Can Investment Incentives Crowd Out Innovation? Evidence from China

We analyze the indirect effect of a fixed asset investment incentive on firm innovation by estimating the influence of China's value-added tax reform in 2004 using a difference-in-difference-in-differences approach. We find that the fixed asset investment incentive significantly reduces firm innovation. In a simple model, we show that the reduction could arise because some firms choose to upgrade their technology as a result of the investment incentive and advanced technology crowds out innovation. Consistent with the predictions, we find that this negative effect is evident in firms with intermediate-level financial constraints but not in firms with tight or loose financial constraints. Moreover, firms with intermediate-level financial constraints increase their fixed asset investments and technology costs after the reform, while other firms do not.