Whether tax incentives stimulate corporate innovation: empirical evidence based on corporate life cycle theory

LIU Shiyuan LIN Zhifan LENG Zhipeng

【Abstract】As China’s economy transitions from high-speed growth to the “new normal” stage of high-quality development, the pattern of economic growth is shifting from factor-driven to technology-driven, and innovation is increasingly becoming a decisive factor in promoting high-quality development. Due to positive externalities, the irreversibility of investments, high costs, high risks and uncertain return horizons, the corporate R&D investments of enterprises in a laissez-faire market often fall short of the social optimum. To solve this market failure, governments around the world usually resort to tax incentives to encourage R&D activities, but there is no consensus on the effects of these policies. With China’s reduction in taxes and fees, it is important to figure out how tax incentives affect corporate innovation. We proposed that the key to understanding the controversies in the literature lies in the moderating effect of the corporate life cycle. There are significant differences in the profitability, tax base, development goal, R&D capability and willingness of companies at different stages of the life cycle, so the effects of tax incentives on innovation should exhibit firm heterogeneity. To test this theory, we used the financial report data of Chinese listed companies and prefecture-level data from 2007 to 2016 to construct the forward-looking effective average tax rate for companies, which measures the tax incentives for investment. We then determined the corporate life cycle stages using the cash flow pattern method and empirically examined how tax incentives affect corporate innovation. Our results showed that tax incentives significantly promote corporate R&D investment, and tests using subsamples of firms in different life cycle stages revealed that the effect of the tax incentives is concentrated on firms in the mature stage, with the effects on companies in the growing or declining stages being insignificant. This phenomenon could be caused by the design of the current tax system, which favors companies in the mature stage, and by life-cycle differences in the investment strategies, innovation characteristics and financing conditions of companies. Further tests showed that the effects of tax incentives on R&D activities are more pronounced for private, high-tech and manufacturing companies in the mature stage but are insignificant for other types of companies. To overcome underlying endogeneity issues, we took the accelerated depreciation policy of fixed assets launched in 2014 as a quasi-natural experiment. This policy provides tax preferences for some industries, allowing us to identify the causal relationship between tax incentives and corporate innovation. The results of a difference-in-differences model are consistent with our main findings. In robustness tests, we substituted patent data as the dependent variable and found that tax incentives significantly increase invention grants for companies in the mature stage, suggesting an improvement in innovation quality. We found that the corporate patenting activities of firms in other life-cycle stages do not respond to tax incentives. Our results are robust to alternative measures of tax incentives, definitions of corporate life-cycle stages and methods for dealing with omitted variables and selection bias. We have made the following contributions. First, we extended the literature on this topic by integrating life-cycle theory into the discussion of the effects of tax incentives on corporate innovation. Second, in addition to using the forward-looking effective average tax rate to measure tax incentives, we provided a series of robustness tests for precise causal identification. Third, we conducted multi-dimensional tests according to the different corporate life cycle stages, ownership types and industrial attributes to uncover the heterogeneities in the effects of tax incentives on Chinese firms and discuss possible causes of the effects. We provided a reasonable explanation for the controversies in the literature and a reference for how to effectively encourage corporate innovation as China’s tax and fee reductions go into full effect. It is important to design tax policies that fit the characteristics of the different corporate life cycle stages and to adjust the current tax system to promote the construction of an innovative nation more actively and effectively.

【Keywords】 tax incentives; forward-looking effective average tax rate; corporate life cycle; innovation;


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Vol 55, No. 06, Pages 105-121

June 2020


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