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The innovation paradox of tax incentives: Evidence from China’s VAT reform

Author

Listed:
  • Yin, Sisi
  • Shen, Zuyi
  • Gao, Yunshu

Abstract

This paper develops a heterogeneous firm model to explain the relationship between tax incentives and firm innovation and analyzes the mechanisms that affect firm innovation. The model results show that tax incentives generate two effects: the cost reduction effect and the competition effect. Using China’s Value-Added Tax (VAT) reform and firm-level data, and employing the difference-in-differences approach for empirical analysis, we find that the VAT reform has a significant negative effect on firm innovation. The finding is subject to heterogeneity depending on firm productivity and trade liberalization in the industry. The mechanism analysis reveals that in China, the market competition effect covering the cost reduction effect leading to a decrease in firm innovation. At the same time, the non-innovation investment crowds out innovation investment, and the R&D investment of firms decreases.

Suggested Citation

  • Yin, Sisi & Shen, Zuyi & Gao, Yunshu, 2026. "The innovation paradox of tax incentives: Evidence from China’s VAT reform," Economic Analysis and Policy, Elsevier, vol. 91(C), pages 423-443.
    • Handle: RePEc:eee:ecanpo:v:91:y:2026:i:c:p:423-443
    DOI: 10.1016/j.eap.2026.03.008
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    Keywords

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    JEL classification:

    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • F12 - International Economics - - Trade - - - Models of Trade with Imperfect Competition and Scale Economies; Fragmentation
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
    • H25 - Public Economics - - Taxation, Subsidies, and Revenue - - - Business Taxes and Subsidies
    • O12 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Microeconomic Analyses of Economic Development
    • O31 - Economic Development, Innovation, Technological Change, and Growth - - Innovation; Research and Development; Technological Change; Intellectual Property Rights - - - Innovation and Invention: Processes and Incentives

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