The Effect of Investment Tax Incentives: Evidence from China’s Value-Added Tax Reform

Abstract:     
We study the impact of investment tax credit on firm investment, utilizing China’s 2004 value-added tax reform pilot that introduces a permanent 17%-tax credit for firms’ fixed investment in six broadly-defined industries in the Northeastern region. Using 2000-2007 data from the annual Firm Census, we present compelling graphical evidence of a positive impact of the investment tax credit on eligible firms. In a difference-in-differences-in-differences framework, the estimated impact is positive and significant with an elasticity of 0.28. The results hold for existing firms, are stronger for small firms, and are robust to specifications that address the issue of firms’ anticipation of future tax change. Domestic privately owned firms, as well as state-owned enterprises, show positive and significant responses to the tax incentive with an elasticity of 0.25. Cash flow has a stronger impact on investment of private firms than SOEs. For private firms, those with lower cash flow are more responsive to the investment price reduction resulted from the tax incentive.

Number of Pages in PDF File: 54

Keywords: value-added tax reform, investment tax credit, firm investment, China

JEL Classification: H25, H32

working papers series