Corporate tax asymmetries and R&D: Evidence from a tax reform for business groups in Japan

Economic theory dating back to Domar and Musgrave (1944, Quarterly Journal of Economics 58, 388-422) suggests that the tax treatment of gains and losses can affect incentives for firms to undertake high-risk investments. We take advantage of a 2002 tax reform in Japan as a natural experiment to test the theory. This tax reform introduced a consolidated taxation system (CTS). The CTS allows business groups to offset gains with losses across firms in their group. Thus, the CTS can mitigate disincentives to high-risk investments. Using information on R&D as the investment risk measures, we estimate dynamic investment models with unique panel data of Japanese firms between 1994 and 2012. For identification, we take an instrumental variable approach in a difference-in-differences framework or in a triple-differences framework. We provide evidence that the CTS increases R&D, in agreement with Domar and Musgrave (1944). We also find evidence that the CTS enhances risk-sharing across group members and across asset types. These findings suggest that mitigating tax asymmetries is an effective policy to help encourage both risk-taking and risk-sharing.