Tax incentives don’t lead to crowd-out – increases overall innovation and enhances effectiveness.

The influence of tax reduction on enterprise innovation has received extensive attention. Against the background of supply-side structural reform, the Chinese government has issued a series of tax and fee reduction policies to reduce enterprise tax burden, improve enterprise innovation ability, and promote enterprise transformation and upgrading to realize high-quality development. Based on the perspective of supply-side structural reform, this paper studies the effect of tax reduction on enterprise innovation activities. Through empirical analysis, the following conclusions are drawn. (1) The positive impact of tax reduction on innovation outweighs the crowding-out effect, indicating an overall stimulating effect. (2) The incentive effect of tax reduction is manifested through the mitigation of financing constraints, the specialized division effect, and the added value creation effect. However, the “financing effect” of tax cuts exhibits channel heterogeneity. Tax cuts can effectively promote corporate R&D investment and innovation output by facilitating internal financing and equity financing, while debt financing channels display a persistent soft constraint. Moreover, the establishment of the “financing effect” is path-dependent for high-tech enterprises. (3) The policy of “additional tax deduction on R&D expenses” demonstrates the most pronounced incentive effect, while the impact of the “15% preferential tax rate” is not significant. The combined implementation of these two policy types exhibits a clear incentive effect on innovation and can enhance the effectiveness of each individual policy. However, there still exists a disparity between innovation input and output, indicating a mismatch.

Research and development (R&D) is a crucial part of technological advancement. The U.S. private sector has led the way in spending on R&D in recent years, which has led to policies designed to maximize innovation. As lawmakers are pushing to change the tax code regarding R&D, it’s first essential to consider whether this policy would have its intended effect.

R&D is how existing products are improved and new ones are created, driving innovation forward. While it can be crucial to innovation, R&D investment does not guarantee that projects will lead to new products; even if they do, market trends could shift before they ever make it to consumers.

To help mitigate this risk, governments often offer tax breaks for companies for their spending in R&D. Historically, companies could completely deduct R&D expenses from their corporate taxes in the United States. However, when looking for ways to reduce the 2017 Tax Cuts and Jobs Act deficit, Congress changed the rules to require deductions to be spread over five years in a process known in the tax code as amortization. A change that some have argued penalizes R&D investment.

In recent discussions over the tax code, there have been calls to reverse the changes made to R&D deductions to encourage more investment. Research suggests this policy may be effective.

The Tax Foundation found that tax credits increased corporate spending on R&D, with spending growing over the years. A review of the investment by companies in R&D found that in 1989, each dollar from tax credits led to between 35 and 93 cents of new research spending. By 2017, this had improved with each dollar from tax credits, leading to about four dollars of investment in R&D.

Other studies reinforce these findings. The study “Do Tax Credits Stimulate R&D Spending? The Effect of the R&D Tax Credit in its First Decade” examined how the tax credit impacted R&D spending from 1981 to 1991. The study used tax filing information to empirically explore how companies spent relative to the tax credits they claimed and where the money was spent. It found that tax credits led to a significant short-term increase in R&D spending. Overall, there is strong evidence that tax breaks for R&D research stimulate companies’ investment in R&D.