R&D tax breaks are often offered to businesses to encourage innovation. This column uses evidence from a tax reform in China to study the relationship between tax enforcement and firm innovation. Lower taxes improve both the quantity and quality of firm innovation, and have a bigger impact on those firms that are either financially constrained or those that engage more in tax evasion.

Innovation has been increasingly recognised as the main engine for economic growth (Romer 1990, Aghion and Howitt 1992, Aghion et al. 2014). To escape the middle-income trap, China’s government launched various policies to stimulate R&D activities (Chen et al. 2018). But we know very little about the impact of such policies on firm innovation and the underlying mechanisms (Ufuk et al. 2018, Djankov et al. 2011).

Theoretically, taxes can have either positive or negative impacts on firm innovation. On the one hand, lower taxes can increase the after-tax profit of firms, so that they have better capacity to invest in new technologies or products. Moreover, lower taxes may reduce the resources that firms spend on tax evasion, such as the costs of bribing tax officers, which can be instead used on innovation activities. On the other hand, lower taxes may also have a negative impact on innovation because they decrease government revenue, and in turn may reduce government spending on public goods such as research, education, and infrastructure. As a result, whether providing tax incentives can improve firm innovation is ambiguous.

In a new study, we investigate the impact of taxes on firm innovation using a natural experiment in China (Cai et al. 2018). In November 2001, China implemented a tax collection reform on all manufacturing firms established on or after January 2002, which switched the collection of corporate income taxes from the local tax bureau to the state tax bureau. After the reform, similar firms established before or after 2002 could pay very different effective tax rates because of the differences in the management and incentives of those two types of tax bureaus. Figure 1 shows that the reform changed the enforcement of tax collection, resulting in a reduction of effective corporate income tax rates by almost 10% among newly established firms. Since firms registered before 2002 were not affected by the reform, the policy change created exogenous variations in the effective tax rate among similar firms established before versus after 2002. We can thus apply a regression discontinuity design (RD) and use the generated variation in the effective tax rate to identify the impact of taxes on firm innovation.

Figure 1 Effective tax rate by firm birth month

Note: This figure is based on data in the year 2007 and compares the effective tax rate paid by firms established before and after the policy change. Birth month of firms established in January 2002 is normalised to 0.

To test the impact of taxes on innovation, we combine a comprehensive dataset of all medium and large enterprises in China between 1998 and 2007 with patent data from the State Intellectual Property Office (SIPO), including all patents applied in China by the year 2014. We use the data to measure three dimensions of innovation activities – input (R&D expenditure and skilled labour ratio), output (number of patent application), and quality (type and characteristics of patent application).

Our analysis yields several interesting results. First, we show a strong and robust causal relationship between tax rate and firm innovation. Decreasing the effective tax rate by one standard deviation (0.01) increases the average number of patent application by a significant 5.7% (see Figure 2 for the graphical evidence). The reform also stimulated R&D expenditures and increased the skilled-labour ratio by 14%. Second, a lower tax rate also improves the quality of patents. The impact of tax reform on patent applications mainly comes from its effect on invention and utility patents – decreasing the effective tax rate by one standard deviation improves the probability of having an invention patent application by 4.4% and increases the number of utility patent applications by 4.7%. This suggests that the improvement in innovation outcomes is not merely driven by the low-quality design patents. We also use the detailed information on patent applications as proxies for the patent quality, including number of claims, number of independent claims, and the amount of effort that was spent on the patent application (length of the application document, number of figures, and length of abstract). In our patent data, only invention and utility patents have the above information, and results suggest that a reduction in the tax rate significantly improved patent quality, and the effect is significant for both invention and utility patents.

Figure 2 Number of patent application by firm birth month

Note: This figure is based on data in the year 2007 and compares the number of patent applications (weighted by firm size) by firms established before and after the policy change. Birth month of firms established in January 2002 is normalised to 0.

Furthermore, we try to study why firm innovation is affected by the tax reform. We test two potential mechanisms: the financial constraint channel and the tax evasion channel. First, we test whether reducing the tax cost can help by alleviating financial constraints, and firms can use the money saved to carry out innovation activities. Under a neoclassical framework, if R&D expenditure is fully deductible, the tax rate should not affect innovation, since it does not change the after-tax marginal benefit and cost of innovation. However, when the financial market is incomplete or inefficient and a firm mostly relies on its own after-tax profit, a lower effective tax rate could affect innovation investment. We use interest payment as the proxy for the degree of financial constraint and provide suggestive evidence that a low tax rate can stimulate firms’ innovation by alleviating financial constraints.

Second, in principal a lower effective tax rate could also release resources that firms spend on tax avoidance, which firms can in turn use on innovation. To test this potential channel, we follow Cai and Liu (2009) to measure the tax evasion activity and find firms that are doing more tax evasion can release more resources for innovation.

Our study contributes to the existing literature in several ways. First, while there are a growing number of papers studying the impact of taxes on firm decision-making, we are among the first to analyse the effect of corporate taxes on firm innovation in China. More importantly, we are the first to look at the impact of changes in tax enforcement rather than explicit tax reduction on firms’ innovation behaviour. Second, our study also contributes to the literature on tax enforcement. The tax-to-GDP ratio is substantially lower in poor countries compared with developed countries. One important reason for low tax revenue is weak tax enforcement. We add to this literature by showing that the management and incentives of tax collection agencies play an important role in the tax enforcement and the tax capacity of a country.