Firm R&D, innovation and easing financial constraints in China: Does corporate tax reform matter?

Abstract

This paper studies the relationship between firms’ innovation activities, financial constraints and corporate tax reform in China. A firm-level proxy for financial constraints is derived using cash-flow analysis and subsequently linked to various innovation activities of the firm. As an identification strategy, difference-in-differences with exact matching is employed to study whether a reduction in the corporate tax burden via China's 2004 value-added tax (VAT) reform influences firms’ innovation activities given they face increasing financial constraints. The results reveal that low access to liquidity in the private sector has a persistent negative effect on firms’ innovation activities and reduces the innovation success for more R&D intensive firms. Given increasing financial constraints, a reduction in private-sector firms’ corporate tax burden spurs new product and process sales despite failing to affect either their decision to pursue R&D or the amount to invest. The findings suggest that easing financial constraints alone cannot correct the market failure caused by underinvestment in China's private sector.