The effect of tighter tax loss offsetting rules on firms' innovation: evidence from South Korea

Abstract

PurposeThis study investigates how the introduction of a stricter loss carryforward offset rule affects firms' innovation.Design/methodology/approachThis study investigates the overall impact of a Korean tax reform that introduced a tighter loss deduction through a difference-in-differences approach and regression discontinuity design.FindingsThis study finds that firms subject to the more restrictive tax loss offset provisions tend to file fewer patents than firms not subject to the provision. The authors further find that this effect is more pronounced for firms with high R&D intensity, more investment opportunities and weaker monitoring mechanisms.Research limitations/implicationsThe results of this study suggest that more restrictive loss carryforward provisions may deter firms from innovation. This study contributes to the literature on the impact of tax loss rules, the effect of tax policies on investments and the real effects of corporate taxation.Practical implicationsThis study sheds light on the debate of the consequences of a Korean tax reform. Specifically, the authors examine whether a stricter tax loss offset policy indeed dampens corporate innovation.Originality/valueThis study exploits a unique and infrequent exogenous tax policy change. The South Korean tax reform creates a treatment group of large firms that were affected by the tax reform, and a control group of small and medium-sized firms that were unaffected. This study takes advantage of this setting to examine the research question.