.…”

The Role of Tax Incentives in Innovation Policies: theoretical considerations and recent developments

“…The leading downside is a possible low elasticity of R&D spending with respect to the reduction of tax costs due to a possible crowding-out effect (Hall and Van Reenen, 2000), although recent empirical analyses did not find evidence of such shortcoming (Czarnitzki and Hussinger, 2018). Additionally, the tax break may not induce an increase in R&D spending if firms report other activities or expenditures as R&D, as suggested by the relabeling argument (Chen et al, 2018). Another drawback is the potential conflict of interests: public money should preferentially finance projects with high levels of knowledge spillovers; companies, on the other hand, would rather develop technologies with higher rates of appropriability and internalized returns (Hall and Van Reenen, 2000).…”

Tax Incentives, R&D Manipulation, and Corporate Innovation Performance: Evidence from Listed Companies in China

“…They do not apply to cases in which the samples of the treatment and control groups are not randomly distributed in a pre-extraction point system. The bunching approach uses the distribution curves observed in reality to conduct high-order nonparametric estimation to obtain counterfactual curves [28,29]. As a new empirical method, this method has achieved good results when dealing with a prebreakpoint system, such as the progressive individual income tax system, the retirement system, and Medicare [30][31][32].…”