Notching R&D Investment with Corporate Income Tax Cuts in China

We analyze the effects of a large fiscal incentive for R&D investment in China that awards a lower average corporate income tax rate to qualifying firms. The sharp incentives of the program generate notches, or jumps, in firm values, and vary over time and across firm characteristics. We exploit a novel link between survey and administrative tax data of Chinese firms to estimate investment responses, the potential for evasion, as well as effects on productivity and tax payments. We find large responses of reported R&D using a cross-sectional “bunching” estimators that is new in the R&D literature. We also find evidence that firms relabel administrative expenses as R&D to qualify for the program. We estimate an intent-to-treat effect of the policy on R&D investment of 18.8%, and find that 45% of this response is due to evasion. These effects imply user-cost-elasticities of 2 for the reported response, and 1.14 for the real response. We utilize the panel structure of the data to estimate the effect of the program on firm productivity, and find an increase of 1.6% for targeted firms. These estimates are crucial ingredients for designing policies that trade-off corporate tax revenue with future productivity growth.