Tax incentives alleviate costs for small businesses – that’s key to innovation.

Innovation serves as a fundamental catalyst for enhancing corporate value and driving overall economic growth (Solow, 1957; Wu et al. 2023). However, many companies exhibit hesitancy towards investing in innovative projects due to their prolonged gestation period and inherent risk of failure. As a result, governments employ a range of public policy incentives to encourage enterprise innovation. Diverging from direct R&D subsidies, tax cuts represent a more comprehensive policy instrument aimed at alleviating financial constraints (Bloom et al. 2002). Specifically, tax cuts primarily aim to reduce the cost of user capital for targeted companies, thereby stimulating R&D investment (Mukherjee et al. 2017; Bloom et al. 2019). In this context, we comprehensively review the current state of research on China, focusing on the following three aspects.

The first strand of literature examines the efficacy of tax cuts in stimulating innovation activities. Emerging economies, facing financial market distortions and challenges in intellectual property systems, encounter significant obstacles to effective management. Consequently, the function and effectiveness of tax cut schemes in these economies differ from those in developed nations (Al Fozaie, 2023; Ivus et al. 2021). The response of Chinese enterprises to tax cuts, as revealed in studies (Han and Kung, 2015; Chen, 2017; Zhang et al. 2018), demonstrates a notably positive attitude compared to their counterparts in other countries (Maffini et al. 2019; Ohrn, 2019; Rao, 2016; Yagan, 2015). Moreover, the government relies on tax incentives as a means to implement national directives, emphasizing technological upgrading and fostering the innovation sector (Wei et al. 2017).

The second strand of literature focuses on the underlying mechanisms through which tax cuts impact innovation. Firstly, tax cuts effectively address the positive externalities associated with R&D activities by lowering costs and expediting resource inflows (Cappelen et al. 2012). This, in turn, incentivizes firms to increase their R&D investments and stimulates enterprise innovation through general equilibrium effects (Lerner and Wulf, 2007) or investments in human capital (Akcigit et al. 2016; Yang et al. 2012). Secondly, tax cuts foster firm innovation by reducing the tax burden on businesses. By diminishing the minimum capital requirements for firms (Jones and Williams, 1998) and lowering the required return on investment in R&D activities for investors (Atanassov and Liu, 2020; David et al. 2000), tax cuts enable enterprises to allocate resources more effectively towards new technologies or products. Thirdly, lower taxes can reduce the resources that companies allocate to tax evasion, thereby redirecting these resources toward innovation activities.