We examine how a firm’s organizational complexity affects innovation portfolio decisions in response to a shock to innovation incentives. Using the 2013 medical device sales tax as a quasi-natural experiment, we find that firms with a complex organization structure, as proxied by organization size and multi-division structure, generate fewer radical innovations (introduction of new products) but more incremental innovations (improvements on existing products) after the tax. Multidivision firms also shift capital investment to their corporate divisions that are not affected by the tax, thereby decreasing their innovation output. Collectively, these responses cause a significant decline in the radical innovation output of the industry in aggregate. We contribute to the literature by advancing the understanding of how organization structure influences managers’ innovation portfolio decisions in response to economic shocks.

Introduction

Innovation is a key driver of firm performance and growth (Audretsch, 1995; Danneels, 2002). Incremental innovations, i.e. improvements on existing products, increase the profitability of firms while radical innovations, i.e. new products that create new revenue streams, fuel the growth of firms (Dewar & Dutton, 1986; Sheng & Chien, 2016). Since incremental innovations are less risky and offer returns in the short-term while radical innovations have high risk/return profiles and long-term horizons, most firms pursue multiple incremental and radical innovation projects simultaneously, referred to as the innovation portfolio of the firm (Klingebiel & Rammer, 2014; Nagji & Tuff, 2012). Managers routinely adjust their firms’ innovation portfolios to maintain an appropriate mix of incremental and radical innovations in line with their strategic goals and environmental circumstances. A major stream in the innovation literature examines how organization characteristics affect firms’ innovation portfolio choices (Christensen, 1997; Czarnitzki & Kraft, 2004; Damanpour, 1996; Hansen, 1992; Messeni Petruzzelli, Ardito, & Savino, 2018; Teirlinck, 2017). While established firms typically create more incremental innovations (Christensen, 1997), small and young firms are better at pursuing radical innovations (Henkel, Rønde, & Wagner, 2015).