Can Investment Incentive Crowd Out Innovation? Evidence from China

Abstract

We analyze the spillover effect of a fixed asset investment incentive on firm innovation by estimating the influence of China’s value-added tax reform in 2004 with a difference-in-difference-in-differences approach. We find that a fixed asset investment incentive significantly reduces firm innovation. In a simple model, we show that the reduction could arise because some firms choose to upgrade their technology given the investment incentive, and the upgrade crowds out innovation. Consistent with the predictions, we find that this negative effect is evident in firms with intermediate-level financial constraints but not in firms with tight or loose financial constraints. Moreover, firms with intermediate-level financial constraints increase their fixed asset and intangible asset investments after the reform while other firms do not. Innovation is a major economic growth driver with positive externalities. Thus, investment incentives may lead to some unintended consequences.

Keywords: Innovation; investment tax credit; fixed asset investment; financial constraint

JEL Classification: O31, O32, G31