Firm R&D, innovation and easing financial constraints in China: Does corporate tax reform matter?

This paper studies the relationship between firms' innovation activities, financial constraints and corporate tax reform in China. A firm-level proxy for financial constraints is derived using cash-flow analysis and subsequently linked to various innovation activities of the firm. As an identification strategy, difference in-differences with exact matching is employed to study whether a reduction in the corporate tax burden via China's 2004 value-added tax (VAT) reform influences firms' innovation activities given they face increasing financial constraints. The results reveal that low access to liquidity in the private sector has a persistent negative effect on firms' innovation activities and reduces the innovation success for more R&D intensive firms. Given increasing financial constraints, a reduction in private-sector firms' corporate tax burden spurs new product and process sales despite failing to affect either their decision to pursue R&D or the amount to invest. The findings suggest that easing financial constraints alone cannot correct the market failure caused by underinvestment in China's private sector. (C) 2016 Elsevier B.V. All rights reserved.