Scholars currently have a limited understanding of the role of R&D tax credit in developing countries. To help fill this gap, this article examines the allocation logic and innovative consequences of R&D tax credit in China. Using a panel data set of listed companies in China from 2010 to 2012, we show that the local institutional contexts, such as government transparency, market development, and industrial policies, promote the allocation of R&D tax credit. The fiscal capacity of local governments constrains the implementation of tax credit policy. Furthermore, this article estimates the causal effect of R&D tax credit on firm innovation. We find that R&D tax credit significantly increases firms’ innovative input and output. The results are consistent and robust using various specifications. Yet the stimulation effect is heterogeneous across industries and scale. R&D tax credit only evidently promotes innovation in manufacturing firms and large firms.

Introduction

R&D tax credits and subsidies are two most popular instruments for governments to support R&D activities (Hall and Van Reenen, 2000). As a horizontal policy with market-oriented features (Czarnitzki et al., 2011), tax credit apparently calls more applause from the practitioners of advanced economies. However, the effectiveness of tax credits is not guaranteed in any institutional contexts. The institutional context is vital for innovation efficiency (Guan and Chen, 2012). Previous studies have mainly focused on developed economies, with little evidence offered for developing and emerging countries (Zúñiga-Vicente et al., 2014). For instance, research shows that R&D tax credits can stimulate firm innovation in OECD countries (Bloom et al., 2002), the United States (Paff, 2005; Wu, 2005), Japan (Kobayashi, 2014) and Canada (Czarnitzki et al., 2011). As tax administration plays a crucial role in effective state institutions (Bird and de Jantscher, 1992), developing countries face great challenges in the establishment of efficient and effective tax systems, and have a limited capacity of tax administration (Tanzi and Zee, 2000). Therefore, the impact of R&D tax credits on innovation investment and performance in developing countries are quite suspicious (Crespi et al., 2016). Developing countries may have distinct allocation mechanisms of R&D tax credits. As the biggest developing country, China provides an appropriate and unique setting for examining the allocation mechanisms and policy effectiveness of R&D tax credits. China has experienced a great boom in R&D input and output in the past decades. Despite the substantial market transition, the political institution in China is still centralized (Xu, 2011).